As the old saying goes, sometimes you have to spend money to make money. This maxim can apply when you expand production, yet reduce the cost of making each individual unit—a phenomenon known as an economy of scale.
Learn how economies of scale work and how they can help your business earn wider profit margins, decrease your per-unit production costs, and boost your earnings.
What are economies of scale?
Economies of scale are the cost reductions and increased efficiency that can result when a business’s operations and output increase. The concept of economies of scale primarily applies to the production process. As production rises, your per-unit cost can decline as you spread out fixed costs for equipment or overhead across more units. However, economies of scale occur whenever expanded operations lead to cost advantages, including with your management structure and marketing efforts.
Although this economic concept typically refers to larger businesses, ecommerce merchants and small business owners also can achieve economies of scale in their production processes. Those cost savings can result in higher profits for your company and even lower prices for your customers, giving you a competitive advantage in the market.
For example, if you run a clothing brand, investing in a new direct-to-garment printing machine could result in faster production that lets you print more t-shirts for a lower cost per unit.
Internal vs. external economies of scale
Internal and external economies of scale can both impact your business. The former is within your control while the latter is the result of broader market conditions. Here’s how each works:
Internal economies of scale
Internal economies of scale are cost savings and efficiency gains resulting from expansions within a business. Companies experience internal economies of scale when the average costs of producing each unit decrease as production levels rise.
Businesses can achieve internal economies of scale in a variety of areas, including:
Purchasing
A dropshipping merchant selling pet toys provided by a third-party supplier could reduce its cost per unit by switching to bulk purchasing at a discount and then handling fulfillment in-house. At scale, this approach could provide higher profit margins. Similarly, product makers can lower their cost per unit by getting a price break on large amounts of raw materials.
Technical
To scale technical economies, companies can upgrade hardware or software equipment to increase their production capacity. For example, you could potentially reduce shipping costs by investing in automation tools like smart shelves that save your warehouse workers time by making it faster and easier to find and pick products for shipment.
Financial
As companies grow, become more stable, and increase their creditworthiness and standing with investors, they can more easily gain access to capital at lower interest rates.
Managerial
When businesses grow, they can spread some of the fixed salary costs of a talented management team across a bigger output base. Additionally, a growing business can afford to hire specialists and consultants to optimize specific aspects of the production process. For instance, a product designer focused on prototyping can lead to higher margins down the line if the products perform better in the market as a result of their work.
Marketing
Marketing is another aspect of your business that can yield economies of scale. For example, a company running several large marketing campaigns can benefit from bulk ad purchases at a discount and the network effects that come with increased exposure.
Risk-bearing
Large companies can achieve a form of economies of scale by spreading risk across multiple projects, campaigns, or markets. For example, a company with enough resources to support multiple product lines diversifies its risk more than a business that offers one specific product that could fall out of favor if customer tastes change.
External economies of scale
External economies of scale involve factors affecting entire regional or even global markets. Government tax breaks for a certain market or an increase in the skilled labor pool are both examples of external economies of scale.
For instance, Silicon Valley is a result of external economies of scale. The clustering of tech businesses facilitates exchanging ideas, leading to efficiencies and new products. The centralized location means many job opportunities, attracting talent from around the world.
Another external economy of scale occurs when your production costs decrease because of an external factor outside of your control. For example, the average cost falls for shipping when the carriers in your area lower their rates in response to handling more freight. Unlike internal economies of scale, external economies of scale can benefit your rivals too, giving you a production cost reduction without any competitive advantage.
What are diseconomies of scale?
Diseconomies of scale happen when a company sees its production costs increase as it expands output. This kind of inefficiency can occur when companies increase their operations beyond the point where it saves money. For example, a company that opens too many stores in one location can eat into each store’s sales, making it harder to justify overhead and operating costs in the face of decreasing profits.
Similar to economies of scale, there are both internal and external diseconomies of scale:
- Internal. Internal diseconomies of scale can come about due to poor internal communication, conflicting management strategies, and redundant systems stemming from overexpansion.
- External. External diseconomies of scale can occur in crowded markets when businesses have to deal with limited resources or labor shortages. Another type of external diseconomy of scale is when too many businesses in one area cause increased highway traffic, leading to longer transit times and higher shipping costs.
Economies of scale FAQ
What are economies of scale in simple terms?
Economies of scale are cost savings and efficiency gains that result from growth and increased production.
What is a good example of economies of scale?
A good example of economies of scale would be a cosmetics company saving money on producing a skincare line by making bulk purchases of raw essential oils to ultimately lower the price per unit of each skincare product.
Why are economies of scale important in ecommerce?
Economies of scale can lower your production costs and result in wider profit margins and lower prices for customers.
