Business Model Analysis, Part 4: Racing for Scale

This post is part of a series on business model analysis for entrepreneurs. The first post in the series presents a comprehensive list of issues (available as a downloadable PDF) entrepreneurs should consider when designing a business model. Others delve into specific issues; this one provides an overview of factors that motivate a startup to race for scale.

"Should we step on the gas pedal?" Based on my work with startups, this is the strategy question that entrepreneurs raise most often. It's crucial to understand whether accelerated growth is a priority, given the attributes of your business model. A flawed plan to "Get Big Fast" can be fatal for a resource-constrained startup.

A new venture has incentives to race to acquire customers if it enjoys: 1) increasing returns to scale due network effects or strong scale economies in production; 2) high customer switching costs; or 3) other first mover advantages, such as opportunities to preempt scarce assets or patents. Potentially offsetting these incentives are scalability constraints and late mover advantages. In this post, I won't address the complex question of whether to adjust a startup's growth strategy in response to a valuation bubble.

Addendum, July 26, 2011: My friend Joel West, a scholar/entrepreneur at San Jose State, makes the very important point that growth is often a choice for entrepreneurs that hinges on their personal preferences as much as on economics. I've written below with the tacit assumption that a founder will always want to grow a business if she can. Of course, there are many lifestyle companies with business models that could be profitably expanded, but also can be operated successfully at a more modest scale, consistent with the owner's goals.

Increasing Returns

Most businesses exhibit constant returns to scale, that is, their margins do not vary much over the range of sales volume that a firm might reasonably achieve. In such businesses, as output expands, scale economies may be offset by diseconomies of scale, including the additional cost of coordinating more complex operations and cost escalation for increasingly scarce inputs (e.g., skilled labor, attractive locations for facilities).

A business that enjoys significant scale economies—either due to strong, proprietary network effects or the ability to leverage high fixed costs—may exhibit increasing returns to scale: its profit margin may continue to improve as the business grows. Firms are strongly motivated to race to acquire customers when they can exploit increasing returns.When customers’ willingness to pay increases with network size or when unit costs decline with greater production volume, acquiring a new customer yields two streams of benefits: 1) profits earned over time directly from that new customer; and 2) profits earned over time from all other customers. For example, with proprietary network effects, as long as a new customer remains affiliated with a platform, all other customers should be willing to pay slightly more for access to the platform. Although this increase in willingness to pay may be infinitesimally small for any given customer, these tiny amounts add up when aggregated across the entire customer base.

Consequently, when acquiring customers in a business with increasing returns, startups can afford to spend up to the present value of future profits earned directly from the new customer (i.e., benefit #1 above) plus the present value of incremental profits from other customers (i.e., benefit #2). By contrast, in businesses with constant returns to scale, companies should spend no more on customer acquisition than the present value of future profits earned directly from a new customer (i.e., benefit #1). In short, when they enjoy increasing returns, firms have a stronger motivation to race for scale. However, when several firms simultaneously enter a new market with increasing returns, they all may pursue an aggressive growth strategy, dissipating any above-normal profits available from the market.

Switching Costs

In a new market, high customer switching costs also can motivate startups to race to acquire first-time buyers—those not yet affiliated with any vendor. After locking in these first-time buyers, a firm should be able to raise prices to them by an amount just slightly less than the switching cost they would incur by changing vendors. As with increasing returns, when several firms simultaneously enter a new market with high switching costs, intense competition for first-time buyers may dissipate profits.  However, dynamics may be different if a pioneer achieves a big time-to-market lead and amasses a significant customer base before rivals enter the market. Under these circumstances, switching costs may encourage the pioneer to be a “fat cat,” pricing high to its existing customers but ceding remaining first-time buyers—and market share—to entrants, who offer a lower price.

