What is Economies of Scale
Larger organizations can save more as they increase their production output. This concept is called economies of scale. As the output increases, the cost per unit decreases due to savings from fixed production costs. That is, fixed costs are spread over a larger volume of output. This production efficiency can offer some pricing advantages in the marketplace.
Benefits of Economies of Scale
Improved Profit Margins
It improves profit margins because fixed costs such as rent, machinery and administrative expenses are spread across a larger output volume. Moreover, the lower cost of production can result in pricing flexibility. This means that such companies can offer lower prices to their customers without sacrificing a significant portion of their profit margins, which attracts more customers and increases their market share.
Financial Resilience
Companies that achieve economies of scale are often more resilient in economic downturns. With lower costs, they are better positioned to weather tough times and invest in growth opportunities.
Stronger Bargaining Power
Economies of scale can also result from lowering variable costs. Larger organizations have a stronger bargaining power with suppliers based on their volume of business transactions. Therefore, they can negotiate for bulk discounts on raw materials, or negotiate more favourable payment terms leading to better cashflow for business.
Types of Economies of Scale
Internal Economies of Scale
This results from cost efficiencies within the organization or business, and can be classified into technical, managerial, marketing, financial, commercial, and network economies of scale.
Technical Economies of Scale
This happens when an organization optimises all production factors (land, labour, capital, and entrepreneurship), leading to cost efficiencies. For example, it might use large-scale mechanical processes and machinery or more affordable labour options.
For example, Toyota uses a combination of high-tech machines and lean practices like Kaizen and Jidoka to produce goods at a lower cost per unit.
What is Jidoka?
Jidoka is the concept of automating production so that machines stop themselves if they notice a problem. This allows humans to focus on monitoring and improving processes rather than just operating machinery. This leads to higher-quality products and reduces costs associated with defects.
What is Kaizen?
Similarly, Kaizen is a continuous improvement philosophy based on two Japanese words: Kai (improvement) and Zen (for the better). Kaizen emphasizes process improvement, data-driven decision-making, and organization-wide contributions to continuous improvement.
Managerial Economies of Scale
This refers to efficiencies from workforce specialization. As a company grows, it can establish several functional areas, so that employees can focus on areas where they have the most experience. Functional managers optimize processes within their domain which benefits the entire organization. A supply chain manager, for example, can optimize logistics routes to reduce transportation costs and improve delivery time.
Financial Economies of Scale
Financial economies of scale are the cost advantages that larger companies gain, from accessing capital more easily and at lower costs than smaller firms. Their perceived stability and lower risk make it easier for them to secure better financing terms, which reduces their overall cost of capital and boosts profitability. For example, Larger firms have a proven track record, established credit histories, and greater assets to offer as collateral. Moreover, publicly traded companies can raise capital by issuing shares on the stock market.
Marketing Economies of Scale
Marketing economies of scale are a company’s cost savings in advertising, promotion, and distribution as it grows. Expenses, such as ad campaigns or distribution networks, often have high fixed costs that can be spread over an increasing output volume, reducing the average cost per unit sold. Also, larger companies can use the same resources, such as advertising teams and digital platforms, for multiple product lines.
Network Economies of Scale
Network economies of scale, occur when the value of a product or service increases as more people use it. This is common in industries where connectivity, interaction, or collaboration among users enhances the overall utility of the product. Unlike traditional economies of scale, which focus on cost reductions through size and efficiency, network economies of scale emphasize value creation driven by the size of the user base.
For example, social networks like TikTok, Instagram and Linkedin where the platform becomes more engaging as more friends, family, and colleagues join and participate. Also, as more riders use ride-hailing apps like Uber and Lyft, more drivers join, improving availability and reducing wait times, which attracts even more riders.
External Economies of Scale
External economies of scale occur when the cost per unit decreases due to external factors in the industry or economy. Unlike internal economies, external economies are shared among firms operating in a similar environment.
Sources of External Economies
Industry-Specific Growth
As an industry grows, nearby suppliers may establish themselves, providing lower prices and more dependable access to resources. This advantages all firms in the region, not just one company.
Skilled Labour Pooling
When a region becomes known for a specific industry, skilled labour pools tend to concentrate there. For example, Silicon Valley is famous for tech talent. This makes it easier and potentially cheaper for companies in the industry to find skilled workers. Similarly, Hollywood’s ecosystem of studios, actors and writers, benefits all film producers operating in the region.
Shared Infrastructure
Government investments in infrastructure, such as transportation, telecommunications, and energy, can lower costs for all businesses in a particular region or industry. For example, good port facilities can reduce shipping costs for companies in a manufacturing hub.
Innovation Spillovers
When a region has many companies in the same industry, ideas and innovations can spread more easily.
