A lot of people that I meet, wonder – Why do investors fund startups who are not profitable? In fact a lot of people avoid asking this question so that they don’t sound dumb. After all investors are smart people they know what they are up to. But then you hear about a startup that went bankrupt, and then you feel why was it getting funded so far.
Let me decipher this for you – What can make a loss making business today become a profitable business tomorrow and what is the actual objective of these investments. The answer is “Economies of Scale”.
Let me throw some simple definitions at this point:
A cost that doesn’t change proportionately with your production or sale quantity. This can be salaries of people, R&D costs, Branding expenses, etc.
These are costs that vary proportionately with your production or sale quantity. This can be sales incentives, part-time delivery staff costs, fuel, etc.
These are costs of materials that are handed off along with the product. This can be ingredients in the food you eat, hardware in your mobile phone, etc. This is often a sub set of the variable costs.
I hope now you are getting a sense of what we are coming at. So let’s talk about Economies of Scale.
Economies of Scale
Definition – A proportionate saving in costs gained by an increased level of production
The graph above plots “Quantity of Production” against “Average cost of Production”. When the quantities are low, you still need cater to your fixed costs which are part of your Average cost of Production. When quantities are high, the fixed costs per quantity go down.
A good business model also expects you to lower your Variable Costs at higher quantities. Let’s take the example of a part time delivery staff. If you can provide him more deliveries and the locations are optimized along with quantity, you can lower your variable expenses per quantity.
However, beware of marginal costs as these are black spots that don’t change along with quantity. Please note that in a pure digital business these are often absent.
But what goes wrong?
Of course this can be for various reasons. When your equations are miscalculated, strong competitive threats, extravagant marketing, etc. But we do have an economic term for this – “Diseconomies of Scale”. The graph below says it all. You start spending more and more with increasing quantity. And this is when you fail your startup.
I hope this was an interesting read for everyone and was informative if you had this question in your mind already. Please drop in your comments, feedbacks or suggestions.