Economy of Scale and a Bad Idea

By on February 19th, 2010

Most people are well aware of the concept of economy of scale – it’s cheaper to buy the huge box of cereal that could feed a family of 10 for a month than to buy the small box that could feed you and your spouse for two weeks. When you buy a lot, the price per unit is less.

This can apply to business as well. If you have a product that you sell for $10 with a margin of $6, then selling 10 at once would give you a higher margin, since some of your costs would overlap. So your margin might be $65 or $70 in that case.

Unfortunately, it also works in the other direction, and I’ll illustrate with an example (I heard this on a tape of a Jackie Mason show):

My friend bought a new watch, and I asked him how much he paid for it.

“Below cost!” he exclaimed triumphantly.

“Below cost? How does the guy make any money?”

“He sells a lot of watches…”

Sometimes in business this makes sense. A store might offer a product for a price at which they lose money. But the objective there is to get you into the store, where you’ll buy other products at a higher profit.

Sometimes in business this is a sad reality. Take Dale Barker from Hamilton, Ontario, who renovated a building to be a beautiful movie theater. He came on Dragons’ Den last week looking for an investment to add a second screen to his theater. The problem, however, is that he was losing money on the existing theater.

This is a classic case of throwing good money after bad. He had a large debt acquired in order to make the renovations, and was dealing with delinquent tenants. His theater was one of the cheapest in town, despite the extra decor. If he spent more money on adding another screen, he would find himself losing money twice as fast. In other words, his business model was losing him money.

In such cases, where the business is losing money, before acquiring additional investments, you need to take a reality check to see if the model itself is sound. If the model itself is not sound, you need to fix it before giving away part of your business and prolonging the agony.

Related posts:

  1. Dragons Flush a Good Idea – Bad Business Down the Toilet
  2. Parks and Membership
  3. I Have a Great Idea – What Now?
  4. Slow Economy and Developing a New Business
  5. Why Not to Compete Based on Price
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  • Graeme

    Hi, I found your blog on Google by accident when searching for something with Dragons Den, and ended up reading it and just wanted to add a comment.

    I’m not sure the watch analogy/joke completely applies here. It’s not like he wants to open a second whole theater (in which case what you and the Dragons said would apply).

    He wants a second screen. It seems like a lot of money he spent was on the lobby and bathrooms. His theater is operationally actually profiting, its servicing all the debt that’s killing him. Under the assumption that bathrooms and the lobby won’t need expanded for a second screen, the second screen could theoretically double his revenue, while only costing a fraction of the original renovations (since the lobby, bathrooms, etc. are already done).

    An analogy I could make would be a restaurant. If a restaurant opens with only a single table, no matter how good they are, they will never be able to cover the overhead with the revenue from 4 people at the one table. There is some level of scale required to break-even, and arguably a single screen theater doesn’t cut it (I don’t think I’ve ever seen a single screen theater other than IMAX, minimum I’ve been to had two).

    I actually think adding a second screen makes sense under one major assumption: he needs to be able to significantly increase revenue (preferably double it). For a variety of reasons, I’m tempted to say this may not be the case, but if his theater is popular enough that he could fill a second screen to a similar point as the first screen, based on the limited financials he gave, I’m tempted to think he could actually be profitable. But I’m basing this off a dangerous assumption.

  • Elie Kochman

    Thanks for the comment. You’re right, there’s more to running a theater than the number of screens, which he had already dealt with (the concessions, the bathrooms, and so on). The problem, however, is that adding a new screen would not be free, and he clearly didn’t understand how to economize on renovations. The second problem is that he wasn’t charging enough to cover his expenses – and didn’t seem willing to compromise on that point.

    His debt costs were estimated at 60,000 per year. That means the first 10,000 people to visit his theater wouldn’t be paying maintenance expenses, but debt expenses. Adding a second screen would increase his costs in terms of maintenance, but also potentially in terms of servicing a growing debt. His business was not running in a positive cash-flow situation.

    As you mention in your last paragraph, a second screen could solve some of his problems, but only with higher revenue, which comes from charging more for admission. But because he wouldn’t look at that as a viable modification to his business plan, it showed a major flaw in the business model that was being ignored.

    The point here was not whether or not he could be profitable. It was that when you’re not profitable, and go looking for money, you need to evaluate your model and be sure that in its current state, it CAN be profitable. More money from investments can’t help that.