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Businesses that benefit from “Economies of Scale”² have low variable costs, relative to their fixed costs. Examples include software, biotech, media, and manufacturing. Business School 101³ teaches you that companies with Economies of Scale have the potential to be highly profitable, since as they grow, their costs stay the same. In case you’re wondering, that’s why venture capitalists love investing in software and biotech but not restaurants.

When you have economies of scale, you will inevitably be asked, “should you underprice your product to get more customers and take advantage of those economies of scale?”

Our take is “no”. Not unless you can pass one (or both) of the following tests.

The story of Amazon has been told 10,000 times by far better authors¹ than myself. People focus on Bezos' Day 1 culture, the company's relentless innovation, and somewhat famously, its lack of profitability. In fact, Amazon did not report a profit until ~10 years after its founding.

For much of Amazon's early retail history, they were employing an adoption strategy.

By focusing on driving total customer count higher, they were able to dramatically reduce their costs. And I'm not merely talking about their fixed costs that they spread over more customers. Their variable costs also plummeted, making each customer even more valuable.

Spreading fixed costs across more customers is boring. Yes, if your warehouses or delivery trucks are half full, you will have more profit per customer by doubling your customer count. But you will also double your revenue, which is always nice. This is the same strategy that any high fixed cost business uses: software, pharmaceuticals, and Netflix all have high fixed costs that they spread across a large customer base.

What's more interesting is what they did with variable costs. By flooding the market, Amazon was able to make delivery driver routes more efficient by serving denser markets.

Amazon also had tremendous purchasing power; with such a strong market position, the company could negotiate lower prices from suppliers, driving variable costs down even further.

Can you lower your COGS⁴ per customer by having more customers? If so, you might want to underprice.

Dropbox is another misunderstood example of economies of scale.

What caused Dropbox's rapid rise to consumer success ~2014? Many things, but only one is particularly interesting for pricing.

What am I talking about? In ~2012 Dropbox allowed customers to refer other customers in exchange for extra GBs of cloud storage. They undermonetized cloud storage in exchange for referrals. This strategy didn't spread fixed costs around to more customers - rather by having more customers, they were able to drive their marketing costs down, relying heavily on their viral loop.

Can you lower your customer acquisition cost (CAC) by having more customers? If so, you might want to underprice.

I love talking about gym pricing - we even did an extensive analysis on the gym market in our series on time-based discounts.

But here’s the thought exercise that’s relevant for economies of scale:

Gyms have phenomenal economies of scale. Provided that you don’t have to open another facility, the cost of running a gym is almost entirely fixed costs (or depreciation). Until you open another location, gyms paradoxically look a lot like software companies⁵.

Should a gym underprice because they have phenomenal economies of scale? I hope it is obvious that the answer is “no”. A gym should set their rates to maximize revenue. If that means that the gym is not at full capacity sometimes, that’s ok, as long as we are maximizing revenue.⁶

My point is this - having economies of scale is not a good enough reason to underprice. Your economies of scale must come from lower variable costs per customer, not just lower fixed costs.

Do you have economies of scale power? Let's find out.

If you your current customer count doubled, by how much would your variable costs decrease? Think about the following:

It might be wise to quantify those assumptions. Stay tuned for the end of this series when we give you a nice party favor to help with that!

Crescendo works with medium-sized software companies to improve their pricing, packaging, and promotion strategies. If you’d like to book a quick consult, reach out at info@crescendo.partners or schedule time via the button below.