We all have an intuitive understanding of “economies of scale.” When companies get big, their scale lets them drive down costs and increase profit margins. It’s what makes Walmart Walmart and Amazon Amazon, right? Fast-growing startups can pull off successful IPOs even as they’re bleeding money partly because of the expectation that they will reach scale quickly and losses will turn to profits. 

“Every time a firm goes public, they put together projections about what the future will look like,” says Jake Thomas, the Williams Brothers Professor of Accounting and Finance at Yale SOM. “Nearly every forecast includes a presumption that growth will mean average costs fall and therefore profit margins will rise. It’s almost accepted as a law of nature.” 

Jacob Thomas has been doing fundamental valuations of companies for 40 years. “The reduction in costs and improvements in margin were just not showing up for the average firm.”

Sources of scale efficiency include the relatively fixed nature of many costs, increased bargaining power relative to customers and suppliers, investments in research and technology, customer acquisition costs, and so on.

It’s obvious and intuitive—but is it actually true? “It’s surprising, but the data don’t support the idea,” Thomas says.

Once more, slowly: when companies get bigger they don’t, on average, lower costs and don’t see bigger profit margins. “It’s a huge deal, but people are very unhappy with the message,” Thomas says.

It took Thomas himself a long time to, as he puts it, “start to question gravity.” He has been doing fundamental valuations of companies for 40 years. Again and again he saw something unexpected. “The reduction in costs and improvements in margin were just not showing up for the average firm.” He adds, “I kept seeing that what actually happened was when an organization doubled sales, everything doubled with it—back office costs, technology, compliance, legal, corporate, everything.” 

Thomas kept thinking he was seeing something unusual. This firm, that industry, or a specific time period represented an exception to the rule. Eventually, the niggling question of why he saw so many exceptions led him to question the rule itself. 

“It only made sense to do a more scientific study with a large sample,” Thomas says. He began working with two Yale PhD alumni, Aytekin Ertan and Stefan Lewellen, in 2016 (Ertan is now an assistant professor of accounting at London Business School, and Lewellen is an assistant professor of finance at Penn State Smeal College of Business.) Their study is forthcoming in the Journal of Management Accounting Research.

Thomas, Ertan, and Lewellen analyzed all the companies that have gone public in the U.S. since 1974. They found that even during the early post-IPO years, when growth is highest, firms have not lowered costs or increased profit margins. 


Read the paper: “Do Profit Margins Expand for High Growth Firms?”

To be clear, Thomas and his co-authors investigate costs per dollar of sales, not unit costs. The distinction is critical. As a company producing laptops gets bigger, for example, it might produce each laptop more cheaply. But lower unit costs might not result in scale efficiencies if selling prices fall at the same time.

For Thomas and his co-authors, unit costs aren’t really the point. “When you’re looking at large organizations, you don’t really have unit costs, you only have dollars of cost and dollars of sales,” Thomas points out. “That is what people really care about—at the end of the day, am I ahead or not?”

The companies in the data set did grow. Median real sales growth (adjusted for inflation) in the sample exceeded 8% annually. But, as the paper puts it, “Contrary to our expectation and the common wisdom that scale efficiencies are pervasive, we do not observe declines in the ratio of costs to sales and increases in the ratio of profits to sales.” The results held for various measures of costs and profits, across industries, time periods, and age of firms.

The initial analysis drew from University of Florida Professor Jay Ritter’s IPO database of U.S. companies. The sample included 6,103 distinct firms which represent 53,079 firm-years between 1975 and 2016. 

To confirm the validity of the results in other contexts, the study looked at three additional data sets, covering all U.S. public firms, public firms worldwide, and private firms in Europe. The results, according to the paper: “Again, we fail to find margin improvement over time.” 

Thomas and his co-authors are curious to know why efficiencies from scaling aren’t showing up. “There’s really a long list of reasons why scale efficiencies might not lead to improved profit margins. I’m not sure which explanation or combination of explanations would account for it,” Thomas says. “We don’t have enough data to answer that.”

The paper posits three possible explanations. First, competition might mean that lower production costs are passed along to consumers as lower prices. Second, if firms start with the most profitable projects, then profit margin improvement from scaling may be offset as they move into less profitable projects. 

Investors, Jacob Thomas says, should “be more skeptical of claims that, as Tesla gets bigger or Uber gets bigger, current losses will suddenly become profits.”

For the third possible explanation, Thomas offers a thought experiment: Imagine a meeting where next year’s projection of 10% more sales are presented. When group leaders are asked what they will need to meet that new level of demand, what do they say? 

In Thomas’ experience, it goes something like this: “All the managers of the different cost lines say, ‘I’m going to need 10% more in my budget to do that.’ Production, technology, advertising all ask for 10%. Sales go up by 10%, cost goes up by 10%, and margin doesn’t change.”

There is a budget model that systematically addresses that very human impulse to grow costs proportionately: zero-based budgeting, which starts from scratch every year. “Every manager has to justify why they’re spending money,” Thomas says, “rather than just use last year as a base then asking for 10% more.” A study of firms using this method could be instructive. “Unfortunately, not a lot of organizations use zero-based budgeting,” he says. “The ones that do typically stop at some point because it’s very stressful.”

Another open question is why, if costs don’t generally go down and margins up as companies grow, people continue to believe that they do. “I think the intuition seems so strong because it’s been repeated so often,” Thomas says, “and it’s been repeated so often because people want to believe it.”

What are the takeaways for business? To investors, Thomas says, “Be more skeptical of claims that, as Tesla gets bigger or Uber gets bigger, current losses will suddenly become profits.” And company executives, Thomas says, will need to get out of the habit of assuming that there’s a natural tendency for their costs to fall with scale: “If you are going to project efficiency, you have to have some concrete story why you expect exceptional results.”