April 28, 2008

Business scalability

I received the following question from rathin and thought that this a good question which cannot be answered in a short comment.

Hi Rohit,Can you elaborate more on "Business scability"...Rakesh JhunJhunwala emphasises on that...Can you also give one practical example of a company??

Rakesh Jhunjhunwala empahsizes the term ‘business scalability’ a lot in his interviews and presentations. Let me try to give my understanding of of the term

I think business scalability should be analysed based on two key factors

1. Market opportunity – How big is the addressable market, the company is trying to target
2. Business model – How scalable is the business model in its ability to tap the above opportunity profitably

Let me expand further on the above two points via some examples

Lets take the example of Bharti or any other similar telecom company.

Market opportunity – The market opportunity is case of telecom is huge. Telecom services are still far below international level and even after years of hyper growth, there is still a large untapped market. Market opportunity is easier to identify and one can compare the indian market with other markets to get a sense of it. However the fallacy by most analysts is to take a direct linear estimation. For ex: for argument sake US consumes 20 Kg of choclate per capita per annum. India’s per capita consumption is say 100 gm. so the market opportunity is 200 times that of US.

This is a very simplistic approach and should be taken with a pinch of salt. There are far more variables involved in evaluating market opportunity and a range of values for most products and services should be considered.

Business model – This is far more complex to analyse. This is where the genius of investors such as Rakesh jhunjhunwala is apparent. They are able to evaluate the business model far in advance and are able to judge if the business model of the company can scale profitably.

For ex: In case of telecom, there is a huge upfront investment in the infrastructure, license, setting up the marketing infrastructure etc. However once these investments are done, incremental cost of gaining a Rupee of revenue is low. Such business models are far more scalable

To get technical – The marginal cost remains steady or reduces in scalable models. Such companies get more profitable as they grow.

In contrast lets look at IT companies. It is apparent that the market opportunity is large. However the business model is not as scalable as Telecom. Here the relationship of revenue and cost is at best linear. In some case there may be a disadvantage to the scale. As the company grows larger, you need to manage more employees, have more layers and there are other costs involved in managing such large organizations. The top tier IT companies now have 100000 employees . A 10% CAGR growth for next 10 years , which is not a high assumption , would take the employee strength to 1 million plus. So you are talking of model which is not as scalable as Telecom

Lets take an extreme example of a roadside eatry. The addressable market is big. However the business model is not scalable as the eatry can only serve limited geography and may be limited by the competency of its owner and the employees running it. However if the owner can develop a franchise and start licensing it, then the model is scalable. Alternatively if the owner can brand its product then it is scalable to a certain extent

Among the two factors discussed above, I think the more crucial aspect is the scalability of the business model and how competent would the management be in tapping the external opportunity.

Next post: How does scalability impact valuations ?


Anonymous said...

Hi Rohit

I agree with you that ability to scale business is a more important variable than the market potential.

You are right in stating that how does business scale up revenues at minimal marginal cost addition.

I think telcom managed to get it right as they figured out how to address the bottom of the pyramid. Also how do I move a customer up the value chain by hence get greater thruput per customer without increasing my fixed cost. the real story in telecom is not just the number of subscribers added but the ability to add VAS ( Caller tunes, music etc) to that subscriber.

I think most businesses are scalable except for commoditised ones like steel, cement etc.

Lets look at IT. We have a Infosys/ TCS etc where they have ran a business based on scaling up numbers. You also a Microsoft which is a phenomenal scaled up business model. The key in IT is whether companies like Infosys/ TCS can move up the value chain and build IP which will enable scalability.

Similar difference exists between a Indian pharma company and a global one. Discover a Viagra and you can stand up and be counted. ( No pun intended :-))

Lets look at FMCG. Soaps have nearly about 95 % penetration level. So what is the scalability. Can Lever migrate a customer from a Lifebuoy to Lux to Dove. Thats scalability and I dont think HUL has been able to crack it.

I thnk the telecom guys did a phenomenonal job and you are right Rakesh J has this uncanny ability of spotting companies/ managments that can make this happen.



Rohit Chauhan said...

Hi ninad

great comment.

The point you make about a TCS/Infosys v/s a product company such as microsoft or pharma companies goes the nature of the business model. although most of the people will not agree with me, having worked with one the top IT services company, i think the transition may not happen to a product based model for them.

the indian IT companies have a different DNA compared to a microsoft or other similar companies. i am not sure if they will be able to make a complete transition ..a small product here or there ..but not to the scale of microsoft.

In case of pharma companies the transition is difficult, but i think more probable. some of these pharma companies are in psuedo product mode - via contract research, molecule discovery etc. So i think the indian pharma companies may make transition to a more scalable model ..which one will do ..i am not sure

some commidity business as scalable ..but maybe only to limited extent