One of the great advantages of writing a blog like mine is that I get to spend time with other professionals who know more than I do. Recently I've become friends with a former partner of the Boston Consulting Group who generously shared his time to help me better understand the difference between the vague economic concept of economies of scale and the more useful industrial concept of experience curve effects that was pioneered by BCG in the late 1960s.
In general, the economic concept of economies of scale describes the aggregate cost advantage to a business as the size of its infrastructure grows and its use of that infrastructure becomes more efficient. The most common sources of economies of scale include:
- Purchasing economies from buying larger quantities of materials;
- Labor economies from worker specialization;
- Technological economies from improved production methods;
- Managerial and marketing economies from spreading costs over a larger number of units; and
- Financial economies from easier access to capital and debt.
A textbook illustration of economies of scale looks something like this graph. In the early stages of an enterprise or technology, production costs decline rapidly until they reach an optimal level. Once production exceeds the optimal level, diseconomies begin to surface from competition, materials shortages, regulation and any number of other factors that make the next incremental unit of production more expensive.
Like many economic concepts, economies of scale are simple to identify as abstract principals and very difficult to quantify. Investors and businessmen intuitively know that economies of scale exist, but they frequently overestimate their importance and their magnitude.
In response to the inherent difficulty of forecasting economies of scale in a real world setting, BCG began studying the phenomenon from an industrial perspective in the late 1960s. They ultimately distilled the vague economic concept down to a generally applicable mathematical formula that says for every doubling of cumulative production volume, the marginal cost of value added activities falls by 10 to 30 percent, depending on the industry. Additional work from Arthur D. Little further refined the BCG's work by observing that experience curve effects were typically exhausted during the first 20 years of a technology's life cycle.
A textbook illustration of experience curve effects looks something like this graph. In the early stages of an industry or an innovation costs plummet as manufacturing methods improve, workers become more skilled and supply chains are optimized. After the initial surge of huge incremental cost savings the curve rapidly flattens. By its very nature, the experience curve captures substantially all economies of scale.
The most common error made by analysts and investors who try to use the experience curve to project future costs of a product is the failure to grasp the notion that experience curve effects are only predictable for the value-added component of manufacturing costs. There are no experience curve effects for raw materials and experience curve impacts for most types of manufacturing equipment are determined by where the producer of the equipment is on his experience curve.
Over the last five years I've watched analyst after analyst misuse the experience curve in battery price forecasts by starting with current cell costs and applying the BCG formula without deducting:
- The cost of purchased raw materials and components that don't have experience curve effects; or
- The cost of machinery and equipment used in the manufacturing process.
The error is so common and pervasive that it's generated a market mythology that can only lead to catastrophic disappointment when future costs don't follow the predicted curve.
When you consider the battery industry, it's critically important to remember that 50 to 70 percent of product cost is the cost of raw materials and purchased components. That means that only 30 to 50 percent of product costs will exhibit experience curve effects. In most battery manufacturing operations, the basic manufacturing equipment has been around for decades so equipment costs are also fixed for all intents and purposes. By the time you eliminate raw materials, purchased components and manufacturing equipment costs from the experience curve base, you're left with 15 to 25 percent of total product cost that may have experience curve effects while the other 75 to 85 percent of product costs remain stubbornly stable.
The same dynamic prevails in the electric vehicle industry where the lion's share of product cost is batteries and electric drive components that are made by somebody else. Electric motors and drive components are so far out on the experience curve graph that there's no reasonable chance of significant future cost reductions. The same is true for lithium ion batteries that will power EVs of the future, if there are any EVs in the future.
Companies like Tesla Motors (NASDAQ:TSLA) can play cute consumer games with battery replacement programs that hint at substantially lower future battery costs, but the financial truth behind the marketing gimmick is that Tesla buyers who choose the battery replacement option will be making an eight year, interest free unsecured loan to a money losing company that could never sell zero coupon debt.
Getting back to the battery industry, I can identify two companies that have significant opportunities for future experience curve effects: ZBB Energy (NYSEMKT:ZBB) and Axion Power International (NASDAQ:AXPW). Since both of these companies are just beginning to sell products based on technologies that are transitioning from R&D to commercial production, both companies are very close to the upper left hand corner of the experience curve. As their future sales ramp from insignificant to substantial, their margins should increase rapidly which will give both companies the ability to reduce product prices and compete more effectively for new business.
The bottom line is that economies of scale do exist and so do experience curve effects, but big cost reductions are only possible with respect to the value added portion of manufacturing costs after eliminating the cost of raw materials, purchased components and any manufacturing equipment that hasn't been used in substantially similar form in other industries.
Additional disclosure: I served as a director of Axion Power International from January 2004 through January 2007.