Economies of Scale: What Are They and How Are They Used?

What Are Economies of Scale?

Economies of scale are cost advantages reaped by companies when production becomes efficient. Companies can achieve economies of scale by increasing production and lowering costs. This happens because costs are spread over a larger number of goods. Costs can be both fixed and variable.

Understanding Economies of Scale

The size of the business generally matters when it comes to economies of scale. The larger the business, the more the cost savings. Economies of scale can be both internal and external. Internal economies of scale are based on management decisions, while external ones have to do with outside factors.

Internal functions include accounting, information technology, and marketing, which are also considered operational efficiencies and synergies.

Economies of scale are an important concept for any business in any industry and represent the cost-savings and competitive advantages larger businesses have over smaller ones.

Most consumers don't understand why a smaller business charges more for a similar product sold by a larger company. That's because the cost per unit depends on how much the company produces. Larger companies can produce more by spreading the cost of production over a larger amount of goods. An industry may also be able to dictate the cost of a product if several different companies are producing similar goods within that industry.

There are several reasons why economies of scale give rise to lower per-unit costs. First, specialization of labor and more integrated technology boost production volumes. Second, lower per-unit costs can come from bulk orders from suppliers, larger advertising buys, or lower costs of capital. Third, spreading internal function costs across more units produced and sold helps to reduce costs.

Internal vs. External Economies of Scale

As mentioned above, there are two different types of economies of scale.

• Internal economies of scale: Originate within the company, due to changes in how that company functions or produces goods
• External economies of scale: Based on factors that affect the entire industry, rather than a single company

Internal Economies of Scale

Internal economies of scale happen when a company cuts costs internally, so they're unique to that particular firm. This may be the result of the sheer size of a company or because of decisions from the firm's management. There are different kinds of internal economies of scale. These include:

• Technical: large-scale machines or production processes that increase productivity
• Purchasing: discounts on cost due to purchasing in bulk
• Managerial: employing specialists to oversee and improve different parts of the production process
• Risk-Bearing: spreading risks out across multiple investors
• Financial: higher creditworthiness, which increases access to capital and more favorable interest rates
• Marketing: more advertising power spread out across a larger market, as well as a position in the market to negotiate

Larger companies are often able to achieve internal economies of scale—lowering their costs and raising their production levels—because they can, for example, buy resources in bulk, have a patent or special technology, or access more capital.

External Economies of Scale

External economies of scale, on the other hand, are achieved because of external factors, or factors that affect an entire industry. That means no one company controls costs on its own. These occur when there is a highly-skilled labor pool, subsidies and/or tax reductions, and partnerships and joint ventures—anything that can cut down on costs to many companies in a specific industry.

Limits to Economies of Scale

Management techniques and technology have been focusing on limits to economies of scale for decades.

Set-up costs are lower due to more flexible technology. Equipment is priced more closely to match production capacity, enabling smaller producers such as steel mini-mills and craft brewers to compete more easily.

Outsourcing functional services make costs more similar across businesses of various sizes. These functional services include accounting, human resources, marketing, treasury, legal, and information technology.

Micro-manufacturing, hyper-local manufacturing, and additive manufacturing (3D printing) can lower both set-up and production costs. Global trade and logistics have contributed to lower costs, regardless of the size of an individual plant. 

According the International Monetary Fund, the prices of both capital goods and the cost of machinery and equipment have been falling in emerging, developed, and even industrial countries for the past three decades.

Examples of Economies of Scale

In a hospital, it is still a 20-minute visit with a doctor, but all the business overhead costs of the hospital system are spread across more doctor visits and the person assisting the doctor is no longer a degreed nurse, but a technician or nursing aide. 

Job shops produce products in groups such as shirts with your company logo. A significant element of the cost is the setup. In job shops, larger production runs lower unit costs because the set-up costs of designing the logo and creating the silk-screen pattern are spread across more shirts. In an assembly factory, per-unit costs are reduced by more seamless technology with robots.

A restaurant kitchen is often used to illustrate how economies of scale are limited: more cooks in a small space get into each other's way. In economics charts, this has been illustrated with some flavor of a U-shaped curve, in which the average cost per unit falls and then rises. Costs rising as production volume grows is termed "dis-economies of scale."