The Lean Business Blog

What is scalability, and why is it important for your Startup?

Posted by Yngve Dahle on March 31, 2016

This blog post is co-written by Yngve Dahle and Mark Robinson.

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One thing that above all else characterizes companies with a successful business model is that they are scalable; therefore we shall explain this concept in detail. “Vekstbedriften” (Dahle et. al. 2012) defines scalability1 as follows:

In an extremely scalable enterprise, each new unit of the product or service costs dramatically less to manufacture and market than the initially developed unit, while the sales price is generally maintained.

We have to say at this point that scalability is not a black-and-white concept. No enterprises will be 100% scalable or non-scalable. On the contrary the drivers for scalability influence the company to a greater or lesser degree. The sum of these influences will put the enterprise somewhere in between non-scalable and fully scalable.

A handcrafted product or specialist service has very low scalability. A shoemaker will spend approximately the same amount of time making a second pair of shoes as on the first, and an attorney has limited opportunities to automate his work processes.

Mass-produced industrial products are more scalable as both production and distribution can be automated; however, there will always be costs involved in manufacturing and distributing each individual item.

Tools that contain advanced control systems are far more scalable. An inspection tool for oil pipelines can be sold for 40 times as much as it costs to produce an individual unit. It will be possible to sell the tool with high profit margins after recouping the initial (and often substantial) research and development costs.

Telecommunications companies have similar scalability to tool manufacturers. Each new customer costs the network operator almost nothing, so the additional subscription costs increase profitability considerably. The initial cost is the installation of the network.

Pharmaceuticals demonstrate how scalability can also apply to physical products. The development and approval of new medicines costs an enormous amount of money, but production costs per unit will be very low. Patent rights can protect against copying and contribute to maintaining a high price for a 20-year period.

Even more scalable is the development of standard software. When Microsoft first creates a new version of Word or Excel, the duplication costs are marginal. Mass production of a DVD disk costs practically nothing. To a somewhat lesser degree this will also apply to software that requires a significant amount of customer adaptation; for example, the logistics system SAP, for which consultancy costs are often significantly higher than the licence itself. While consultancy revenues are welcome, this type of business model will reduce scalability.

The most extreme instance of scalability is so-called Software-as-a-Service (SaaS). These are systems made available over the Internet such as Saleforce.com, Skype or Google. Beyond the initial development costs, these enterprises have neither production nor distribution costs. In principle they develop a complete solution and upload it to the Internet. Their customers download it and pay online by credit card. This is the way iTunes, Spotify and Amazon distribute music, games and books.

 

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In summary, scalability increases along an axis as shown in the figure above. We believe that almost all enterprises can be made more scalable. For example, if you make a living lecturing, you can hold multiple lectures using telephone conference services or by training employees. Or you can create a franchise business based on your coffee bar and extend it across the globe, like Starbucks.

Drivers of scalability

We use four components that can contribute to increasing scalability for a solution. We call these drivers of scalability as illustrated in the figure below.

 

 

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Scalability in production: This relates to the percentage of production cost that is directly dependent on the number of manufactured units. If there are major research and development costs for the construction of a prototype and thereafter-low production costs for each produced unit, we have this type of scaleability.

For physical products, it is possible to increase scalability by automating production. The simplest example is to cast a brick instead of forming it by hand. This concept can be applied to all modern industrial production. By their nature, non-physical solutions such as software, e-books and digital music have this type of scaleability. Apple iTunes and Amazon Kindle e-book readers are examples. Digital copies of both books and music can be duplicated at almost zero cost. Some services that involve a minor degree of knowledge exchange between customers and vendors, to some degree, can be industrialized and made more scalable. (For example, creating a fast-food franchise modelled on a successful restaurant.) Standardization contributes to improving cost-efficiency in a similar way to physical products. Services that do not require much specialist knowledge, however, are difficult to protect from competitors. Therefore, the price you can obtain in the market will be reduced. If you can reduce costs more than this price drop, you can still achieve a degree of scalability.

