Economies of Scale

Economies of scale are talked about often in the world of investing, private equity, and consulting. More and more businesses face pressure to grow into the global marketplace if they hope to survive. But what exactly are economies of scale? Are they something every business has to worry about? Should businesses be pursuing economies of scale, and is there ever a downside? Whether you’re a small business owner looking to grow or an aspiring consultant looking to up-skill, this article will tell you everything you need to know about economies of scale.

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What Are Economies of Scale?

At its most basic level, the term economies of scale refers to a phenomenon in which the unit costs associated with production decrease as output increases. More simply, as companies get bigger, the cost of making each unit often goes down. This leads to increased profitability for the company, and potentially savings for the consumer. The phenomenon also applies to companies that offer services. As they acquire more customers and subscribers, the costs of delivering services decreases.

Economies of Scale Examples

Let’s take three identifiable scenarios.

  1. A regional supermarket chain opens several new branches nationwide, and increased purchasing power means the unit cost of supplies drops.
  2. A technology company is able to obtain cheaper raw materials to manufacture into components, after a separate company opens up a more direct shipping route from the region where the raw materials are extracted.
  3. A successful brewery is able to lower the production costs of each beer after buying newer, more specialized brewing equipment.

Which of these is an example of an economy of scale? The answer is, they all are.

Economies of scale take many different forms and arise from a variety of conditions associated with increased productivity. They can be broadly grouped as either internal or external economies of scale. Let’s take a look at some examples of each.

Internal Economics of Scale Examples

First, internal economies of scale are specific to an individual business, and occur as a consequence of that business’s own growth. There are many different types of internal economies of scale.

Types Of Internal Economies Of Scale

  • Technological economies of scale result when businesses operating on a larger scale are able to invest more money in expensive and specialized technology to further increase productivity and efficiency. The brewery example listed above is an example of this. Smaller or less successful competitors may not be able to afford the same equipment, meaning their costs will be higher.
  • Specialization economies of scale occur when a business is able to split its production process into distinct, specialized tasks. This allows expert workers to focus solely on a limited range of tasks. This leads to an increase in efficiency in comparison to a company where each worker is forced to perform a variety of different tasks. An example of this kind of economy of scale is Ford’s famous innovation of the assembly line for manufacturing automobiles.
  • Managerial economies of scale result from larger companies being able to afford more experienced and specialized management. Better management itself is able to lower production costs through innovation and increases in operational efficiency.
  • Financial economies of scale occur because larger companies are able to earn favorable sources of capital investment as compared to smaller companies. Larger companies are often able to borrow more at lower interest rates and friendlier repayment schedules. Further, publicly traded companies can more easily raise capital by issuing shares of the company.
  • Purchasing economies of scale refer to the lower costs of acquiring inputs that larger companies face. This is often the result of larger companies having greater negotiating power. A large supermarket chain will be able to command cheaper foods from suppliers than a single corner store. This power of lowering costs by buying more is often referred to as monopsony power.

External Economics of Scale Examples

External economies of scale function somewhat differently. Instead of being specific to an individual firm, external economies of scale occur within an entire industry or region. For example, as a local industry grows, a governing body may decide to devote extra resources to improving transportation to and from the sites of that industry. This will result in cheaper costs for the local companies. Alternatively, if an industry or region grows enough, their suppliers and related support businesses will gravitate toward the manufacturing centers, lowering manufacturers’ production costs.

What Does Economies of Scale Mean in Business?

The phenomenon of economies of scale can be observed across almost every industry. It’s generally accepted that most companies stand to benefit from an economy of scale as their productive output increases. Across all of the examples above, growth creates economies of scale that result in lower costs and more efficiency. In today’s growth-obsessed, hyper-globalized marketplace, this often translates into a belief that all companies should be growing and improving productivity as rapidly as possible.

However, there are limits to economy of scale, and not every company stands to benefit from it. If a company continues growing, it’s almost certain to encounter a tipping point at which it experiences a diseconomy of scale. This occurs when further increases in output lead to rising costs. Imagine needing to make a big investment in a distribution system and sales team to penetrate a new country. Yet, not realizing that the overall revenue potential in that country does not support the required sales team.

Wrap Up

Business owners and consultants should be familiar with the concept of the economy of scale. But they should be cautious about pursuing growth in output as their sole or primary strategy. There are often other ways of improving unit costs, and these should not be abandoned solely for growth when growth isn’t appropriate.

Further, business owners and consultants should familiarize themselves with economies of scope as well. This refers to a company’s ability not only to increase production, but to diversify into different related lines of products and services. This can help a company to spread out risk and to achieve some of the same benefits of economies of scale. For example, Netflix originally just offered DVD rentals through the mail. If they had solely focused on acquiring more subscribers and purchasing more DVDs, they would have been bankrupted by the revolution of streaming content. Instead, they diversified into not only offering streaming content, but also into producing their own entertainment. They were able to lower costs for these different services because they were all related enough to each other. And by diversifying their business strategy, they were able to survive the shift in the market as consumers turned away from physical DVDs.

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Filed Under: Consulting skills, Financial Consulting