Achieving Economies of Scale

Understanding Why Bigger Can Be Better

Achieving Economies of Scale - Understanding Why Bigger Can Be Better

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Load up on the benefits from economies of scale

"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 and it needs to make more of a product, the average cost of making each item falls, resulting in a rise in profits. Similarly, if a store buys a product in bulk, it can often negotiate a discount from the wholesaler and, as a result, sell the item at a cheaper price than its rivals. Economists call this "economies of scale."

In this article, we'll look at the two different types of economies of scale that can give businesses a competitive advantage. We'll also explore what happens when organizations get too big, and are hit by "diseconomies of scale."

Economies of Scale Definition

Economies of scale are cost savings that a company (and, by default, its customers) can reap as a result of efficient production processes. Generally, these cost savings are achieved because the average of cost of producing something falls as the volume being produced increases.

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).

Figure 1. Economies of Scale by Cost and Quantity Produced

Economies of Scale

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.

Economies of Scale Example

Now let's look at an example of how economies of scale can work in business:

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 designing 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. You will therefore save money by producing more product brochures.

Internal Economies of Scale

In general, there are two different types of economies of scale – internal and external. Let's take a look at how internal economies of scale work first.

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 that can benefit companies:

1. Technical

You can achieve technical economies of scale by improving the efficiency and the size of your production process. For example:

  • Dividing your production process into separate tasks can increase productivity. Your workers will likely become more specialized and efficient, and you can slash unit costs by using mass production techniques, such as investing in specialist machinery.
  • Building on your experience can improve the efficiency of your processes because you have accrued greater knowledge and research in a specific area. This can often lower production costs.
  • Taking advantage of the law of increased dimensions, or "cubic law" 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.

2. Purchasing

Bulk buying can cut costs dramatically, as we can see from the brochure example, above. If you're a large manufacturer, you'll likely have more bargaining power than your smaller competitors 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.

3. Managerial

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.

4. Financial

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 even 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.

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5. Risk-Bearing

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 their industry and the wider 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 more readily available.
  • A good transportation network may be available.
  • Improved technology may drive down your costs in various areas of your business.

Diseconomies of Scale Definition

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.

When this happens, average costs stop falling as production increases, and costs can start to rise again as a result of this inefficiency. This point is known as a 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.

Figure 2. Diseconomies of Scale by Cost and Quantity Produced

Economies of Scale

Key Points

Economies of scale refer to the cost savings that organizations can make from efficient production processes that enable them to produce more for less. Taking advantage of economies of scale can have a number of benefits - it can enable companies to become more price competitive, make production processes more efficient, and improve profits.

There are two main types of economies of scale:

  1. Internal – costs savings that are specific to a business or organization regardless of the industry it operates in. These can include technical, purchasing, managerial, financial, and risk-bearing economies of scale.
  2. External – this is when a company gains an advantage because of events and developments in its industry or the wider external environment.

Organizations must be careful about outgrowing their economies of scale and getting too big, as this can cause diseconomies of scale. This is known as the "Minimum Efficient Scale" and marks the point at which prices start to rise again as production increases because of inefficiencies.

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Comments (4)
  • Over a month ago BillT wrote
    Hello irfan22in,

    Starting a business requires a large amount of planning - probably the most unpaid work you'll do to get your business off the ground. If produced properly, the business plan can predict the most common scenarios and lay in place strategies to deal with them.

    Here's and article https://www.mindtools.com/community/pages/article/newSTR_96.php that talks about start up planning, and includes something called the USP (Unique Selling Proposition) which helps you to gauge your uniqueness in the marketplace.

    I hope this article can give you some ideas.

    Mind Tools Team
  • Over a month ago irfan22in wrote
    In past i was planing to start packed food business. However during analysis initial numbers did not show good profitability until unless the business is done in large volumes.
    Investing in machinery for large production,marketing requires large initial capital. Any if the product is not not successful then whole capital is at risk.
    Do you have any suggestion for such startups here where initial costs can be reduced until the feedback from the market is observed upon which production no can be increased.
  • Over a month ago Midgie wrote
    Hi Angel,
    Thanks for that feedback!

    Mind Tools Team
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