How Elon Musk leverages economies of scale and vertical integration

When economics professors explain the concept of an industry with high “barriers to entry,” the examples they usually reach for are automobiles and space flight. Setting up a lemonade stand (or, these days, a software company) may be child’s play, but the complexity and massive capital requirements of the “metal-bending industries” have kept them more or less closed shops for as long as they’ve existed.

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So how did two spunky startups come to dominate these two impenetrable industries within the space of a few years? Many have pondered this question, and several plausible answers have been found—most having to do with disruptive technology. However, innovative technology, or an innovative business model, will only take you so far. One of the reasons it’s so hard to challenge the Toyotas and Boeings of the world is their economies of scale. You may be able to build a great car, or a spaceship, in your garage, but you’ll never be able to sell it at a reasonable price unless you can build thousands of cars, or dozens of spaceships.

As Enrique Dans writes in a recent piece published in Forbes, for Elon Musk and his fellow visionaries at Tesla and SpaceX, economies of scale don’t represent an obstacle, but rather an integral part of the companies’ respective business plans.

Economies of scale are what allows SpaceX to put satellites, and now human astronauts, into orbit at a fraction of the usual cost. By making its booster rockets (and other components, such as fairings) reusable, the company is able to reduce not only the hardware costs of launching payloads into space, but also the turnaround time between launches. SpaceX’s Starlink project, which may involve deploying as many as 42,000 satellites to provide global internet access, would never be viable without keeping the cost of each launch to a minimum. More launches translate to lower costs per launch.

SpaceX’s sister company, Tesla, also relies on economies of scale. Elon and his merry men and women understood from the beginning that the only way to get battery costs down would be to manufacture lots of them—that’s why Tesla started building the Gigafactory well in advance of beginning volume production of Model 3.

Believe it or not, economies of scale represent one reason that Tesla is beating the much larger legacy automakers at their own game (Oh, the irony!). Whereas Tesla enjoys healthy profit margins, at least on its higher-priced models, other carmakers complain that they can’t make a profit on EVs. According to a recent report from Lux Research, prices of EVs from the traditional brands have dropped drastically since 2016, but most remain unprofitable. Of course, this isn’t likely to change as long as the companies insist on producing just enough EVs to satisfy regulations in markets such as California.

Tesla continuously upgrades its production processes to improve quality and squeeze out costs, and most of these innovations rely on economies of scale to make them feasible. One of the big changes from Model 3 to Model Y is that the latter uses two huge cast pieces of aluminum for its rear underbody. This replaces some 70 smaller parts, and allows the size of the body shop to be reduced by about 30%. Later this year, Tesla hopes to make the rear underbody a single-piece casting. However, this will require “the world’s biggest casting machine, which we have two of,” as Elon Musk explained to the Third Row Podcast. “It’s around a 6,000-ton casting machine. It’s the size of a small house.” Tesla could never justify the expense of such a gargantuan contraption unless it planned to use it to build hundreds of thousands of cars.

Another important aspect of Tesla’s manufacturing revolution is vertical integration. When it started out with the Roadster, the young company had no choice but to follow the usual auto industry practice of relying on other companies for key components, and even for vehicle assembly. Once it started building Models S and X, Tesla soon found that outside suppliers weren’t able to keep up with its rapid innovations, and it gradually brought more and more operations under its own roof. Tesla is said to be the only auto firm that makes its own seats; it dropped Mobileye as a supplier of the computer that powers Autopilot, and now makes them in-house; and it is widely believed to be close to making its own battery cells.

Tesla’s mission is to convert the entire global transport system to electric power, just as SpaceX’s mission is to make humans an interplanetary species. Tesla isn’t waiting for the legacy automakers to take the lead—on the contrary, it’s scaling up at warp speed to produce EVs in huge volumes. At the heart of this strategy lies a thorough understanding of the power of economies of scale.

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Written by: Charles Morris; Source: Forbes