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In-N-Out Doesn't Want to Be McDonald's

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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Yesterday, I discussed efficiency wages and why they are not a strategy that an entire industry, or the entire low-wage labor market, can follow. Which brings me to the point I wanted to make today: Not everything scales up well.

We are the heirs of the Industrial Revolution, and, of course, the Industrial Revolution was all about economies of scale. Its efficiencies and advances were made possible by banding people together in larger and larger amalgamations, and we invented all sorts of institutions -- from corporations to municipal governments -- to do just that.

This process continues to this day. In its heyday, General Motors employed about 500,000 people; Wal-Mart employs more than twice that now. We continue to urbanize, depopulating the Great Plains and repopulating downtowns. Our most successful industry -- the technology company -- is driven by unprecedented economies of scale that allow a handful of programmers to make squintillions selling some software applications to half the world's population.

This has left us, I think, with a cultural tendency to assume that everything is subject to economies of scale. You find this as much on the left as the right, about everything from government programs to corporations. People just take it as naturally given that making a company or an institution or a program bigger will drive cost efficiencies that allow them to get bigger still.

Of course, this often is the case. Facebook is better off with 2 billion customers than 1 billion, and a program that provides health insurance to everyone over the age of 65 has lower per-user overhead than a program that provides health insurance to 200 homeless drug users in Atlanta. I'm not trying to suggest that economies of scale don't exist, only that not every successful model enjoys them. In fact, many successful models enjoy diseconomies of scale: After a certain point, the bigger you get, the worse you do.

This is a bit counterintuitive, so it's worth sketching out some of the reasons this happens.

Let's start with limits to resources, because this conversation grew out of a Facebook thread about WinCo Foods, a much beloved and be-GIF'd employee-owned regional grocery store in the Northwest. It pays higher wages than Wal-Mart and is frequently cited as the retail giant's "worst nightmare."

As I noted in the discussion, it's possible that WinCo will destroy Wal-Mart. But first, I want to see whether it can expand beyond about 90 stores in eight states, most of them oceans of cheap land.

Why worry about scale? WinCo has an interesting retail strategy: It appears to sell national-brand products at close to cost in order to drive traffic, making its money on the private-label and local brands that it buys direct from suppliers, bypassing distributors. It buys lots outright rather than renting. You bag your own groceries, pay cash and pocket the price savings. It has a few huge distribution centers instead of a lot of little ones, which presumably means that the stores themselves are doubling as warehouse space.

This is a great strategy for an expanding business in areas where land is cheap. But it might get tricky to expand into other areas where, say, someone else already has deals locked in with local suppliers. Or where expensive land makes it difficult to site a new store and use it to store large amounts of product. Or where a high-volume cash business is an invitation to frequent armed robberies.

Corporate culture is another limiting factor: The larger your company gets, the harder a great corporate culture is to maintain. From all accounts, WinCo has a great community of workers, and it has 15,000 of them, which sounds like a lot. But Wal-Mart has more than 1 million employees in the U.S. It might be hard to maintain that level of excitement as you get into the hundreds of thousands of employees. If you try to expand quickly to get scale, your core of loyal employees who have been with you forever shrinks relative to the newcomers who don't yet have the same commitment to the company. This is particularly a problem in employee-owned companies; as you get more employees, you can dilute the sense of ownership, because each employee's contribution makes such a tiny impact on the bottom line -- or you may get wars between groups of employees, as we saw with United Airlines.

This is related to another key challenge: management. As organizations grow, they have to change. Anyone who has been through a startup can attest to this -- when you start out, you don't need to have many meetings; you just hash stuff out impromptu when the need arises. As the company grows, you start to need management reporting lines, and defined roles, and scheduled meetings, and other bureaucratic unpleasantness that everyone hates. But if you try to do without it, everything quickly degenerates into a chaotic mess.

Not every company is good at this transition. If one of the things that made you great as a little baby company was your informality and flexibility, you may find that growing makes your key producers unhappy and ultimately saps the creative flux that made you great at what you do.

This is also a big challenge as the company moves beyond "small" and into "large"; in fact, every time you dramatically increase the size of your business, you will find that it needs to gut-rehab its management structure. Your three great managers who made all the trains run on time can no longer oversee things at the level of detail they once did; they need to spend more of their time making sure that other people do so. Some of them aren't good at that role, but they will be unhappy if someone else is promoted or hired over their head. You start to rely more and more on well-standardized processes rather than individual initiative, which may require some compromises on quality to maintain the price point that your customers expect. It is the difference between an exquisitely pulled shot at your local coffee shop and the massive amount Starbucks has invested in machines that make exactly the same coffee every time.

As I understand it, this is why In-N-Out Burger remains a regional chain rather than a national one; it doesn't think it can deliver the same level of quality as a far-flung mass-market operation. Not to mention the effect of expanding beyond easy trucking range of top-notch California produce. McDonald's solved this problem by relying on frozen products machine-prepared to exact written specifications. Which is why so many people prefer In-N-Out to McDonald's.

All of which is to say that while "selling burgers to the public" is certainly a business that can benefit from economies of scale, In-N-Out's particular business model might not. If it tried to get much bigger, it might lose what's great about In-N-Out.

Am I saying that WinCo definitely can't take on Wal-Mart? Of course not. What I'm saying is that if it did, it might end up looking a lot more like Wal-Mart than the WinCo everyone knows and loves. Or some third thing that we haven't imagined yet.

But the only way to find out whether it can meet those challenges, and overcome them, is to see WinCo do it. A lot of businesses have made the leap from local to regional to national. But a lot more have failed and been forced to scale back or close entirely. WinCo seems to be great in the West, and it might be great everywhere. Or it might lose the very things that make it great.

  1. Owning the land your stores are on becomes a millstone around a company's neck if the market changes and those locations get less valuable, and that is apt to drive the company into bankruptcy. But when you're expanding, it's great.

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