Economy of Scale: What can it do for you?
Written by Brandon Allen
Executive Director / Fortify Foundation
What comes to mind when you hear the phrase ‘economy of scale’? Perhaps it’s just a phrase you’ve heard in passing with no sort of context. Maybe the context was back when you were sitting in your college economics class, and you haven’t given it a second thought since then. Is it something we should think about? Does it provide any benefits, and if so, how does it apply to our Christian institution?
I can guarantee that regardless of who you are, you have thought of and have taken advantage of some sort of economy of scale at some point in your life whether you realized it or not. Perhaps most recently it was at the grocery store. When looking for the best deal, we compare products to find out which will suit our needs and yet save us the greatest amount of money. This may be buying an off brand or a different brand that has cut costs in packaging. Does cereal from a bag and box make that much of a difference versus just cereal in a bag? What about buying a larger sized container of peanut butter versus a smaller sized container? Typically, and you might have to be careful with this one, the larger container usually costs less than the smaller one when you compare the cost per ounce. If you have a larger family perhaps you’ve expanded your ability to take advantage of an economy of scale by adding a Sam’s Club, Costco, or BJ’s membership to your annual expenses. Why? The ability to buy in bulk far outweighs the minimal membership costs that we pay each year. We know that the savings is well worth the initial investment.
The same scenario applies when we go to buy our own institutional operational supplies. We may need just one pen to operate in the immediate as an individual but when there is a whole team that needs the same thing, we start to think in different terms. Oh, and if they are red pens, we know they may only last us half the school year since we are correcting our student’s papers with them. With that in mind, we need to buy extras to ensure we won’t run out. Equipped with that knowledge, let’s plan for 200 pens. Oh wait, there’s a deal for half price per pen if we buy 500! We can always use pens, plus it’s a commodity which has no expiration date, so why not take advantage of it.
In short, these are examples of an economy of scale. It is the cost advantage gained due to a particular increase in production and operation which allows the wholesaler / retailer to sell at a reduced cost.
A business that runs a variable cost model sees their expenses fluctuate based on their output. As the output is increased, the cost per unit decreases and many times those savings are passed on to the consumers and we can reap the benefits! We can all appreciate when this happens.
The only potential caveat that can come into play is the initial capital that is required to make these savings happen. Sometimes, we may not be able to make that initial investment due to other expenditures that ties up our capital. Just by way of example, sure, I’d love to buy 1,000 rolls of toilet paper in case there’s another run on that product, but I really don’t have $1,000 to freely spend on that commodity. It’s a great deal for those that do! But not everyone has that capacity!
The beautiful thing about having a network of friends is that we may not be able to accomplish it on our own, but together, it makes it feasible for each of us to take advantage of that economy of scale.
This is exactly what we are accomplishing at Fortify Foundation!
Have you ever heard of the phrase ‘it takes money to make money’? One thing I’ve learned over the years is that this statement is 100% accurate! At least to the extent that the margins are much greater when more money is involved. That’s not to say that people who don’t have as much money shouldn’t be investing. We all need to start somewhere. But that is to say that those that have either been investing a while or those that have earned more definitely have greater opportunities to take advantage of bigger gains. There are typically two reasons for this. First, is the expense side. Second, is the investment side.
Any time a new investment account is opened it typically starts at a fairly nominal amount. Even a six-figure amount, while an incredible start for a lot of institutions, it is still a small amount for a lot of wealth managers to hold. With that being said, some institutions won’t even start a fund until you reach the seven-figure number. In either case, both scenarios would be something that would just get you started. At inception, there are typically higher fees because of this nominal amount. Fees that could go as high as 2.5%+ for a high institutional well managed fund. That’s not to say that you can’t find a better rate, BUT it is to say that you will have to pay more upfront than an institution that has a much larger fund. This covers the expenditure side, now for the investment side.
A nominally invested amount will afford nominal investment opportunities. The greater focus for decent returns lies in the equities or stock portfolio. The thing is, we must buffer that with an alternate less risk, low return option so we don’t lose the shirt off our back when the economy or markets go south so to speak. This is why many choose and maintain a certain category of risk at the inception of their fund. Typically, the higher the risk, the greater the reward OR the lower the risk, the lower the reward. A larger fund can gain greater rewards with lower risk through alternative investment options that smaller funds can’t access.
On top of that, most financial institutions will likely not spend as much time with your fund as that of a larger account unless there is a personal connection. It’s great when you have a larger fund that has a personal touch or focus on it to help get those greater gains on your fund. Again, pointing out these areas really does reveal, ‘it takes money to make money’.
One way that institutions often counter these two differences in their portfolio is to stick their investment in a generic index or vanguard fund. The main initial reason is due to the low-cost options that it provides. This helps offset some of those initial fees that a high-level institution would otherwise charge. And then there is the return side. When evaluating investments, we always look at averages over a 10- or 20-year period to provide the best point of reference. These funds do typically net a decent return but not the best. This is an initial point of evaluation that most should consider. Can we gain a higher return on our money elsewhere? We obviously want to be the best stewards of God’s money as we can be. Doing our due diligence for any investment strategy is key.
Another thing that we as Christians must consider is what we are invested in. The beautiful thing about these low-cost options is the diversity that they provide which helps bring a well-balanced portfolio to the table. The problem with this is that you are inevitably investing in things that would be contrary to what the Bible teaches. I’ll be the first to say that there will be no perfect formula in this arena but we most certainly want to have a certain level of consciousness in what we are promoting. James 4:17 challenges us that if we know what’s right and still do what’s wrong, then it is most certainly sin. Sure, we may not always get it 100% right with the nature of shelf / parent companies, but we never want to intentionally invest in something that is downright wrong.
Fortify Foundation’s mission is addressing all these areas through our component fund strategy. At the inception of any fund regardless of whether it is $10,000 or $10,000,000, every fund will get to take advantage of a higher institutional strategy than it could on its own. Our mission is to get schools to think further down the road and start developing an infinite strategy. Something that will sustain us from now until our Savior returns. If we persuade each school to at least start an endowment, we feel as if we have accomplished our mission. However, if we convince 50 schools and each of those schools start a $1 million dollar fund (which, let’s be honest, the vast majority of Christian schools probably wouldn’t be able to do without a very generous donor(s)), they still would each be invested at a $1 million dollar amount. But, if those same 50 schools pooled their endowments together, they now would be invested at a $50 million dollar strategy! Their endowment still accomplishes the same thing and in turn they get to take advantage of an economy of scale that they couldn’t otherwise accomplish on their own. Their fees are reduced, and their return rate is greater. On top of that, they are comfortably invested in something that won’t compromise their beliefs.
We believe that endowment is a key to the future. The problem is we should have been doing this since our school’s inception and so we have a ways to go before it may make a huge impact on your school. Fortify Foundation wants to help close that gap as quick as possible! Regardless of your school’s size, each of you will get to become part of something bigger than what you could on your own. Plus, instead of work with a for-profit institution, you are partnering with a non-profit that works on your behalf and is always looking for ways to benefit you and your school!