Economy of Scale Example: How to Compete

Competing in the age of big box stores can be overwhelming.  "Mom and Pop" stores have been run out of business by huge corporations like Walmart, Home Depot, Kroger, and yes, even Amazon.  Yet, many consumers want to "shop local" and support business owners.  But how can a small business compete with the big box giants of today?  By applying strategic innovations to their businesses.

But first, we must understand why it is important to have an awareness of economies of scale.

Understanding Economies of Scale

I first learned of the concept of "economies of scale" in my high school business class.  It was explained to me in basic terms that big businesses gain efficiencies from being large that make it difficult for small businesses to compete.  I was given an economy of scale example based on the creation of a widget and how creating more reduces the cost per item.  While economies of scale include things like a knowledge base, expertise, distribution, partners, and advertising, one of the biggest challenges small business owners have in competing with giant retailers is price.

Several years ago, a friend of mine owned a game store where they sold all types of games, both common and unique.  He was able to dig into a niche market and were experiencing success.  His story is a great economy of scale example.

At the time, the game "Apples to Apples" was brand new and building momentum.  My friend started offering this game early on before it was available in most retail stores like it is today.  As I often do, I was intrigued by his business model and was asking where he got his inventory.   I was absolutely shocked when he told me that he had just picked up a large supply of Apples to Apples at the local Walmart, which was now beginning to also sell this game.  He explained that he was actually able to buy his inventory cheaper at Walmart than what he could get it for from his supplier.  But how could this be?

This was "economies of scale" at work.  He was a very small store who sold dozens of a certain game each year.  Though it was one of his best selling items, he still only sold a couple hundred units of this game each year.   Walmart, on the other hand, is a huge retailer that is able to buy this particular game in bulk of thousands of units at a time (except for the technical fact that Walmart actually has a just-in-time model that is a discussion for another day).  What my friend was experiencing was that Walmart had such a "buying power" that they were given such a low price due to the large quantities they sell that is actually a lower price than what my friend could buy a few units for.  Therefore, it was cheaper for him to just buy his inventory at Walmart.

As you can imagine, it becomes very difficult to make a profit when your customer can purchase a product for cheaper than what you can get it for through your wholesaler.  Fortunately, my friend was aware of how these economies of scale affected his business.  He knew his product life cycle - as a game grew in popularity, it would get picked up by the mainstream retailers and he would no longer be able to compete due to price.  Therefore, he strategically focused on introducing new games to customers which became his real niche.

Being Aware

Just like my friend, it is important for every business owner to be aware of economies of scale for three reasons.

It's Not Going Away

As our global economy evolves, corporations are getting larger and larger.  And this means that the competitive advantage these corporations have through their economies of scale is becoming greater and greater.  Walmart is the perfect example of how economies of scale are used to grow a business, which ultimately is putting small shops out of business.  Even as there is greater focus on buying local, it is human nature to want to save a few dollars when making purchases. For this reason alone, Walmart is always going to have customers.  And this means that their economies of scale won't be going away.

Price Isn't Everything

The second reason every business owner should be aware of economies of scale is that price isn't everything.  Yes, we often first think of pricing disparities when we talk about economies of scale, but the reality is that other opportunities to gain a competitive advantage exist.

When a large retailer focuses solely on price, this strategy creates holes in areas that also generate demand.  For example, I despise shopping at Walmart.  While I love to support small businesses, the reason I don't shop there isn't really because they are so large.  The reason I don't shop there is that they have horrible customer service.  I remember a period of time when I recall not being able to get through the checkout process in less than ten minutes, regardless of what time of day I went into the store.  There were multiple factors for this: employees didn't move quickly; the system would "think" forever, forcing employees to move slowly; and, management always understaffed the number of check-out lanes.  All of these factors meant that prices were kept to a minimum, but they also meant that price was valued over customer service.  And lots of people are willing to wait in these lines because they value price over customer service.

For me, I would rather pay a few dollars more in exchange for being able to check out quickly.  Or, being able to find an employee to help me with a question.

My point here is that large corporations often leave holes when they utilize their economies of scale for price. Things like customer service, culture, and community support become ways options for gaining a competitive advantage.

The Demand Is There

If we look just at the pricing disparities created by economies of scale, it can seem overwhelming.  But don't be discouraged.  The reality is that there is a huge demand for what you have to offer.  Your challenge is not to be able to compete with the economies of scale that a big box corporation utilizes, but to strategically innovate your niche in an area that gives you a competitive advantage.

For example, I have talked about how Walmart lacks in customer service.  Compare this to Target.  Target has a completely different model; they appear to focus on customer service over price.  At Target, the check out lines are appropriately staffed, employees respond to the "help me" phones within seconds, employees utilize hand held radios to tap the knowledge base of every employee, and employees taking your payment have the authority to give pricing discounts and make changes without a manager override.  (Yes, I know that Target is also a big box store, but they are a good model of how to compete with Walmart.)

A Question for You

How aware of economies of scale have you been in your business?