Software and Computer Engineering

What is a Business that Scales

Scale is a word that so often gets thrown around in technology and entrepreneurial circles that it nearly loses its meaning. Let me examine what scaling means from first principles.

First of all, at a “micro” level, the magic of the economy relies in the fact it is not a zero-sum game.

As an example, say person A and person B both need shirts and shoes (the items in particular are not important, just a placeholder for any demand). In an initial situation without trade, person A and person B each have to manufacture shirts and shoes to fulfill their own needs.

Instead, if person A and person B both reach an agreement where person A only makes shirts and person B only makes shoes, it's likely that the time and effort that an individual takes to produce two units of the same product will be less than the time it took to produce two units of distinct products.

This is the argument for specialization: through trading, both person A and person B benefit. Through experience, person A becomes a better (more productive) shirt maker and person B becomes a better (more productive) shoe maker, which is valuable for both.

At a “macro” level, this fundamental idea is repeated thousands of times in our modern life in many distinct areas: an individual doesn't have to learn to lay bricks to have a house, sew textiles to have clothes, farm animals and plants to have food -- they can instead contribute other ways to society and recruit the people who have way more skills and tools which are then able to address each of these needs in a fraction of the time, cost and effort it would take themselves to learn and do it.

Coming back to what it means to scale. For a business to scale, it needs to both: 1) be able to reproduce its success, time and time again; and 2) do so at an ever decreasing marginal cost.

For almost any busines, revenue is proportional to the number of customers. If a business serves 10 customers a day, it has a certain revenue X. If it were to serve 100 customers, it would (ideally) have 10X the revenue.

There are practical aspects which makes serving 10X customers difficult, though: maybe the store isn't big enough to fit ten times the people, maybe there's not enough staff to serve everyone in a timely manner, maybe there's not enough products to address all the customers.

For classic businesses, expenses grow in a roughly proportional manner to the number of customers: a larger place is needed for the operation, more staff is needed on the payroll, more inventory needs to be stored, and so on.

For the coveted business that scales, its costs and expenses grow an ever diminishing fraction of the current size of the operation. As an example, a single engineer can design a website which serves thousands of people a day. If the business is growing to serve tens of thousands, maybe we need two engineers now. Hundreds of thousands can be served with, say, a team a three or four engineers.

For the business that scales, a 10X increase in customer base only represents a X increase in operating costs; a 100X increase in customers amounts to 2X increase in costs, and so on. This means that revenue can keep increasing at an exponential rate -- proportional to the number of customers --, while costs are increasing at a linear rate -- proportional to the number of staff and cost of infrastructure. This is the mathematical recipe for the business that scales.