Economy of Scale and a Bad Idea

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.