Additional First Mover Advantages

In addition to factors that yield increasing returns to scale and switching costs, pioneers in a new market may enjoy other first mover advantages, including opportunities to preempt scarce assets, patents, or capacity:

• Preemption of Scarce Assets. Through purchases or long-term contracts, first movers can lock up valuable assets, for example, component supply contracts, skilled labor, or attractive geographic locations for factories. Scarce assets become more costly to acquire after rivals enter. In some cases, entry may be impossible once a crucial asset is locked up, as with government-licensed spectrum for telecommunications services.
• Preemption of Key Patents. By exploiting a head start in research and development, first movers may be able to secure patent protection for key technologies. If the pioneer decides not to license its intellectual property, prospective rivals may find it costly to “invent around” the patents and, at the extreme, may be unable to enter the market.
• Preemption of Capacity. If the minimum efficient scale of production facilities is high in relation to the expected size of the mature market, the first firm to build such facilities may be able to deter prospective rivals from ever entering the market. In the early 2000s, for example, Teledesic and SkyBridge both proposed to spend billions of dollars to launch scores of low Earth orbit satellites that could provide high-speed Internet access anywhere in the world. However, it was unclear whether the market was large enough to support even one competitor, so each firm had to decide whether to offer its service at all if its rival managed to launch first.

Scalability Constraints

Startups must consider operational capacity constraints on their pace of growth. Rapid expansion is more feasible when production and customer service functions can be outsourced to vendors equipped to handle volume surges. For example, by relying on Amazon’s S3 cloud storage service rather than building its own infrastructure, Dropbox was able to acquire 25 million customers within four years of its founding.

When operations are kept in-house, capacity can be scaled more readily if general-purpose equipment is employed. Rapid growth is more challenging when companies rely on specialized production and distribution facilities (e.g., proprietary equipment for packaging Keurig’s coffee capsules; Webvan’s use of highly-automated warehouses for its online grocery service). Such companies must build capacity well ahead of sales if they plan to pursue accelerated growth—a risky proposition when demand in a new market is still uncertain. Webvan took this gamble and failed after investing $800 million.

Likewise, when customer service interactions are complex, a startup’s growth may be constrained by the pace at which it can attract and train skilled personnel. This constraint is relevant for online stock brokerages, whose call center reps must respond to customers’ questions about a wide variety of transactions, including “stop loss” instructions, options trades, and margin calls.

Late Mover Advantages

Potential late mover advantages include opportunities to:

• Reduce R&D Costs Through Reverse Engineering. While some pioneers enjoy strong patent protection, others are unable to prevent rivals from copying their products. Reverse engineering usually results in significant R&D cost savings compared with amounts spent by the pioneer on the original product.
• Leapfrog Leaders with Newly Invented, Superior Production Technology. Late movers may also gain an edge in terms of cost or product performance by leveraging new technology that was not available when the pioneer launched. For example, Qualcomm was a successful late mover in establishing standards for cellular telephone equipment. Qualcomm’s CDMA standard leveraged leading-edge spread-spectrum technologies that deliver superior capacity and reliability relative to competing digital standards.

• Free Ride on Pioneers’ Investments in Educating Customers. In the earliest stages of a new market’s development, a large investment in “missionary” marketing may be required to educate prospective customers. The pioneer may bear 100% of the investment in education, only to find that late movers reap a return on that investment without sharing its cost.
• Avoid Pioneers’ Positioning Errors. Pioneers often face great uncertainty about customer needs, so they are more likely than later entrants to need to pivot, that is, change their business model. When a company dramatically changes its value proposition, it may destroy goodwill by confusing partners and alienating existing customers who were sold on the original brand promise. If a pioneer pivots and customer attrition rates rise in response, then the value of earlier investments in accelerated growth may be negated. Late movers can avoid such positioning errors by learning from the leader’s mistakes.

If, in aggregate, late mover advantages are strong, they can encourage what might be thought of as reverse racing. Prospective pioneers may have an incentive to throttle back their marketing efforts or even delay their launch plans when they can secure significant late mover advantages through reverse engineering, by free riding on missionary investments in customer education, when a major technological breakthrough is expected, or when trailblazers are likely to get lost in terra incognita.

Business Model Analysis, Part 3: Switching Costs

This post is part of a series on business model analysis for entrepreneurs. The first post in the series presents a comprehensive list of issues (available as a downloadable PDF) entrepreneurs should consider when designing a business model. Others delve into specific issues; this one provides an overview of switching costs.

Switching costs are incremental expenditures, inconveniences, and risks incurred when a customer changes from one supplier to another. For example, when consumers switch from a Windows PC to a Macintosh computer, they must buy and install Mac-compatible application software and invest time in mastering a new interface.

