Value Investing

Economies Of Scale: An Analytical Framework For Assessment Of A Firm’s Competitive Advantage

Economies Of Scale: An Analytical Framework For Assessment Of A Firm’s Competitive Advantage

March 8, 2016

by Baijnath Ramraika, CFA and Prashant K. Trivedi, CFA

“The moat in a business like our auto insurance business at GEICO is low cost. I mean people have to buy auto insurance, so everybody’s going to have one auto insurance policy per car basically, or per driver. And…I can’t sell them twenty…but they have to buy one. What are they going to buy it on? They’re going to buy it based on service and cost. Most people will assume the service is fairly identical among companies, or close enough, so they’re going to do it on cost, so I gotta be the low cost producer. That’s my moat. To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat.” – Warren Buffett[1](emphasis ours)

In our previous article in our series on sustainable competitive advantages, we identified six distinct sources of competitive advantages. This article focuses on one of those sources: economies of scale.

Economies of scale: A widely discussed framework

“Economies of scale“ is possibly the most widely discussed of the competitive advantages. A Google search returned a mind-boggling 48 million results. So, what is the meaning of economies of scale?

Here is how investopedia defines economies of scale: “Economies of scale is the cost advantage that arises with increased output of a product. Economies of scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost because these costs are shared over a larger number of goods. Economies of scale may also reduce variable costs per unit because of operational efficiencies and synergies.“

The basic tenet is that the cost per unit declines as output increases. The lower cost per unit is largely driven by the presence of fixed costs within the business’s cost curve. Figure 1 shows the concept of economies of scale by plotting the cost per unit in relation to the production volume.

Figure 1: Economies of scale; Declining costs with increasing output

Economies of scale

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