Liv Steigrad* does a deep dive into the principles of scalability and how it influences investors’ choices.
What is scalability?
In business, scalability generally refers to the ability to increase in size or scale at whatever pace the demand requires.
It also needs to be able to maintain, if not increase, its efficiency.
If you can’t scale to keep up with demand, you might end up with a whole lot of disappointed customers or clients, and you might have missed out on all that extra profit too.
We think that scalability is absolutely crucial to maintaining competitiveness and quality.
It can be a particular concern for small businesses, as they are generally trying to optimise their returns with more limited resources.
This concept is closely linked to economies and diseconomies of scale.
Economies of scale refers to a situation in which more production leads to lower production costs and higher overall profit.
Diseconomies of scale is when increased production leads to higher costs and lower profits.
This typically occurs in retailing; to gain scale, retailers open more stores, but eventually they may open in less desirable locations leading to unprofitable stores and less efficiency.
Example:
You love baking. You learned from your grandmother and you’ve spent hours perfecting your own recipes.
Your house is always fragrant with vanilla and cinnamon and chocolate – your friends have always told you to start a business and sell your cupcakes.
So you do.
It starts out great. Your friends are buying your cupcakes, and you can easily bake 12 per batch so it’s fine.
Occasionally, someone orders 12 or 24 for a party, and that’s fine too.
Then, things start stepping up. You start getting catering orders. Corporate events, a wedding of 300.
You’re just one person in a kitchen.
You stay up all night baking and you still can’t keep up with the orders. You’re totally overwhelmed.
You couldn’t scale.
Real life case study 1: Crumbs Bake Shop
Crumbs Bake Shop was the largest cupcake company in the world.
Was. It closed its doors back in 2014.
Sometime back around 2000, Sex and the City aired an episode in which Carrie Bradshaw ate a cupcake.
People flocked to the West Village Magnolia bakery, and people started going crazy for cupcakes.
Jason and Mia Bauer spotted the opportunity early, and opened the Crumbs Bake Shop soon after.
Their premise was a simple, neighbourhood bakery that made delicious cupcakes. It took off.
They went from offering a handful of flavours to having over 75 on offer.
They opened shops in Washington D.C., Los Angeles, and Philadelphia, and Inc. Magazine named them one of the 500 fastest growing companies in America.
By 2010, Crumbs had generated around US$1.8 million net income, and expected to double its profits the following year.
Problem: other people seemed to notice the cupcake craze and decided to get their piece of the pie (or cupcake).
Competitors started popping up left, right, and centre.
In order to maintain their competitive edge, Crumbs decided to expand. Aggressively.
We think that Crumbs Bake Shop’s failure is largely attributed to four factors:
- Increasing competition
- Decreasing customer interest (the cupcake fad passed)
- High real estate costs
- They kept opening new stores and couldn’t sustain it.
It would appear that Crumbs didn’t have a system in place to adapt to changes in the market.
So when demand shifted, they “crumbled”.
Real life case study 2: Netflix
Netflix started out with mail-order DVD’s, back in 1997.
Today, it dominates the market, with millions of users all over the world logging in every day.
As it moved to a more digital model, it acquired the digital rights to the back catalogues of pay TV channels.
People could now access these shows on demand.
Knowing that competitors would spring up at some point, Netflix needed to remain the streaming service of choice.
So they start producing their own ‘Netflix Originals’ and offering all new shows available nowhere else.
Next up, dominating foreign markets with increased non-English language titles on offer.
In early 2018, Netflix announced it would be nearly doubling its production in Europe.
Netflix also had to keep its technology cutting edge.
Apparently, each title has to be encoded 120 times before it can be relied on to stream properly on all the different devices and platforms.
Scale helps Netflix improve its recommendations and its algorithims benefit from more customer viewing, which leads to more data, which leads to better recommendations.
Many companies struggle with scale, including Crumbs Bake Shop, as mentioned above.
After a while, bureaucracy and people factors may offset scale benefits with technology, and for Netflix in particular, scale is important.
Unlike many products, Netflix appears to get better with size and scale.
Back in 2009, Netflix held a competition, inviting coders to improve their collaborative filtering algorithm (which predicts how much you’ll like a film, based on what you’ve previously watched).
So far, it seems to us like Netflix is successfully scaling to keep up with the huge demand – but only time will tell!
The Spaceship Origin Portfolio currently invests in Netflix.
Important! We’re sharing with you our thoughts on the companies in which Spaceship Voyager invests for your informational purposes only.
We think it’s important (and interesting!) to let you know what’s happening with Spaceship Voyager’s investments.
However, we are not making recommendations to buy or sell holdings in a specific company. Past performance isn’t a reliable indicator or guarantee of future performance.
The information in this article is prepared by Spaceship Capital Limited (ABN 67 621 011 649, AFSL 501605).
It is general in nature as it has been prepared without taking account of your objectives, financial situation or needs.
*Liv Steigrad is a creative copywriter with a background in psychology.
This article first appeared at spaceship.com.au.
