‘Scale Economics Shared’ Business Models: Embracing Less Greed for Sustainable Success
I have very few original ideas to share in this post. There is a wealth of thoughtful insights shared by others over the past 14+ years. Feel free to explore the summary below and refer to the reference section at the end of this article for additional readings on this topic. Happy Reading!
Summary:
To build a business that continually appreciates value(market cap), founders must prioritize creating value for all stakeholders, with customers at the forefront. This involves enhancing the value proposition through reinvestment of profits while keeping profit margins low to deter competitors and capture market share. Embracing this strategy entails prioritizing long-term shareholder value over short-term gains, while simultaneously delivering instant gratification to customers through improved goods/services.
Back to Basics: What are ‘economics of scale’?
Economies of Scale occur when a product or service has the potential to impact millions or billions of people upon launch, such as drug discovery for diseases like lung cancer by pharmaceutical companies. These companies invest billions in research and development costs to innovate new drugs and conduct efficacy tests. Once FDA approval or similar regulatory clearance is obtained, the company incurs fixed costs — upfront investments in purchasing manufacturing equipment, hiring staff, and funding marketing and sales efforts. Regardless of sales volume, these costs remain constant. However, as demand for the medicine grows and millions of tablets are produced annually, the incremental cost of replicating the drug becomes marginal for the pharmaceutical company. This is known as variable costs in financial terms. The concept applies to various industries, including media, consumer goods, books, and automobiles, where selling more products dramatically reduces the final cost per unit, a phenomenon known as ‘scaling’ or ‘selling at scale’, i.e you spread fixed costs over a large volume of products as you start selling more.
So, what are the common sources that cause economies of scale to occur?
‘Companies can incur either two types of costs over the course of their operations, fixed costs and variable costs.
- Fixed Costs → Fixed costs remain relatively constant regardless of the production volume (e.g. purchase of machinery and equipment, factory build, office rent, product design/development)
- Variable Costs → In contrast, variable costs are tied directly to the good/service provided and thus fluctuate proportionally in line with each additional unit produced (e.g. raw materials, labor)’ (source)
Back to Basics: What are ‘Platforms’?
The word ‘platform’ might be new to you. But think of a few of the most valuable Fortune 500 companies: Uber, Google, Amazon, Apple, Airbnb & LinkedIn. What’s common between all of these is that they are one or another form of ‘platform business models’.
I like this definition of platforms from the book ‘Platform Revolution’: “A platform is fundamentally an infrastructure designed to facilitate interactions among producers and consumers of value. These two basic types of participants use the platform to connect and to engage in exchanges — first, an exchange of information; then, if desired, an exchange of goods or services in return for some form of currency. These participants come together on the platform to engage in a core interaction that is at the heart of the platform’s value-creating mission. In time, other interactions may be layered onto the platform, increasing its usefulness and attracting other participants.”
A platform serves as a digital marketplace or ecosystem where users can connect, transact, and derive value from each other’s activities and contributions.
Scale economies shared(SES) business model
Imagine you are the CEO of ‘Comedy Central Enterprise’, which generates $100 Billion($100B) in Annual Revenue with a Net Income of $10B in 2023. Consider Net income as the profit on hand after accounting for all expenses, including interest, taxes, depreciation, and amortization. Now, as a CEO with your other executives, you have to decide what to do with these profits. Let me just list four of them,
1. Pay yourself and all of the shareholders (As Dividends and Bonus)
2. Buy one of your competitors to strengthen your market positioning and improve market share.
3. Invest in R&D projects that can create the next $10B market
4. Reinvest in your core business
I liked this summary of SES business models written by Johnny Cornish
— ‘The strategy of SES is where a company benefitting from economies of scale chooses to lower its prices and/or improve its offerings to customers to win market share over the long-term, rather than pricing its products & reducing its investments to maximize per-unit profit in the short-term.’
Let’s break it down. Firstly, SES is a strategy through which a company can decide to pursue market share instead of higher profit margins. SES strategy is when a CEO and the Comedy Central Enterprise management team decide to reinvest in their core business and offerings to keep increasing the value proposition for their customers rather than paying themselves with fat dividends each quarter.
So, why would any company and management team do this?
Companies do this to generate more customer loyalty and with the hope that their customers do not switch to a different product or platform. Secondly, it’s one of the best strategies for companies in platform business models because of the ‘nature of business model’. Platforms grow through positive network effects. More satisfied and happy customers would spread the word about Comedy Central Enterprise and refer their products and services to friends and family.
Example: The most obvious example of this is Amazon Prime. With a Prime subscription, you not only get a 1–2 day free shipping, but you also get access to Prime Videos, Amazon Music, millions of e-books on Kindle, Audible (thousands of audiobooks), GrubHub Subscription (food delivery marketplace in the US). All for just $14.99.
‘SES businesses have a ‘flywheel’ because their competitive advantages increase as the business grows larger, making it harder and harder for competitors to offer as much value to customers.
