Everything you need to know about economies of scale
Economies of scale are the secret to the success of many of the most prolific companies since the industrial revolution. Understanding how they work in today's world is essential if you want to recognise when and how you might be able to seize the opportunity and scale up your own company.
What are 'Economies of Scale'?
The heart of the economic concept of ‘Economies of Scale’ is very simple. As your firm produces more of something the cost to your organisation of making each unit of that product decreases.
You might easily misunderstand the concept as saying that each item you produce is cheaper than the last but economies of scale describe the difference in cost per item between producing a small amount and a large amount.
If you were choosing between building 10 houses or deciding to build 100 houses, the decision to build 100 houses would only be cheaper per house than building 10 houses, however only if you were going to build 100 houses from the outset. Building 10 houses, then deciding to build another 10, and another, until you had built 100 would not be counted as scaling up and you would not make savings from economies of scale.
The essential take home is that to ‘scale-up’ requires a conscious decision and investment from the start in order to be effective.
The modern context
This definition of economies of scale is centred around the old-fashioned understanding of business in terms of manufacturing. It is often a source of complaint about economic teaching that it is not keeping up with the context in which we now live.
The classic example of economies of scale is still Henry Ford and his Motor Company’s strategy for manufacturing cars. On the other hand, there are now sectors and industries that were not conceivable when Henry Ford was ‘scaling-up’. Understanding how economies of scale are applicable to modern services and businesses requires a more nuanced approach in comparison to manufacturing and often you need to search hard to find out how average costs might fall as a result of scaling.
Breaking down economies of scale
Like any beautifully simple and intuitive academic concept, the world of academia has done its best to muddy the waters of economies of scale. However, this does help businesses break down where in particular there are opportunities to ‘scale-up’ by isolating the opportunities that are available within different sectors.
With this in mind we can first consider two broad categories of Economies of Scale:
Internal economies of scale
Internal economies of scale are about the growth of the business or organisation. Internal scale is the size of the company. By scaling up internally you can gain access to lots of different opportunities:
Technological improvements are an obvious example in the modern era. Stock management software and intelligent systems for distribution and logistics are being deployed in supermarkets globally. Firms like Ocado are clearly leading the way in this but other firms such as Tesco and Sainsbury’s are following suit and they are able to because of their size.
Smaller firms, especially when you get down to independent retailers could never gain the efficiency advantages that this technology offers because the cost outweighs the benefit at their scale. When you increase your size you essentially have more buying power to access efficiency improvements and your revenue is great enough that small percentage growths due to marginal improvements in efficiency can easily cover the costs of investing in technology.
Another good example of an opportunity gained from increasing internal scale is that of specialising your workforce. In small companies you need people to be able to cover all the bases because being smaller you have less staff to do all the different jobs required. However, when you increase the scale of your workforce you can afford to employ people in much more specific roles where they can focus and your organisation can benefit from the expertise that this develops.
A note of caution though. Internal Economies of scale require consideration because less is often more. Taking the last example of gaining specialists with scale, there will come a point where specialising stops improving efficiency and starts to damage it. This can happen through over-complexity in the leadership and organisation structure, the inability to communicate between specialisms, and generally a lack of ownership for things out with your specialists’ specialities. There is a trade-off in scaling up your organisation and you need to be careful not to go too far.
External economies of scale
External Economies of scale are a vaguer and harder idea to capture. In a nutshell the external economy of scale is the benefit gained in scaling up the industry rather than your organisation. It is hard to put a finger on what theorists mean by this so the best way to try to grapple with the idea is to look at examples.
One example might be the establishment of new R&D facilities that multiple firms invest in to share and develop new technology to improve industry efficiency. JLR, Tata Steel and WMG’s combined new innovation centre that they’ve invested in constructing at Warwick University is a case of such an institution. The aim is to use the research and development from the centre to ‘drive’ growth in the UK automotive industry generally. This sort of programme can grow sectors and bring strength and resilience to all the companies involved.
Other examples of external economies of scale would be the investment by government in infrastructure to support industry or the logistical collaboration of companies that use each other’s products. In the latter case this would involve companies that supply parts building their factories close to the factories of those they sell their parts to. This benefits both companies by reducing transport and logistical costs and hence grows the sector.
Some examples you might have heard of...
The following is a short list of some companies that have capitalised on scale to maintain their market share and attain truly supreme levels of dominance.
This company, which just sold its most famous brand Costa, is well acquainted with the benefits of scale. They are also the owners of the Premier Inn, the UKs largest hotel group, among other businesses. Whitbread’s models for both Costa and Premier Inn predicted that their businesses would continue to grow with new locations across the UK and despite their already astonishing geographical coverage. They are specifically targeting scale to push up profits on products that are very much targeting budget consumers and therefore are low-cost and carry low profit margins per unit but offer a vast revenue and net profit.
Intel are among the largest of tech giants and they have used their scale to invest heavily in research and development strengths. The result being that competing with them is hard even for the substantial numbers of other companies out there trying to. They have well and truly cornered the mid-range Processor market for PCs. Whenever their position is challenged by tech improvements from competitors their R&D strength resulting from their scale means they can react quickly to update and improve their own products.
Ford Motor Company
The production of the model T ford as probably the world’s first mass-produced car is perhaps the most famous example of scaling up. In a matter of a couple of years, Henry Ford took his company from selling a couple of thousand cars a year to selling millions in a period of 20 years.
There is little more to be said as this is the quintessential example of economies of scale at work. Ford dropped the price of the model T and ramped up production to offset the per unit profit drop in profit. Revenue and net profit increased and the rest is history. Ford, using economies of scale, profoundly changed the automotive industry - if not the world.
Facebook alongside Snapchat, Pinterest and other social media platforms require scale for their very survival and the moment they lose their scale their business model is done for. This is because these companies make profit from quantity, that is quantity of users. For a new social media platform to survive they need to grow and grow fast.
Facebook is the most famous example of this success but it is just as well to look at those platforms that failed to maintain the sufficient quantity of users, MySpace or Bebo. We look back and laugh but these are the ghosts of what any of these platforms could become in a matter of a year or two if the users depart. The absolute reliance of these companies on scale seems almost to undermine the argument of the strengths of economies of scale.
This is a prime example of a new start-up currently pushing for scale hard. Monzo offers a new style of banking centred around its mobile app that is user-friendly and offers good access to data about the way you handle your finances. In 2017 the company was granted permission to start operating as a fully licensed bank and it has grown rapidly and steadily in use. Look out for the flashy pink cards, once you see one or have one, you’ll start to see them everywhere!
Although undoubtedly innovative, Monzo relies on scale for profitability just like any other high street bank does. They make money from depositors and that is how their business can be sustainable. The more people bank with Monzo, the more scale the company has, and hence the more you can guarantee that this well-intentioned start-up will stick around.
Clearly, Economies of Scale offer opportunity for growth and stability that will strengthen your business or organisation. However, properly understanding the mechanics of scaling up and where your company actually has the opportunity to do so are both essential to harnessing this economic phenomenon. Just remember that for all the success stories I’ve just listed there are many firms that either went too far or chose the wrong path whilst scaling. It’s a tough line to walk and if you miss step, the consequences can be massive.