Economies of scale is the single most important competitive advantage that a company can possess in its market. Economies of scale is achieved when a company can progressively lower its costs as more and more products are produced. Said another way, the more customers you have for a product or service, the more you can spread fixed costs to each customer which lowers the total cost of each product. It follows then that the types of business that most benefit from economies of scale are those that have very high fixed costs as opposed to high variable costs.
So why are economies of scale the most durable competitive advantage available? Imagine you own the only grocery store in town, for years it is profitable, and everyone seems to enjoy going to it. One day a new grocery store opens across the street and begins taking market share. Should you, the owner, panic and sell the store immediately? No of course not. Assuming the new grocery store is not much more efficient and does not have much better selection or technology, your store will always win because you can spread your fixed costs across your large customer base while your competitor cannot. So, if there is a price war you will always win and even before that you will always have lower prices than your competitor.
Ok, what does this have to do with Amazon and Berkshire Hathaway? Amazon’s entire business has been and always will be about scale. I present to you the world’s most famous napkin:
This is Amazon’s business model in nutshell, drawn in the late 90s by Bezos himself. Note that the inside of this reinforcing loop can be applied to almost any retailer that has ever existed. Amazon’s real special sauce though, is the way that it lowers cost structure by investing in scale and then uses that scale to lower its prices. Investing in scale means building fulfillment centers, hiring software engineers and doing whatever it takes to own the entire value chain. Crucially, this investment in scale means that it is harder for competitors to replicate Amazon’s value proposition because, as we’ve seen before, investing in high fixed costs businesses mean that you must have enough customers to be able to spread those costs until it reaches a reasonable per unit level. Since Amazon’s second main organization focus is customer service, they are hoping it would be very hard for competitors to get enough eCommerce customers to get those fixed costs down to a competitive level. So, this is the principle behind everything that Amazon does. AWS? Scale. Prime Video? Scale. And so on. You might be wondering, if Amazon keeps entering these extremely high fixed cost businesses, how do they get enough customers to make it work? The answer is Amazon Prime. Amazon is the new grocery store that also gives you everything else in the town for free. So now if you are the owner of the old grocery store in town, you're not just competing with the new store, you're competing with everything else the town has to offer bundled into one. That's how they get around the scale problem and that's how they can keep on entering tough, scale intensive, industries and succeed.
Submitted August 29, 2020 at 08:37PM by InvestingExplained https://ift.tt/3lvLDCv
