In finance, the Gurus on Wall Street can talk to you all day about standard deviation, upside ratios, and r-squared. However, they balk when asked about a company's competitive advantage.
This week I will talk about the second competitive advantage identified by Howard Helmer, author of the book "7 Powers: The Foundations of Business Strategy" which has helped the best companies in the world obtain market dominance.
This week I will explain Scale Economics using Amazon as a real-world example.
Economies of scale is a concept in economics that refers to the cost advantages that a company can achieve by increasing its scale of production. This means that as a company produces more goods or services, its average cost per unit decreases.
Here's a simple example:
Imagine you own a business named Car Manufacturing Inc. and decide to build a large factory capable of producing more cars per day. This would mean that your car manufacturing company could potentially spread the fixed costs of the new factory over a larger number of cars, which lowers your average cost per car.
Everyone has heard the story of Amazon changing the retail game but how did they obtain true scale?
It all started with their founder, Jeff Bezos, a breakaway hedge fund manager with a background on Wall Street.
His business model was counter-positioned from the beginning by operating no brick-and-mortar retail stores. He believed that by focusing on distribution he could get products to consumers in a timely manner using the internet and third-party delivery services.
He was right and the demand for their ecommerce services proved it.
He then had to make several choices. Did he prioritize margins and Wall Street? Or did he invest aggressively to expand distribution capacity to reach more consumers?
He chose the latter which was terribly bold and risky. As a matter of fact, Amazon operated at a deficit for more than 20 years.
He was correct though. He knew that by increasing investment he'd eventually obtain operating leverage over his fixed cost base in a massive way.
In fact, According to a 2022 report by S&P Global Market Intelligence, Amazon has invested over $600 billion in capital expenditures since its inception in 1994.
Amazon eventually created a flywheel which I will explain in further depth once we get to network economics.
They focused their investments in 4 key areas:
- Fulfillment network: Amazon has invested heavily in its fulfillment network, which includes warehouses, transportation, and delivery. This investment has allowed Amazon to ship products to customers more quickly and efficiently.
- Cloud computing: Amazon Web Services (AWS) is the world's leading cloud computing platform. Amazon has invested heavily in AWS, which has allowed it to grow into a major player in the cloud computing market.
- Research and development: Amazon has invested heavily in research and development, which has allowed it to develop new products and services, such as Alexa and Amazon Go.
- Acquisitions: Amazon has acquired a number of businesses, which has allowed it to expand into new markets and acquire new technologies.
As a result of Amazon's investments, their Gross Margins nearly doubled from 29% to 45% over the last 15 years. They began to obtain leverage over their fixed cost base in a massive way.
Amazon is a compelling story and I highly encourage my network to study them as closely as possible. Especially if you are an entrepreneur or interested in business. Bezos taught the world a masterclass lesson about scale economics.
That's all I have today. As always, I am always a phone call or office visit away. Take care!