Switching costs fall into three broad categories:

• Redundant Relationship-Specific Investments. Because their old and new vendors may have different requirements, customers who change suppliers sometimes must invest in new software/hardware or repeat certain activities they have already completed. For example, to switch online stockbrokers, users incur the hassle of transferring funds and securities. For that reason among others, customer retention rates for online stockbrokers have been high.
• Disruption Risks. When businesses outsource “mission critical” activities, changing vendors may involve considerable risk. For example, some companies reduce their need for IT staff and infrastructure by relying on cloud computing services. Switching from one cloud service to another exposes a company to significant risk if customer records are lost or corrupted during the transfer.
• Contractual Penalties. Companies can impose penalties on customers if they end a contractual relationship prematurely. For example, mobile phone carriers often charge an early termination fee to customers who have signed multi-year contracts. In some cases, these contractual penalties significantly exceed the true costs incurred by a firm due to customer attrition.

When its current customers confront high switching costs, a firm is well positioned to capture a portion of the value it creates. Specifically, by raising its price just below the point where current customers are indifferent between staying with a firm’s product and switching to a rival’s, a firm should be able to earn above-normal profits equal to the sum of the switching costs confronting its customers (“above normal” implies profits in excess of a competitive return on capital; see the technical appendix below for analysis of the impact of switching costs on pricing and profitability).

Switching costs are important in securing a first mover’s position. In their absence, an entrant that offers a superior product or a deep discount might quickly usurp the market lead.

Given these economic benefits, companies often seek to deliberately increase switching costs, either through contractual or technological means. Apple, for example, has employed proprietary digital rights management software, locking in its customers by making it difficult for them to transfer iTunes Store purchases to rival media players. However, efforts to increase switching costs are not likely to escape the notice of prospective customers, who will fear hold-up in the form of a “low then high” pricing strategy. Anticipation of lock-in can represent a significant barrier to adoption for a new product. To ease customers’ concerns about lock-in, firms sometimes license their products to “second source” rival suppliers.

Technical Appendix: Switching Costs and Pricing Leverage

This appendix is only likely to be of interest to readers who want to dig deeper into the economic foundations of business models. To see how switching costs can impact firms’ pricing flexibility and their motivation to race for scale, consider the following example, adapted from my note “Racing to Acquire Customers.”

Assume that two firms, Alpha and Beta, offer identical products. A typical customer purchases one unit of either firm’s product in period 1, then requires a replacement unit in period 2. The variable cost of producing one unit is the same for both firms: $100. In a perfectly competitive market without any switching costs, Alpha and Beta would both price their products at $100 in periods 1 and 2. If either firm tried to raise its price, the other could steal all of its customers by slightly undercutting the new, higher price.

Now assume that each firm has a base of customers that it acquired in period 1, but these customers would incur a $50 cost by switching suppliers in period 2. Assume further that during period 2 the firms are able to offer one price to their existing customers and—in an effort to steal share—a different, lower price to their rival’s customers (e.g., a “special promotion”).

If Alpha wanted to steal Beta’s customers in period 2, it would have to compensate those customers—in the form of a lower promotional price—for the $50 switching cost they would incur. However, Alpha must also recover its $100 variable cost, so the lowest possible price it could offer in period 2 to Beta’s customers and still break even would be $150. If, in response, Beta set its period 2 price for existing customers at $149.99, its existing customers would not bother to switch to Alpha’s product. Beta would retain all of its existing customers and earn a period 2 profit equal to $49.99 from each of them.

Finally, imagine that a new, first-time buyer—as yet unaffiliated with either Alpha or Beta—enters the market during period 2. Like other customers, this first-time buyer will wish to purchase a replacement unit—albeit during period 3. Also, like other existing customers, the first-time buyer will face a $50 switching cost after he commits to a vendor.

Assuming once again that Alpha and Beta can offer different prices to existing versus new customers, what price would they offer to this new, first-time buyer during period 2? Following the logic above (and ignoring the time value of money), we can see that the lowest period 2 price that each firm could afford to offer would be $50.01. Whoever secures this new customer would then raise their period 3 price for this customer to $149.99. Total revenue across the two periods would equal $200, as would total cost, and net profit across the two periods would be zero.

In this manner, switching costs allow firms to raise prices to their existing customers, but the resulting profit opportunity also motivates them to race to acquire first-time buyers. In a competitive market, deep discounts or heavy marketing spending to attract these first-time buyers will dissipate any above-normal profits that otherwise would accrue due to switching costs.