Scalability in distribution: You can also create scalability by minimizing distribution costs for each manufactured unit. You may have a product scalable in production, but might still incur significant sales, distribution, adaptation and installation costs. These costs reduce the product’s total scalability.

As we have already explained, software always has scalability in production. Software installed at the customer location, however, often has consultancy costs in connection with installation and adaptation that exceed the licence costs.

Many of the new system providers (Salesforce.com, Google) use the Internet as a distribution channel. They run their systems on a central server and allow users to connect via a regular Internet browser. This type of SaaS distribution, as we have previously mentioned, by its nature will maximize the distribution-based scalability. However, suppliers that install software locally can also increase their scalability. They can improve their installation and training routines and select customers that do not require special adaptation of the product.

This type of scalability is also found for physical products. Amazon.com and Dell are examples of how something physical such as a book and a computer respectively, can be distributed in a cost-effective and thereby scalable manner.

Scalability and networking: Here we discuss scalability created by interaction between people.

When the value of using a product (and thereby the willingness to pay for it) is related to how many others who also use the product, economists call it positive externalities (Stiglitz 1988). This happens when the customer helps to further refine the product. In its simplest form, the customer contributes to requirement specifications, customization and deliverance. For this reason, software development can be considered a type of joint venture. Many customers with similar interests contribute with licence payments, and also with input into the development of new functionality and testing of the product. Suppliers with many customers (or participants in the joint venture) are able to improve the scope and quality of the product faster than those that have fewer customers. New businesses with fewer customers need to use more of their own resources to make up for their competitors’ technological head start. Prahalad and Ramaswamy (2004) call this interaction between customers and suppliers “co-creation”.

A more complex example of positive externalities is when the interaction between customers itself increases the experienced customer value. Much of the value of a bar or nightclub is associated with the presence of other guests. Similarly, the value of social networks such as Facebook or LinkedIn will be directly dependent on the presence of other users. The same applies to marketplaces or auction portals such as Craigslist or eBay. If there are no potential buyers, the portal is of no interest to sellers. If no one is selling products, there is no point in going there to buy. Several SaaS solutions allow customers to contribute with content that increases the value of the service. Two examples of this type of solution are Amazon.com and iTunes that both provide product recommendations based on analysis of previous customers’ purchasing patterns.

Scalability in infrastructure: The final driver is where growth in the number of customers makes it possible to increase the payback from investments already made in infrastructure. When telecommunications or broadband companies acquire new customers, they increase the returns from the investments they have made in cables and network. A company with an automated system for distributing music files to several hundred digital music stores will earn more money the more artists they represent. The system is in place and the increased costs of increasing traffic through the product are small. The ownership of such infrastructure provides in itself a potential for scalability.

These four drivers for scalability can work together or independently. For example, Facebook, which is perhaps one of the most scalable enterprises in existence, has aspects of all four. The software that supplies the service is produced with a large degree of scalability. As the service is distributed directly over the Internet, distribution is extremely scalable. The fact that the perceived value is created by the interaction with other users contributes to network-based scalability. Steadily increasing numbers of new users that utilize the existing server park will create a value increase in the infrastructure. Another company that is scalable in production and distribution and via positive external influences is Wikipedia. What makes this example particularly interesting is that Wikipedia's value for users increases as other users, at no charge, create and add content. This joint-venture way of thinking is something we often see in scalable companies.

Why is this important for your Startup?

Simply because the main purpose of tweaking your business model, is to make your operation as scalable as possible. A scalable business model will stand a much larger chance of being profitable in the long run. And it is always possible to influence the scalability of your business model by trying to manipulate the four drivers. Think of them one by one, and see if you can’t get some ideas concerning your own Startup.

We hope that this blog post may inspire you, and perhaps start a discussion. If some of the entrepreneurship terminology used is new to you, you will find it better explained in the Business Model chapter of our Lean Business Planning book. You can download a free introduction to the book by cliking on the call to action below.

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Topics: Business Model, Scalability

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