Search Economics – Automation and Economies of Scale

This post is the second in the series on Search Economics. The first post discussed a concept called the Law of Diminishing Returns. This series on Search Economics is intended to help search marketing firms understand the economics of their own businesses, and also to help explain some difficult concepts to clients. Primarily though, this post in particular helps to explain the industry's fascination with automation.

Definition:
Economies of scale are defined as; when more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale (ES) are said to be achieved. In lamen's terms, the more you produce, the lower the average cost of production.

The Apple Tree Analogy:
Lets go back to our apple tree example from the previous post the Law of Diminishing Returns.

Let's imagine for a second that now we've found this apple tree brimming with ripe red fruit, we want to start a small business by picking a bunch of apples and then selling them to tribe members back at the base camp (we're cavepeople remember), rather than merely eating our fill on the spot.

Different Types of Costs:
If that's the case, there are two groups of expenses that we really need to understand:

1) variable costs ... these are the costs associated directly with the picking of the apples, and with each and every apple picked. Every single apple picked requires more time and effort. Also, remember in the last post, the Law of Diminishing returns showed that the more apples we picked, the more time (ie. cost) it took on average per apple. Accordingly, our average variable cost increased with quantity picked.



2) fixed costs ... these are more one-time costs, or costs faced very infrequently, and are not a direct function of the production volumes. In today's business environment, rent, and major equipment purchases would likely would fall into these categories. As production volumes increase, the fixed cost per apple drops. In the apple example, the fixed costs would be the time needed to:

a) find something (like a strong leaf or a skin) to place the apples in, so numerous apples could be carried back to base camp
b) the time needed to walk to and from the apple tree

Again, these are costs that are roughly the same whether you pick 10 apples or 100 apples.

The Math:
As you may have surmized already for our apple example:
a) average variable costs increase with each apple picked (as was shown in the previous post ... the Law of Diminishing Returns).

b) average fixed costs per apple decrease with more apples picked. Let me illustrate:

If it took us 2 hours to find the perfect apple carrying leaf (a leaf large and strong enough for us to pack 100 apples into), this is a fixed cost. If it takes us 30 minutes to walk to the tree, and another 30 minutes to walk back from the tree, this is also time that must be considered. In essense:
Fixed Costs = 2 hours + 1 hour
Fixed Costs = 3 hours or 180 minutes

If we picked 1 apple ... average fixed cost per apple (AFCA) would be 3 hours (3 hours/ 1 apple) or 180 minutes
If we picked 10 apples ... average fixed cost per apple would be:
AFCA = 3 hours or 180 minutes / 10
AFCA = 18 minutes per apple
* where AFCA = Average Fixed Cost per Apple

Implications:
So, the more apples we pick, the lower our fixed cost per apple. This reduction in average fixed cost per apple is therefore the magic behind economies of scale. If we're then in a business that is fixed cost intensive, economies of scale are possible. Often, these are manufacturing type industries rather than service type industries.

For the most part however, SEO/PPC is variable cost intensive, which means "the law of diminishing returns" is typically more powerful. There are minimal set-up costs, and virtually no barriers to entry, which is typical of service base industries. This makes scaling operations much much more difficult.

All in all, it sure is easy to see why so many are trying to create tools to automate the SEO process. Doing so would be to take our industry's biggest weakness (scalability) and turning it into our biggest strength (economies of scale). So, if you find yourself with an idea for a great piece of industry software ... make sure to give me a call! I know we're working on it!