In the last three parts of this series, we explored how to identify companies with strong cost leadership that have have can generate great shareholder value. In Part 1, we talked about how why cost leadership is a crucial area for the stock picker, and in Part 2, how effectively managing operational costs is crucial for businesses to become cost leaders. Part 3 spoke of how companies can become low cost producers; we now conclude this series by looking at how they can achieve economises of scale and economise of scope resulting in a sustainable competitive advantage.
The journey towards becoming a Low-Cost Producer by achieving economies of scale, is much like how a tree that grows taller and wider over time, gaining more ability to reach the sunlight and withstand the winds. It is a strategy that companies use to grow stronger and more resilient in their market. It refers to the cost advantages a company can achieve by increasing production volume. In simpler terms, as the volume of production increases, the cost per unit of production decreases.
Let’s look at Maruti Suzuki which is India’s larger car manufacturer. Maruti Suzuki has managed to maintain its cost leadership through vast economies of scale. With its massive production volumes, the company has been able to spread fixed costs over a larger number of units, reducing the per-unit cost. This advantage allows them to offer vehicles at competitive prices, thus bolstering their market share. It’s not just about the production cost; Maruti’s economies of scale also extend to procurement. Due to its large order volumes, the company can negotiate better prices with its suppliers, translating to lower material costs. They even launched their own insurance to keep the savings from the massive auto insurance policy purchases in house.
Economies of scale also allow Maruti Suzuki to invest heavily in research and development, helping them stay at the forefront of innovation. This emphasis on R&D has enabled Maruti to lead in terms of fuel efficiency, a crucial selling point for the Indian consumer, thus strengthening their market dominance.
Similarly, Reliance has effectively leveraged economies of scale in its various businesses, particularly in its refining and petrochemical segments. With some of the largest and most complex refineries in the world, RIL enjoys significant cost advantages.
But it’s not just the size; it’s about how you use it. For RIL, it has been about continuously investing in technology and innovation to enhance operational efficiency, increase output and produce higher-value products. This continuous drive to expand and improve has kept RIL ahead of its peers.
These examples demonstrate that economies of scale can provide significant competitive advantages. But it is essential to note that achieving economies of scale requires careful planning and execution. Companies must balance the benefits of increased production with the risk of overexpansion, which could lead to inefficiencies and increased costs. It’s a delicate balancing act, much like a tree ensuring it does not overgrow its capacity to sustain its own weight.
If economies of scale are about growing taller and wider like a tree, economies of scope are about growing varied branches, each reaching out to different areas, yet drawing from the same core. Economies of scope occur when the production of one good reduces the cost of producing another related good. This concept is a compelling reason behind the diversified nature of many Indian conglomerates.
Take the case of the Tata Group: the group’s diversified nature, with businesses ranging from steel and automobiles to tea and IT services, is a perfect illustration of economies of scope. Their diversified operations enable them to leverage shared resources across businesses, achieving cost efficiencies and enhanced value propositions.
For instance, Tata Motors can collaborate with Tata Steel for its raw material requirements, potentially benefiting from cost efficiencies. Similarly, Tata Consultancy Services (TCS) can offer IT services across the Tata Group companies, leading to synergies and cost savings. Tata Group’s wide range of businesses allows it to cross-sell and bundle products and services, thereby enhancing customer value and boosting revenue. This strategy has been particularly effective in their automotive and financial services segments.
Building economies of scope is extremely challenging because managing a diversified portfolio requires exemplary strategic foresight, effective coordination, and seamless information flow across businesses. Without these, the benefits of diversification can quickly turn into a liability. Very few can pull it off like the Tatas, Mahindras or Reliance, with a coherent and relentless business strategy.
Caselets for Economies of Scale and Scope
In addition to Maruti, we can anchor this article by reflecting on the following case lets.
- Amazon: A prime example of economies of scale. It utilizes its massive distribution network to reduce per-item shipping costs, and its huge customer base allows it to offer products at competitive prices.
- Walmart: Another titan leveraging economies of scale. Walmart uses its purchasing power to get goods at lower prices from suppliers, passing on savings to customers and thereby increasing market share.
- Reliance Industries: A multifaceted giant in India that capitalizes on economies of scope across its different sectors like petrochemicals, telecommunications, and retail. Its supply chain, infrastructure, and technological capabilities are shared across divisions for cost advantages.
- Tata Group: A diversified conglomerate that takes advantage of economies of scope through its businesses in steel, IT, automobiles, and consumer goods, among others. Each subsidiary leverages Tata’s core competencies, infrastructure, and resources for cost savings and efficiency.
- Google: Shows economies of scale in its search advertising model. The cost of serving an additional ad diminishes as the number of served ads increases, allowing for significant margin expansion.
- Toyota: Utilizes economies of scope by platform sharing among its various brands. One design of a car model can be slightly altered to create a new product under a different brand, saving design and production costs.
- Samsung: Achieves economies of scale in semiconductors, and economies of scope by expanding into various electronics and appliances. Its core technologies are adapted for products ranging from phones to refrigerators.
- Unilever: Demonstrates economies of scope with its wide range of consumer products. Shared marketing strategies and distribution channels among different product categories lead to cost savings.
These real-world examples provide a tangible understanding of how both economies of scale and economies of scope can be successfully leveraged for competitive advantage. They serve as food for thought for those considering the strategic pathways to cost leadership.
In this four part series, we have examined the mechanics of how companies can forge a sustainable competitive advantage through economies of scale and economies of scope. Just like a tree, which must strategically grow to reach the sunlight and withstand storms, companies must grow in a calculated manner. Whether it’s Maruti Suzuki’s effective scaling to keep per-unit costs low or Tata Group’s successful leveraging of scope to create synergies among diversified sectors, the underlying principle is one of smart, scalable growth.
To achieve this, companies that we prefer to invest in, must need not just resources but also relentless focus, innovation, and strategic planning to achieve economies of scale and scope. This is not merely about growing bigger; it’s about growing smarter. While scaling has its merits, overextension (saddled with high capex costs) can be as damaging as underdevelopment (not achieving optimal costs). It’s this precise balance that companies must strike to achieve long-term shareholder value and market dominance.