When it comes to economies of scale, bigger really is better for companies.
That's the reality of economies of scale, which is the term economists use to describe the link between the size of a company and its product production cost. The larger a company is and the longer it's been around, the greater the economies of scale.
Conversely, the smaller a company and the shorter its duration, the more it costs to produce goods and products.
Economies of scale is an important issue for companies both large and small. The term has been around for hundreds of years, and has fueled the development and profit potential of entire economies, especially with the concept of mass production. Economists say that economies of scale were a significant driving force behind the industrial revolution, which started in England and spread across Europe and beyond from the period between 1760 and 1840.
What are economies of scale and why should businesses pay close attention? Primarily, the answer lies in understanding what economies of scale bring to the economic table - the ability to cut production unit costs and create stronger consumer demand by offering products with lower costs to customers.
That's what happens when a business discovers that, as their production rises, it becomes less expensive for that company to manufacture its products. A good example is Ford Motor Company (F - Get Report) and its founder, Henry Ford.
Once Ford latched on to the idea of mass vehicle production (or "bulk" production), and started building (and selling) his Model T vehicles, he built assembly lines that churned out vehicles even faster, leading to larger sales figures and lower line production costs.
That's the beauty of economies of scale, Henry Ford style.
What Are Economies of Scale?
Economies of scale are defined as the link between the size of a company (especially the size of its production/manufacturing plants) and that company's ability to sell its goods and products at the lowest potential costs.
The theory behind economies of scale is this: When a company boosts its product production output, it can more easily achieve a cut in the cost of producing its own goods and products. When cost reductions are realized after stronger and more sustained production, economists call that economies of scale.
There are two primary points to make when examining economies of scale, and company executives focused on sales and production costs would do well to take notice:
- The demarcation line of economies of scale is clear - when a business sees its production costs begin to inch downward, and sees sales rising, economies of scale are in play for that company. Typically, that is only achieved with larger companies who run mass production lines on a large scale.
- The term "scale" is highly applicable in a discussion of line production and costs, on both sides of the seller and buyer equation. Usually, the more a business grows and the more products it manufactures, the lower the price of producing that product becomes. Think of a retailer who buys soap on bulk, from a soap manufacturer. That retailer can usually count on getting a price break by purchasing the soap in large quantities. After receiving a price discount, that retailer can sell the soap at a lower price than competitors, thus insuring more customers and more profits.
What Are the Different Types of Economies of Scale?
The formula for economies of scale is a simple one - the stronger the product output, the lower the cost per unit to create that product.
That formula works across the line on economies of scale, but there are different models of economies of scale that can be "in play" for companies. Here's a snapshot:
At a top-down view, there are two primary models of economies of scale - internal and external economies of scale.
Internal Economies of Scale
This model of economies of scale focus on the size and scope of a company, in production manufacturing terms. Internally, companies (like Henry Ford and Ford Motor Co.) have their own unique techniques, strategies, disciplines, and capabilities in producing goods in mass quantities. These are known as internal factors of economic scale - usually issues and needs a company has control over.
Examples of Internal Economies of Scale:
- Streamlined and/or improved product line efficiencies, developed by in-house manufacturing experts.
- Discounts on bulk purchases of raw materials needed to create a company's products.
- Investments in technology that, over time, pay for themselves by improving a company's rate and cost of production.
External Economies of Scale
Conversely, external economies of scale mean exactly that - factors and conditions outside the company - and largely outside its control - that can impact economies of scale. Those factors could be positive or negative industry trends or country-wide economic trends, like a stronger gross domestic product and resulting robust consumer demand, that can drive economies of scale. By and large, external economies of scale mean that as a business sector and country economy grows, the price of production falls, as sales rise.
Examples of External Economies of Scale
- Economic growth in a company's industry that leads to stronger buyer demand and higher revenues.
- Tax incentives provided by local, state and federal government designed to keep companies "in the stable" and lead to a lower cost of doing business.
- Access to a stronger, smarter labor pool in a region where a company resides (for example, a technology company in Boston adjacent to MIT, Harvard of Boston University.)
Example of Economies of Scale
A company that can provide their products at a lower cost to buyers will likely attract even more buyers, giving the company a decided price advantage over its competitors.
Economists call that type of price undercutting as a "moat" around the company benefiting from economies of scale. The problem for competitors in this scenario is that they usually don't have the vast financial resources to remain competitive in a market where competitors have already achieved economies of scale.
With a market capitalization of $293 billion and revenues of $503 billion, Walmart is the largest general retailer in the U.S.
The company's economies of scale are derived from a unique ability to buy its merchandise in bulk, usually at significant discounts. To do business with Walmart is a coup for suppliers - its products are seen by millions of shoppers each day across the globe. That access comes with a price, as Walmart forces suppliers to accept low prices to remain in its good standing.
For a real work example, let's say that Walmart can purchase a three-pack of socks from a supplier for $2, while a competitor has to pay $3 for the same product, as it can't buy as much in bulk as Walmart. Additionally, Walmart only pays $2 to distribute and display the socks in its stores, while it costs a competitor $3 to do the same thing. Walmart can then sell the socks at a price of $5 to consumers for a $1 profit. As for the competitor, the outlook is bleak - it can't sell the socks at $5, instead, it's forced to sell the socks for more than $6 to stay profitable, even though that leads to a competitive disadvantage compared with Walmart.
In economy of scale terms, Walmart has grown so abundantly that its ample size has increased its purchasing power, and gives it even more bargaining leverage with its suppliers.
That end results leads to a beautiful "sweet spot" for Walmart, as not only does the retailer pay less for its store products, its robust growth also allows it to achieve lower cost distribution, leading to more expanded profit opportunities in an industry that Walmart now dominates.
What Economies of Scale Mean for You
No doubt, companies of any size can learn from Walmart, and other larger companies that have achieved economies of scale.
The primary lesson is this - no matter what, a company's primary goal is to keep growing and keep doing so in a manner where efficiency and cost are prioritized, giving the company the best chance to keep growing over the years, until one day, too, its production costs decline and its sales and revenues continue to grow.
That's the magic of economies of scale, and a good lesson to learn for younger companies who dream of growing into a Walmart-sized success story one day.