What Are Economies of Scale? (Plus Importance and Examples)
By Indeed Editorial Team
Published 24 October 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Businesses often make decisions regarding their production, output or growth that affect their costs and savings. Economies of scale can occur if production becomes more efficient. Learning about this concept can help you create cost savings and a competitive advantage for the organisation you work for. In this article, we define economies of scale, explain why they're important and list the different types you might find in practice.
What are economies of scale?
If you want to help the company cut costs, you may wonder what economies of scale are. Economies of scale are cost advantages that occur when a company increases its production and reduces its overall costs as it becomes more efficient. A company's variable and fixed costs, such as rent and administration, are spread over more units of output as the company increases production, lowering its overall costs and creating a competitive advantage for the business.
A company's size can influence the speed at which it achieves economies of scale. Larger companies typically have higher production levels than smaller ones due to increased capacities, leading to more savings.
What are diseconomies of scale?
Diseconomies of scale occur when a company exceeds its maximum efficiency and the costs per unit of output increase rather than decrease. Sometimes a company might seek to take advantage of economies of scale by investing heavily in manufacturing lines, equipment or space, which can make it grow too large. For example, total costs would continue to increase if a company invests in another warehouse because of overproduction.
Importance of economies of scale
Economies of scale are an important concept for businesses in various industries and represent the competitive edge larger companies have over smaller ones. Understanding how they work impacts a company's production costs and can generate cost savings. As a manager, you can use these savings to increase company profits or to lower the cost of goods for the customer, potentially increasing the customer base.
The way in which economies of scale work depends on the goods produced or the services sold. For example, a company can create economies of scale by simply extending its operating hours to get maximum usage out of expensive machinery. Any efforts you make to lower per-unit costs by increasing output can enable economies of scale for the company you work for.
Types of economies of scale
Economies of scale vary depending on how companies can control them. The following are the main types:
Internal economies of scale
Internal economies of scale are controllable as they result from factors internal to the company. They arise from a company's ability to cut costs because of its size or efficiency-led decisions made by management. Internal factors such as accounting, information technology, marketing and supply pricing can all impact them. As a manager, you can help promote internal economies of scale by adopting practices such as reducing marketing spending, bulk purchasing or hiring efficiently.
Technical economies of scale
These are a subset of internal economies of scale, created specifically by efficiencies developed in an organisation's production cycle through the use of automation tools, efficient manufacturing equipment or other technological factors. For example, data mining software can save customer service companies a lot of time, leaving more time for outreach. Similarly, shipping companies might invest in larger ships or delivery companies in better warehousing technology. Technical economies of scale are typical of larger companies with the time and money to invest in such efficiencies.
Managerial economies of scale
These are another subset of internal economies of scale created when a company hires subject matter experts or industry specialists who can manage a part of the business more efficiently. Often, the experience and skills of these professionals might equal that of the entire junior team. They enable higher productivity through their strategic know-how, and typically the savings they bring to a company justify their higher salary.
Network economies of scale
Network economies of scale typically occur because of additional profit opportunities generated by value-added services. Many online companies benefit from them by leveraging their existing digital infrastructure to provide customers with supplementary options. For example, a ride-sharing app might offer customers a more costly premium vehicle option alongside its regular vehicle selection. As the company uses its existing infrastructure to offer the premium service, it incurs no additional costs.
Financial economies of scale
A company can achieve financial economies of scale when it can easily raise or acquire capital in a manner that doesn't increase its overall costs. Startups may gain financial economies of scale through successful fundraising. Similarly, larger companies may access them by getting funding from the stock market through an initial public offering.
External economies of scale
External economies of scale result from factors external to a company and are typically outside the company's immediate management control. Such factors can include industry or geographical changes or the introduction of a new governmental policy. These changes impact the entire industry and create cost savings for all companies in the same field or those using similar resources for production.
Examples of economies of scale
The following are examples of internal and external economies of scale that you can use when making cost-saving decisions for the company you work for:
Here's an example of internal economies of scale for a retail store:
A large retail store buys stock and supplies in bulk. This lowers the cost of supplies. Management can choose to keep these savings to increase the business's profits or pass the savings on to the consumer, lowering the price of goods and creating a competitive advantage in the marketplace.
Here's an example of internal economies of scale for a manufacturing firm:
A large manufacturing firm invests in efficient production technology, such as an additional production line or equipment, that smaller manufacturing firms can't afford. This investment leads to faster, more efficient production and lowers the overall cost per production unit. This strategy is only effective for bigger manufacturing firms because they can spread out the cost of the new technology over a larger production quantity of goods and still benefit from cost savings despite the initial investment.
Here's an example of a banking company:
Banks tend to view larger companies as being more creditworthy and having a lower financial risk than smaller companies. This gives larger companies access to better financing options and lower interest rates. This enables a larger company to save more on its production costs because it can access more capital at a lower cost than its smaller competitors.
Review this example of external economies of scale:
The government wants to increase the production of electric cars, so they offer a 15% tax break to any car manufacturers that produce more than 50,000 electric cars. Car manufacturers can choose to expand their line of electric cars or increase the amount of production of their existing electric car lines and lower their overall average cost of production because of the tax break incentive. Every car manufacturer can benefit from this tax break, but larger car manufacturers or electric-only manufacturers are still likely to benefit more than smaller manufacturers because of their higher production volumes.
Review this example of diseconomies of scale:
The owner of a large chain of retail stores hires store managers for each branch and delegates decision-making to each individual store manager. This causes different decision-making to occur between stores. For example, one store manager may be more efficient at making decisions that are in the best interests of the owner and the company overall, while another store manager may make decisions that have a positive impact on their individual store but not on the entire company.
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