“Biggest is best” and “Stack ’em high, sell ’em cheap” are not the most elegant phrases in the English language. But they accurately describe an important business reality.
This is the idea that, as a company grows, it makes more of a product. The average cost of making each item then falls, so profits rise. Similarly, if a store buys more of an item, it can negotiate a discount from the wholesaler, and it can sell the item cheaper than its rivals. Economists call this “economies of scale.”
In this article, we’ll look at the two types of economies of scale that can give businesses a competitive advantage: internal and external. We’ll also explore what happens when organizations get too big, and are hit by “diseconomies of scale.”
What Are Economies of Scale?
Economies of scale are cost savings that occur as a result of making more of a product. The Economist defines them as, “Factors that cause the average cost of producing something to fall as the volume of its output increases.”
In other words, a company can increase its profits by making its production processes more efficient, rather than by increasing the price of a product.
Here is an example of how economies of scale work:
The cost of making 200 copies of your organization’s new product brochure is $4,000. The average unit cost is $20 (that’s $4,000 divided by 200). But to make 1,000 copies is only $5,000, an average cost of $5 a copy. This is because the main element of the cost of making the brochure is labor for design and editing the material, and setting up the printing press. These are fixed costs that remain the same no matter how many brochures you produce.
In short, you get more for your money when your organization achieves economies of scale. So, while you may incur initial extra costs by investing in new machinery, additional labor or more raw materials, you save money on the average cost of each unit you produce (see Figure 1, below).
This basic principle has been the driving force behind many major economic developments, such as the industrial revolution and mass production. And it is why bigger companies are often more efficient and can deliver goods and services at a low price, yet still make a healthy profit.
Think of how Ford’s assembly line changed the face of car manufacturing, for instance. And consider how Walmart’s “everything under one roof” style and immense purchasing power allows it to beat its competitors on price.
Now, let’s look at internal and external economies of scale.
Internal Economies of Scale
Internal economies of scale are cost-saving factors that are specific to organizations, regardless of the industry or environment that they operate in. There are five types of internal economies of scale:
You can achieve technical economies of scale through improving the efficiency and the size of your production process. Here are some examples:
- Dividing your production process into separate tasks can increase productivity, and your workers will likely become more specialized and efficient. Also, you can slash unit costs by using mass production techniques, such as specialist machinery, despite the initial capital investment that’s needed.
- Building on the experience of what you do. Processes become more efficient through greater knowledge and research and, as a result, your average costs of production fall.
- Taking advantage of the law of increased dimensions, or “cubic law.” This promotes economies of scale in industries such as transport and logistics. If you double a container’s length and height, for instance, its capacity increases 400 percent. Think of supertankers or Amazon’s huge warehouses.
Bulk buying can cut costs dramatically, as in the brochure example, above. If you’re a large manufacturer, for example, you have more bargaining power than your smaller competitors have to negotiate lower prices with your suppliers.
Bigger firms can also get better delivery rates, because they require more products to be moved. Efficient inventory or stock management is another way to reduce average unit costs, by not paying for, or unnecessarily holding on to, component parts in store.
You can achieve managerial economies of scale by investing in expertise as your organization grows. Specialist managers who oversee and improve production systems can streamline processes and increase productivity, resulting in lower average unit costs and economies of scale.
Larger organizations often have better credit ratings than smaller ones, because they have more assets to use as collateral. This means that they can borrow more cheaply in order to finance investment and realize greater economies of scale. They then reap further rewards from their investment because the lower interest rates they are offered mean that it costs them less to borrow.
Companies that are quoted on the stock market have further access to new finance, and thus to even greater economies of scale through the sale of equities or shares.
The more a company diversifies its activities and spreads its costs, the less overall risk it assumes in any one line of business and the lower its unit costs will be.
The ability to take the risk of carrying out complicated and expensive research is another benefit for large firms. Big pharmaceuticals companies, for example, are able to profit from this aspect of economies of scale. Bigger companies can also afford to market and advertise their products more effectively.
External Economies of Scale
External economies of scale occur where a company gains advantages as a result of events and developments in the industry as a whole, and in the external environment.
Here are some examples:
- Industry growth may allow you access to specialist or lower-cost suppliers.
- Low demand and large supply may bring down the cost of your supplies.
- Where many similar companies operate in the same area as you, there may be a bigger pool of pre-trained people to recruit from.
- Industry infrastructure may already be in place to support your organization’s growth.
- Training facilities may be available.
- A good transportation network may be available.
- Improved technology may drive down all your costs.
Diseconomies of Scale
All of these economies of scale can occur as your company grows, and increases its production. But what happens if it grows too much?
Very large companies sometimes suffer from decreased efficiency. They may have once had efficient labor specialization, but now there are simply too many people doing the same thing.
Too many layers of management, too little control, too many locations, and too many products are all potential sources of “diseconomies” of scale.
There’s a point at which average costs stop falling as production increases, which may also be the point at which costs start to rise as a result of this inefficiency. This point is the company’s Minimum Efficient Scale. No further economies of scale can be achieved beyond this point.
This is illustrated in the U-shaped curve shown in Figure 2, below.
The bottom of the curve is the optimal place to be. At production volumes higher than this, the company’s size is no longer an advantage.
Companies can reduce their average unit costs and increase their profits by taking advantage of the opportunities that come from larger size and increased output.
They can also create many internal opportunities simply by growing. And sometimes the external environment also provides economies of scale, based on factors such as industry size or geographic location.
Organizations must be careful about outgrowing their economies of scale and getting too big. Average unit costs usually decrease with increased output, but only to a certain point. After that point, costs may begin to rise again as the company creates unwanted inefficiencies.