The power of the scale

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My parents are always lamenting the disappearance of their favorite shops and stores in my hometown. They grew up in the same town, and they often mention little mom-and-pop shops that, they say, used to flourish and are now gone. They blame the big box stores that have popped up in the area: Walmart, Target, and Best Buy, to name just a few.

Why is it so easy for these big stores to run the little ones out of business? I know that these big stores offer lower prices, but why are they able to do that? Isn’t it more expensive to run Walmart than to run a tiny little shop?

It certainly isn’t cheap to run Walmart–but Walmart also makes a lot of money. The company is worth $230 billion. How did it get that way, and how is it able to offer such low prices?

For Walmart and the other big box stores, the key is scale. As you correctly point out, Walmart (the corporation) has higher expenses than a mom-and-pop store. But Walmart’s expenses are spread across a huge number of stores, and on a per-store basis, their costs don’t look quite so high. That’s because of the power of economies of scale, a very important concept in business and economics.

The idea behind scale is pretty simple: as you increase whatever you’re doing–whether it’s buying a product, making something, or hiring an employee–things get cheaper as you go. Making 100 widgets a day costs more than making 10, but you need a widget factory either way–so each additional widget costs you more in materials and labor, but the cost of that factory is spread out across more and more widgets. And that means you might be inclined to sell large amounts of widget at a discount, so the same principle of scale applies to widget dealers, too.

That’s the secret of low prices, say expert wholesale distributors: buy in bulk. Walmart gets its products for less than most mom-and-pop stores, so it can sell them for less even if it’s making the same profit.

And Walmart is not necessarily making the same profit. Since Walmart stores sell so much stuff, they can afford to operate with slimmer profits. Again, scale is in play. Selling 10 widgets at a $1 profit per widget is the same as selling 100 at a 10-cent profit, so the massive size of Walmart’s operation again gives it an advantage over its mom-and-pop competition.

Of course, size isn’t everything, and plenty of experts believe that small shops offer things that the big box stores just can’t compete with: things like expertise, ambience, and a personal touch. And there are other factors in Walmart’s low prices–critics argue that their wages are too low, for instance. On top of this, big box stores are facing a challenge of their own in the form of ecommerce. The picture we’ve painted here is incomplete, but hopefully it gives you a sense of how scale works in business.

“I decided that if I could paint that flower in a huge scale, you could not ignore its beauty.” — Georgia O’Keeffe

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