what are economies of scale?
Economies of scale are the increase in cost savings and efficiency that come with an increase in production.
Generally, these cost savings take the form of fixed costs that are spread out over more units (lowering the per-unit cost), but increased production can also leverage the concept of economies of scale to result in lower variable costs.
Cost savings produced by economies of scale are most closely associated with for-profit businesses, but they can be applied to government agencies and nonprofit organizations as well.
Internal Economies of Scale
The cost savings and efficiency associated with the concept of economies of scale exist in two broad categories: internal and external.
Internal economies of scale are controllable by decision-makers within the organization. External economies of scale, on the other hand, come from sources that are external to the organization.
Reduced costs in any area of a business contribute positively to that business’s bottom line, so business leaders are often seeking ways to cultivate and leverage economies of scale.
These cost savings can become so profound that they generate substantial competitive advantage for the organization large enough to exploit them.
Internal economies of scale have several sources:
Larger organizations can utilize larger, more efficient machines and processes. In some cases this may mean larger batches, larger deliveries, longer operating hours, or other industry-specific economies of scale.
For example, a large distributor may benefit from the economies of scale that come with a larger shipping center. A larger building means more loading bays, and this in turn means that more trucks can be loaded in the same amount of time that it would take a competitor who has a smaller building. This increase in efficiency also means a decrease in the effective cost to load each truck.
Another example would be a baker who bakes four loaves of bread in a small oven. By switching to a larger oven she can produce twice as much bread in the same amount of time, thus increasing output.
A company that purchases so much of a product that it can buy in bulk or negotiate lower unit costs is leveraging economies of scale. While smaller organizations would love to take advantage of volume or discount pricing, they may not have the cash on hand to afford the bulk pricing, or they may not have the means to store the product or to process it efficiently.
For example, mega-retailer Walmart regularly offers their customers discounts due to the fact that they are able to purchase and sell massive quantities of the products they stock on their shelves.
Large organizations can leverage their economies of scale to produce financial advantages. These often manifest in the form of lower-cost access to capital. A large corporation has an extensive credit history and a track record of success, meaning they enjoy lower interest rates from lenders.
Additionally, larger organizations often have multiple streams of revenue, which gives lenders more confidence that the organization will be able to repay its obligations.
Network advantages come in the form of highly developed and wide-reaching infrastructure within an organization. Consider Netflix. The cost of adding a new customer is practically nothing, and therefore each new customer’s revenue is nearly pure profit. Similarly, banks spend time and money developing their processes and systems so that new customers produce almost pure profit.
External Economies of Scale
Internal economies of scale come from investments and efforts that business leaders can make to increase their efficiency and decrease costs. External economies of scale come from sources outside the organization.
This most often manifests as preferential treatment from other organizations—specifically, governments, vendors, and suppliers.
Governments at all levels are often willing to provide benefits or incentives to larger corporations, because they know that larger organizations can make a greater positive impact on the economy in the form of taxes, jobs, and development.
Additionally, vendors, suppliers, and customers who are also of larger scale often prefer to work with firms that can meet their specific needs, meaning that increasing the scale of your organization can open the door to working with a wider range of potential suppliers and business partners.
When Economy of Scale Goes Wrong
Economists refer to the negative aspects of organizational scale as diseconomies of scale. Simply put, these negative conditions arise when the increasing size of an organization contributes to reducing its efficiency and increasing its costs.
These diseconomies can manifest in a variety of ways:
- Longer decision-making times
- General organizational inflexibility
- Inefficiency that goes unnoticed
- Supply chain inefficiencies
- Multiple redundant staffing positions or business units
- Culture clashes with international business units
- Loss of focus on original mission or core culture
Economies of Scale versus Economies of Scope
While economy of scale refers to organizational size and the advantages growth can convey, economy of scope refers to the advantages that can be gained by branching out into multiple product lines.
For example, a home goods company that sells mops can leverage the economies of scope by developing and selling floor cleaning solution in addition to mops. The company may incur significant costs in developing and producing this additional product line, but it can bundle together the cleaning solution and the mop to increase sales and the amount of revenue produced per unit.
While it is true that a company that benefits from the economies of scale often expands by introducing new product lines—therefore benefiting from an increased economy of scope—the economies of scale and scope do not always go hand in hand.