#31 Economies of Scale, 7 Powers, Chapter Review 💪
In this post I’ll review the first source of power highlighted in the book 7 Powers by Hamilton Helmer. 7 Powers is a strategy framework developed by Hamilton.
Key insight from the book: Strategy is about Power.
Introduction
What is the book about?
Detail how power is a driver of potential fundamental business value
Provide an actionable understanding of the primary levers of Strategy
How to identify, create, and seize the opportunity for power
Talks about both aspects of power
Statics - being there - how to hold on to Power
Dynamics - getting there - how to become Powerful
Definitions
Strategy: study of the fundamental determinants of potential business value. Value refers to absolute fundamental shareholder value. Best measure of value is NPV (Net Present Value) from future cash flows
Power: set of conditions creating the potential for persistent differential returns
strategy: a route to continuing power in significant markets
Fundamental equation of strategy
Value = current market size * discounted market growth factor * long term market share * long term differential margin
Where long term differential margin is net profit margin in excess of that needed to cover the cost of capital. The product of current market size and discounted market growth factor captures market scale (or significant markets in the definition). The ability to increase or maintain market share while maintaining a positive and material long term differential margin provides the numerical expression of Power.
For significant persistent differential returns, two components must be present
Benefit: some condition which yields material improvement in the cash flow due to reduced cost, enhanced pricing, or decreased investments
Barrier: some obstacle that prevents competition from engaging in behaviors that destroys margins
Persistence is a key ingredient in maintaining differential margins by establishing and maintaining rare conditions that provide value while being immune to competitive onslaughts.
Economies of Scale
One of the sources of power is economies of scale. The quality of declining unit costs with increased business size is referred to as Scale Economies. Why do scale economies result in power?
Benefit:Â improved cash flows by
Enhancing value, enabling higher pricing
Lowering costs
Example: Amazon offering Prime - free shipping on Prime products.Â
Barrier: Prohibitive costs of gaining market share because
They are unable to deploy the necessary resources
Deploying resources and taking action will be economically unattractive
Example: Netflix moving to exclusives and originals
Scale economies emerge from the following sources:
Fixed costs are spread over higher volumes. Example - manufacturing, software products
Volume-area relationships i.e when production costs are closely tied to area, while their utility is tied to volume. Example - warehouses
Distribution network density i.e. as the density of distribution network increases to accommodate more customers per area, delivery costs decline as more economical route structures can be accommodated. Example - shipping costs for Amazon
 Learning economies i.e. learning leads to a benefit and is positively correlated with production levels
Purchasing economies a large scale buyer can often elicit better pricing for inputs. Example - Walmart
In order to calibrate the intensity of the scale leader's Power, Hamilton proposes the notion of Surplus Leader Margin
This is the profit margin that the business with Power can expect to achieve if pricing is such that competitor's profits are zero. If C is the fixed cost
Surplus Leader Margin = [C/(Leader Sales)] * [(Leader Sales)/(Follower Sales) - 1]
The first term is tied to the economic structure of the industry and the second term reflects the position of the leader wrt the follower.
Surplus Leader Margin = Scale Economic Intensity * Scale Advantage
For Power to exist, both the terms must be significantly positive
PS: Summary of all the Amazon Shareholder letters from 1997-2018 are available as a Kindle book.