Scale. It’s a fickle thing. All companies want to harness its absolute potential, yet only a few really are able to fully utilise it. Every company who made the jump from a microcap used it. It is one of the oldest theory in economics, yet many microcap investors overlooks it. One aspect particularly overlooked is when a company is sub-scale.

Scale (or economies of scale), at its most basic definition is where the cost per goods gets cheaper as a company produces more of said goods. This can be seen in a car factory where the per car cost of producing 1 car is more expensive than the per car cost of producing 100 cars. The fixed costs associated with the factory is divided onto more output.

However, the advantages (and disadvantages) of scale doesn’t stop there. It also varies between industries due to the industry structure, input costs and distribution channel amongst other things. In fact, for a good overview of this topic I highly recommend you reading the whole scale section of Charlie Munger’s talk entitled A Lesson on Elementary Worldly Wisdom.

So what is a sub-scale company?

Put simply, sub-scale is a situation where a company has not reached the required scale needed to be sustainably successful in its industry. Importantly, the required scale changes over time.

If they don’t have the required scale, it becomes a lot more difficult to have a sustainable profits and can often mean the difference of a business suceeding or failing. Being sub-scale is more dangerous in some industries (think social media, search engine, airlines, etc- in fact any industry with large network effects) as compared to others.

This disproportionally affects a lot of companies in the smaller end of the market (due to their size).

Jeff Bezos explained the trouble of being sub-scale in the context of the e-commerce industry in his 2000 Letter to Shareholder:

“Online selling (relative to traditional retailing) is a scale business characterized by high fixed costs and relatively low variable costs. This makes it difficult to be a medium-sized e-commerce company. With a long enough financing runway, Pets.com and living.com may have been able to acquire enough customers to achieve the needed scale.”

That was 2000. Fast forward to 2017 and things have changed in the e-commerce industry.

The scale requirements of a sustainably successful online selling has gotten lower due to the raft of as-a-service offerings available in the market, from renting computing power from AWS, fulfilment by Amazon, and other offerings. Furthermore, customer acquisition costs has also declined from the development of targeted social media ads and exploding inventory of internet advertisement as well as social acceptance of purchasing from the internet.

The changing nature of scale requirements can also be seen by analysing Bulletproof Group (ASX: BPF), a cloud services provider I have previously written about. It’s an example of a business that had sufficient scale in its early life, yet developments in the market made it a sub-scale business.

In the beginning, BPF surfed the wave very well. Their customers weren’t very sophisticated and there weren’t many competitors, so they could charge high margins for basic services. They grew very well during these early years. The required scale in the cloud services provider industry was quite low. However, as I previously wrote:

“Unfortunately for me, it is an example of a poor business model with a small and declining moat. The revenue growth of the past years have stalled as more and more competition join the fray, reducing their margin to get business and hurting BPF twofold, in winning less work and forcing BPF to reduce their own margins…

The way to differentiate and attract higher margin is to create bespoke and niche solutions through the professional services division.”

Now, the cloud services provider industry require larger scale from the need to continually train the workforce, develop bespoke offerings and thrive in a slimmer margin environment.

In that light, the announced acquisition by Macquarie Telecom (ASX: MAQ) is a saving grace. Pulling BPF out of the downward spiral is a good thing for the long suffering shareholders. Indeed I have sold the rest of my small holdings after the announcement.

Therefore, whether a company is sub-scale or not needs to be a key consideration in the investment process. If it is sub-scale, does it have a clear plan to reach the required scale? If not, then the company is going against the odds.

Nothing here is advice.