Background
We’ve all grown up hearing that size matters. That bigger is better.
But rarely did I hear people talk about the different types of big.
In business, there are two main types of size advantages: economies of scale and economies of scope.
Today’s post will be an overview of each, how they are different and how you can use this knowledge at your startup. I hope you enjoy!
Economies of scale
This is what most people think about when they think about size being a competitive advantage for a business. If you have a bigger company, you can allocate your costs more effectively and gain an advantage over a smaller competitor.
Let’s use a home insurance company as an example.
(I am really looking forward to when OpenAI’s DALL-E learns to spell.)
When the home insurance company first started, they were likely in one city, brokered most of their insurance policies, and relied on local insurance salesman to go around selling policies.
However, as the insurance company grows, they can do all sorts of new things:
When they enter a second and third city, they can leverage their existing accountants and support staff. They only need to set up a sales office. This gives them operating leverage on their fixed assets and allows them to start offering cheaper rates to consumers.1
When they start selling policies at scale, they can bring the actual underwriting of the policies in-house instead of relying on external providers. This vertical integration saves them money and let’s them drop rates even further.
When they become a national insurance company, they can start to advertise on National TV. Paying millions for a Super Bowl ad wouldn’t make sense if they were just in a handful of states but there’s a reason you see GEICO ads everywhere. These ads are an effective way to reach masses of customers and saves the company more money, which can be passed onto consumers.2
In each of these examples, our fictional insurance company is gaining advantages — operating leverage, vertical integration, new go-to-market strategies — that come from doing more of the exact same thing (selling home insurance).
One key thing to notice, is that all of these advantages are around cost savings. The operating leverage lowers SG&A, the vertical integration lowers COGS, the national TV ads lower CAC.
These advantages tend to have diminishing returns and eventually, there becomes a point where getting bigger makes them less efficient, due to increased coordination costs and bureaucracy.
You can also get so big that the government steps and tries to break you up, like they did to Standard Oil, AT&T, and (almost) Microsoft.
Economies of scope
If you can’t tell by the name, economies of scope are about expanding the scope of what your business does.
In our previous example, our insurance company could have decided to launch a car insurance product instead of simply trying to grow their home insurance business.
You may ask what advantage there would be from having a small home insurance company and a small car insurance company under the same roof?
If you are already selling someone home insurance, you can call them up and see if they’d also like car insurance. This is a much easier sell since you already have a trusted relationship with them and all of their information. This upsell lets you increase the LTV3 of your customer!4 And you don’t have to stop with car insurance. You can sell them life insurance, flood insurance and pet insurance too. This is the power of bundling!
When you go to upsell a customer on car insurance, you have data on they behaved as a home insurance customer. If they always paid their premiums on-time and never had any claims on their home insurance policy, chances are they are probably a pretty good person to insure for car insurance as well. This additional data lets you improve your underwriting models which means you have lower loss ratios which means you can charge lower premiums than your competitors. You can also use this data to underwrite customers you would not have otherwise been comfortable offering insurance to, which expands your universe of potential customers.
Some customers might only want to shop at an insurance company that can handle all of their insurance needs. After all, it’s annoying to manage four different billing cycles, keep track of all of those passwords and remember who to call for which issue. Offering multiple product lines might further open you up to a new set of customers.
While some of these advantages are related directly to costs, I think about economies of scope as expanding your revenue opportunities. With bundling, you can now sell twice as many insurance policies to the same customer. With better data, you can reach customers you would not have previously been comfortable insuring. And with being a one-stop-shop, you can reach a brand new segment who values convenience and consistency.
Economies of a startup
One thing you are probably noticing is that it’s hard to have economies of anything at a startup. After all, when you are so much smaller than the incumbents, they probably have both more scale and more scope than you do.
This is why the standard advice for startups is that your product needs to be 10x better than the incumbent. If it’s only twice as good, people will likely stick with the cheaper, safer, more convenient option. However, if it’s 10x as good, some (not all) people will be willing the make the leap.
But just because you don’t have any size advantages doesn’t mean you shouldn’t be thinking about them.
If your competitor relies on economies of scale, taking even 5% of their customers can have major impacts on their bottom line. We talked about a business like Blockbuster that relied on getting a certain number of video rentals for their stores to be profitable. Once they lost a small amount of their market share, their stores starting losing money.
If they rely on economies of scope, focus your efforts on a single vertical. Just like with economies of scale, taking away one vertical can have an outsized impact on their economics.
As you grow, use this framework to think determine if you should grow in scale or in scope. Startups are extremely resource constrained so being focused and intentional is crucial.
Or increase their profit margins, increase employee salaries, or a plethora of other options.
Or, as mentioned previously, given to shareholders or employees or whatever.
Lifetime Value.
You can also think about this as there being two customers (one for home insurance and one for car insurance) and splitting the CAC between them.