Economies of Scale

What is the Definition of Economies of Scale?

The concept of economies of scale describes the relationship between the cost advantages received by a company and its rate of output (i.e. the volume of units produced and sold).

• Increase in the Scale of Production → Decline in Average Cost of Production Per Unit
• Decrease in the Scale of Production → Increase in Average Cost of Production Per Unit

All else being equal, if the output of a company rises, there should be a proportional reduction in the cost per unit of production.

Why? The average cost per unit decreases as more output units are produced due to the total costs being able to be spread across a higher quantity of goods.

Therefore, as a company’s revenue (and production volume) increases, the per-unit costs decrease as expenses are spread across a higher number of units.

What are the Different Types of Economies of Scale?

Generally speaking, there are two types of economies of scale: internal and external economies of scale.

1. Internal Economies of Scale → The costs savings that are company-specific, such as:
   • Technical → Proprietary software and/or greater technological capabilities compared to the rest of the market
   • Purchasing → Achieved by placing orders in bulk (and negotiating pricing discounts)
   • Financial → Favorable rates of borrowing received on debt lending terms
2. External Economies of Scale → The cost savings gained due to external factors, such as industry-specific trends or macro events

What Causes Economies of Scale to Occur?

So, what are the common sources that cause economies of scale to occur?

Companies can incur either two types of costs over the course of their operations, fixed costs and variable costs.

• Fixed Costs → Fixed costs remain relatively constant regardless of the production volume (e.g. purchase of machinery and equipment, factory build, office rent, product design/development)
• Variable Costs → In contrast, variable costs are tied directly to the good/service provided and thus fluctuate proportionally in line with each additional unit produced (e.g. raw materials, labor)

As a company continues to grow in size, companies with a higher percentage of fixed costs in their cost structure benefit from seeing these fixed costs being spread out over a higher number of produced units, translating into lower fixed costs per unit on average.

On the other hand, those that operate in industries where the marginal cost of each unit cannot be reduced as output increases – i.e. service-oriented industries (e.g. hospitality, consulting) whose cost structures are more skewed toward variable costs – do not see the type of reduction in average costs.

Therefore, companies in industries with high fixed costs benefit the most from economies of scale, creating barriers to entry for potential competitors and protecting their profitability.

What are the Benefits of Economies of Scale?

The most notable benefit of economies of scale is the positive impact on the profit margins of a company, which most companies strive to achieve with greater scale.

Since unit costs per product decline as volume increases, new entrants come into the market at a significant cost disadvantage from the start.

In effect, the company should be capable of selling its products at lower prices and capturing more market share – as well as protecting itself from new entrants attempting to steal customers via price cuts.

Not all companies that have reached a high level of scale are low-cost providers like Costco and Walmart, but most have the flexibility to:

• Offer products at low prices relative to the market to create a sustainable “economic moat” (or)
• Cut product prices if deemed necessary as a protective measure

Economies of scale create a barrier to entry that can deter new entrants, as only incumbents tend to be able to afford to offer products at lower prices, whereas smaller providers typically must increase prices to produce more revenue.

Another benefit of economies of scale is that higher volume orders from suppliers can lead to more negotiating leverage and thus more discounts, resulting in lower inventory costs and longer days payable outstanding (DPO).

To summarize, the advantages of economies of scale are as follows.

• Reduced Costs Per Unit
• Improved Profit Margins (%)
• More Leftover Funds to Reinvest into Growth
• Higher Return on Invested Capital (ROIC)

What is the Difference Between Economies of Scale vs. Diseconomies of Scale?

The limitation to economies of scale is termed “diseconomies of scale,” which is when a company reaches a certain size where its operating efficiency actually begins to decline.

The source of diseconomies of scale can stem from any of the following factors:

• Loss of Control in Organizational Structure
• Bottlenecks in Operational Flow
• Miscommunications Among Different Divisions
• Revenue Concentration in Geographic Locations
• Overlapping Business Divisions and Functions
• Weak Employee Morale and Reduced Productivity

Beyond an optimal production quantity, the cost per unit changes direction and the curve begins to curve upward (i.e. creating a “U” shape on the cost per unit vs production quantity graph).

The shape of the curve indicates how any units produced past that optimal point increases production costs per unit, as opposed to decreasing them.

Average Cost Per Unit Calculation Example

Let’s say, for instance, there is a company that sold 200 product units at a total cost of production of $5,000.

Given, those two assumptions, we can back out the average cost per unit of $25.00.

• Average Cost Per Unit = $5,000 Total Cost Per Unit ÷ 200 Total Production Volume = $25.00

In the next fiscal year period, the company manages to sell 1,000 product units at a total cost of $8,000.

• Average Cost Per Unit = $8,000 Total Cost Per Unit / 400 Total Production Volume  = $20.00

Despite the production output doubling from 200 to 400 units, the total costs incurred increased from $5,000 to $8,000 – an increase of 1.6x. This is due to the associated increase in variable costs as production volume increased.

Hence, the average cost per unit is now $20.00, representing a 20% reduction from $25.00 in the prior year.

• Change in Average Cost Per Unit = $20.00 – $25.00 = ($5.00)
• % Differential = ($20.00 ÷ $25.00) – 1 = (20%)

Economies of Scale Example: Apple and Suppliers Industry

One real-life example of a company benefiting from economies of scale is Apple (AAPL), particularly in the context of working with its suppliers located overseas.

Since Apple sells millions of iPhones each quarter, Apple can commit to component orders at significant volumes, with favorable negotiating leverage that results in volume-based supplier discounts.

There are also many Apple products that share the same components (e.g. processing chips, display screens), enabling Apple to place even larger (and even better-priced) orders.