Ever wondered why a larger business can charge so much less than a smaller business for a similar product? It’s all about economies of scale – cost reductions that can occur when businesses increase production. Find out everything you need to know about the advantages and disadvantages of economies of scale and see why maximising business growth is so important for start-ups and early-stage businesses.
What are economies of scale?
Economies of scale are cost advantages that can occur when a company increases their scale of production and becomes more efficient, resulting in a decreased cost-per-unit.
This is because the cost of production (including fixed and variable costs) is spread over more units of production.
Economies of scale provide larger companies with a competitive advantage over smaller ones, because the larger the business, the lower its per-unit costs.
Example of economies of scale
A common example of economies of scale in action is seen when looking at large supermarket chains versus independent grocers.
With the larger chains having more cash in the bank and a greater number of customers, they are able to purchase a huge quantity of groceries from suppliers, resulting in a lower cost per unit, compared to the independent stores.
This is why it's cheaper to do your weekly shop at a big chain rather than a small business.
What are the different types of economies of scale?
There are two main types of economies of scale – external and internal.
External economies of scale
External economies of scale are dependent on external factors. Anything that enables a company to cut down on costs can be considered an external economy of scale, including tax reductions, government subsidies, an improved transportation network, or a highly skilled labour pool.
Internal economies of scale
Internal economies of scale are controlled by the company. They can occur any time a company cuts costs, from buying in bulk and investing in state-of-the-art machinery to accessing extra financial capital and hiring a specialised workforce.
Technical economies of scale
Technical economies of scale are a type of internal economy of scale. They are economies of scale achieved via technology. That is, larger businesses more readily have the capital to invest in newer and better technology, which can bring them cost advantages smaller businesses are otherwise unable to achieve.
Purchasing economies of scale
Purchasing economies of scale, also called buying economies of scale, are a type of internal economy of scale. They are economies of scale achieved via buying in bulk. That is, larger businesses more readily have the cash and output to warrant buying materials in much larger quantities, which can bring them per-unit cost advantages smaller businesses are otherwise unable to achieve.
Financial economies of scale
Financial economies of scale are a type of internal economy of scale. They are economies of scale enable more favourable rates of borrowing. That is, larger businesses are seen by lenders as more reliable or worthy of credit due to their size, whereas smaller businesses will tend to pay higher rates of interest.
Advantages of economies of scale
The benefits of economies of scale to industries and businesses are wide-ranging, but generally speaking, it enables large corporations to reduce their costs, pass the savings onto the consumer, and gain an advantage over the competition. So, what are the advantages of economies of scale?
Reduced long-term unit costs – One of the main benefits of internal economies of scale is reduced costs, enabling businesses to improve their price competitiveness in global markets.
Increased profits – Economies of scale lead to increased profits, generating a higher return on capital investment and providing businesses with the platform to grow.
Larger business scale – As a business grows in size, it solidifies and becomes less vulnerable to external threats, such as hostile takeover bids. This is one of the key benefits of economies of scale to industries as it has a positive effect on the company’s share price, as well as their ability to raise new financing.
Of course, there are also plenty of advantages of economies of scale for consumers, as lower unit costs often feed through to reduced prices. What are the advantages of economies of scale for consumers?
Lower prices – Reduced cost-per-unit leads to lower prices for the consumer, meaning that overall, consumers will have higher real incomes and easier access to affordable products.
Product improvements – Businesses can potentially reinvest their capital savings in research and development, leading to improved products (e.g. cheaper pharmaceuticals and food).
Higher wages – For employees, another key benefit of economies of scale is the potential for profit sharing and higher real wages due to savings on cost.
Disadvantages of economies of scale (Diseconomies of scale)
When a business becomes too large, its unit costs may begin to rise. This is referred to as a diseconomy of scale, and it’s a major drawback that growing businesses need to pay attention to. Diseconomies of scale can be caused by a number of different factors, including:
Poor communication – Ineffective communication, wherein it becomes more difficult to coordinate a large workforce as your company grows, is one of the major factors behind diseconomies of scale.
Loss of control – As a business grows, it becomes increasingly difficult to monitor the productivity and quality of thousands of employees, leading to inefficient production processes.
Duplication of effort – Duplication of effort can also be an issue, where more than one person ends up working on the same function or task.
Weak morale – As businesses become larger, staff are more likely to feel remote and develop a sense of alienation, which can lead to reduced productivity and wastage.
External opposition – Behaviour that would have gone unpunished in a smaller firm is more likely to be seen as a threat as a business increases in size, leading to public and government opposition.
In addition, the benefits of internal economies of scale for consumers may not be as impressive as they appear. For a start, economies of scale may not always result in lower prices, as dominant firms may simply form a monopoly and enforce higher prices. It’s also worth remembering that the environmental consequences of mass production can be significant, from pollution to e-waste.
Making economies of scale work for you
While there are some drawbacks associated with economies of scale, these can be averted through a greater focus on management and communication. And while the benefits of economies of scale can be leveraged more effectively by large companies, even start-ups and small businesses can take advantage.
We can help
A healthy cash flow is a key factor in achieving business growth, making an efficient payment system like GoCardless a great investment. Find out how GoCardless can help you with ad hoc payments or recurring payments.