Growth Frameworks: Economies of Scale, Scope and Learning

Most company grow in one of these three ways

In the silicon valley the term (or buzzword) "scale" gets thrown around quite frequently to make a point about applying resources to some activity. For example, "By getting additional people or funding we are going to scale these kind of events", this particular use of the word does not necessarily mean scale. It's also often incorrectly used to define a linear increase of inputs and outputs or at best higher operating leverage. I recently pulled out my school notes and wanted to go back to the definition of 'economies of scale'. After stripping out most of the math, below is my attempt to bring more clarity to the term. 

Also found this post on LinkedIn where Google’s Eric Schmidt talks about Scaling Google. 

EXAMPLES OF SCALE 

Economies of Scale: Increasing output by a higher proportion than the increase in input. Economies of scale happens when a much larger capacity is added and used at optimal capacity to get lower average unit cost. Some really good examples are going from a live learning session to a web-based learning system where capacity is increased by orders of magnitude while lowering average unit cost. Note that this discussion does not account for what lost engagement does to change in quality of service. Another example is going from replying to email requests for product info to enabling a website where clients can download your product material. Similarly for analysts enabling a dashboard or self service tool vs. responding to ad-hoc queries. Notice that most examples include some sort of technology that dramatically increases the capacity. This however pose a serious problem for those of us who in the business of providing high quality of in person service (Consulting, Sales, in-person marketing, etc). In these professions it is almost impossible to get web-style orders of magnitude scale but there still exists a huge opportunity to bring down average unit costs by optimizing process and averaging automation tools. Moreover, there exists opportunities of economies of scope and learning. 

THE MATH (Skip if you don't care). The following equation measures economies of scale: b = log (c2/c1)/ log (s2/s1) where c2 is average costs after adding new capacity and c1 previous average cost. Similarly S2 is units produced with additional capacity and S1 is units produced in previous capacity. If b is negative then you have economies of scale, if it's positive you may have dis-economies of scale. 

Economies of Scope: Economies of scope exists when there are benefits of combining two or more products or activities. Most scope economies arise from sharing knowledge or from economies of scale in the production of events or services that are utilized by both activities. Economies of scope can be often be estimated by breaking production down into two components; one component being the commonality between products or services, and the other component being their separate exclusive features . The economies of scope derive from the extra economies of scale obtained in the combined operation. This might seem lucrative but evidence suggests that as you add more product you add more complexity increasing administration and overhead costs. Two different activities or operations should only be combined when economies of scope very highly outweigh cost of variety.

Economies of Learning: This occurs when average costs fall as a result of organization gaining experience in doing something over and over again. This is sometimes also referred to as the experience curve. This is what connects a firm with it's history in a way that a new entrant can not replicate right away. The key driver for economies of experience are the tools and processes (infrastructure) that the firm puts in place to run more efficiently. 

EXAMPLES OF NON-SCALE 

Linear Increase: If today I have an output of Y with X resources, with doubling of resources I would have 2 x Y output and no more. This is a linear increase with no scale. Any request for such resources should typically not be funded because it buys the company no incremental value for the increase in cost. The opportunity cost for such investments is too high. For a marketing organization, typical company funded events represents such activities where, while important, it represents little to no scale. Events in general will scale very little, however, there are some potential economies of learning and scope that may be applied to this. 

Operating Leverage: The higher your capacity utilization the lower your average unit cost. Again there is no scale here but average costs go down the more you produce. Consider an executive briefing center that costs $1000 to maintain each year. Suppose each time you bring a client through the briefing center it costs you an additional $10. The average cost of bringing in 1 client is (1000 + 10) /1 = 1010 , the cost for bringing in two client is (1000 + 2 x 10)/2 = $510 and similarly for 250 clients the average cost is only $14 per client. Again, there is no scale here but operating leverage