Flywheel specifics vary across industries.
The most obvious example of “scale economies shared” is in businesses like Walmart and Amazon where scale enables them to lower prices for consumers — “sharing” that scale through price reductions.
But “sharing” scale doesn’t always have to be through reducing price — it can be through investing in improving the customer experience in other ways, too, such as increasing selection and convenience. The value proposition to customers should increase over time while the business’s financial profile improves, too. This is an incredibly powerful, albeit rare, combination.’
SES Strategy is when companies share the scaling benefits with their customers.
My takeaways:
There are a few seemingly counter-intuitive lessons for founders and investors from SES strategy.
1. Maximizing Shareholder Value with your customers at forefront: Continuous innovation aimed at delivering significant value to customers over time is a powerful strategy. Striving for at least a 10x value creation can set a high bar for creating a meaningful impact in your customer's lives. Example: Reducing shipping time from 10 days to 1 day.
2. Prioritize Long-Term Thinking over short-term gains: Embracing delayed gratification and prioritizing long-term goals can fundamentally shift the mindset within an organization. I think it was Duolingo founder Luis Von Ahn who said that he wanted to create a 100-year-old company(and I think they have a real shot at it because of the nature of the product. As long as humankind is alive, we are always going to need language for communication). I can only imagine the product culture within Duoliongo with this stretched time horizon.
3. Low Margins and Competitive Advantage: Embracing low margins can serve as a strategic advantage, effectively deterring competitors. Capitalism works. When you innovate and disrupt existing industries with new technologies, you will start attracting competition. However, if you start sharing your profits with your customers too, you will create customer loyalty and a brand for your products which is are intangible but super deep moats(Case Study — Coca cola, Karft-Heinz, Patel Motels, Geico Insurance).
What’s Next?
The past two decades have been all about platform business models; What will be the best business model for the upcoming decade? What business models could create the next 100 billion-dollar companies?
If you have thought about these questions, share your thoughts in the comments section of this article.
Appendix:
Types of Problems that are best suited for Platform Businesses
1. Multiple Stakeholders: Platform businesses navigate the complexities of multiple stakeholders, balancing the needs and interests of diverse participants to create win-win outcomes for all involved parties.
2. Emphasis on Customer Experience: Customer experience is king in today’s competitive landscape. Platform businesses prioritize customer satisfaction through intuitive interfaces, personalized recommendations, and responsive support systems.
3. Fragmented Marketplaces: In fragmented markets, platform businesses serve as centralized hubs, bringing together buyers and sellers from diverse backgrounds and industries, fostering efficiency and accessibility.
4. Marketplace Inefficiencies and Data-Driven Insights: Platforms democratize access to information, empowering users with knowledge and resources previously out of reach. Whether it’s educational content, industry insights, or consumer reviews, platforms serve as invaluable repositories of information. Leveraging data analytics, platform businesses identify and address marketplace inefficiencies, enabling dynamic pricing strategies and offering valuable insights into market needs and demands.
5. Operational Excellence: Platform businesses thrive on operational excellence, streamlining processes and optimizing workflows to deliver seamless user experiences and maximize efficiency.
6. Ecosystem Building and Network Effects: By fostering vibrant ecosystems and harnessing network effects, platform businesses create value that extends far beyond individual transactions, fueling growth and innovation across interconnected communities.
7. Regulatory Compliance Made Easy: Navigating regulatory complexities can be daunting, but platform businesses streamline compliance processes, providing businesses with the tools and support they need to meet regulatory requirements effortlessly.
8. Trust Issues: Building trust is paramount in any business endeavor. Platform businesses excel in implementing trust mechanisms such as user ratings and reviews, ensuring transparency and reliability in transactions.
References:
- Article — Scale Economies Shared (One of the best articles on this topic I came across during my research. Before reading this article, I was familiar with Costco, Walmart, and Amazon as one of the best examples of ‘Scale economies shared.’ Reading this article, I also learned about the flywheel of Charles Schwab and the New York Times.)
- Amazon 2020 shareholders letter (Bezos talks about how businesses should create more for all their major shareholders than what they charge them)
- Bonus: Nomad Investment Partnership Letter (This is a hidden gem :) It’s Probably my favorite book(this is a bunch of shareholder letters by Nick Sleep and Zakaria) on investments so far. There is always something you can learn from each of these letters, I recommend reading the letters on Amazon and Costco. My original introduction to this ‘Scale Economies Shared Business model’ are from these letters.)
- Book: Platform Revolution (One of the best books out there on platform business models)
- Article: 4 Types of platform business models
- Book- Information Rules A Strategic Guide to the Network Economy by Carl Shapiro & Hal Varian (The chapter on Positive Network effects is awesome)
- Book — Good to Great by Jim Collins (I think it was Jim Collins who coined the term ‘Flywheel’. I like the chapter on ‘traits on great leaders’ & flywheel in this book)
- The Everything Store by Brad Stone
