External vs. Internal Economies of Scale- Definitions and Examples
To experience the cost-savings from economies of scale, businesses must understand how they can increase production while lowering costs. Organizations can start by determining the most applicable strategy in relation to their industry, company size, and business model.
What are Economies of Scale?
By increasing production while lowering costs, businesses can spread their expenses over a large number of goods and reap the benefits of economies of scale. The bigger the business, the more accessible economics of scale is and the more cost savings opportunities there will be. Increasing the output level creates an inverse relationship between the fixed or variable cost-per-unit and the quantity of the product.
The calculation behind this is relatively simple - the more significant the production output, the lower the per-unit cost. Economies of scale can be implemented by companies at any stage of the production process. For example, it can be applied by a marketing department when hiring new marketing professionals as well as a production warehouse.
Internal Economies of Scale
This will typically occur in large companies, resulting in larger volumes of production. There are five main internal economies of scale.
1. Technical Economies of Scale
By improving the efficiency and size of production processes, economies of scale can be achieved. When a business doubles its output, manufacturing costs can fall to 70%-90%, so investing in more efficient equipment and labor will create significant savings in the long-run.
Examples of technical economies of scale include-
- Dividing production processes into separate tasks makes workers more efficient in focusing on one role and specialized in their area of expertise.
- Cutting unit costs by using mass-production methods like specialized machinery.
- Increasing dimensions of storage or delivery containers, for example, to increase the capacity of stored units and the ability to ship larger quantities.
2. Purchasing Economies of Scale
Also known as monopsony power, a company buys products in bulk to reduce the per-unit cost. For example, Wal-Mart can offer low prices by purchasing large bulk quantities of products.
Large manufacturers will have more bargaining power than small competitors. Enterprise companies can also access better rates for delivery, as more products need to be moved. Inventory management also plays a role in reducing unit costs as efficient stock control can reduce holding fees and overspending on unnecessary products.
3. Managerial Economies of Scale
Investing in expertise is one way to grow economies of scale, where specialist managers can enhance production systems to streamline processes and increase productivity. When large companies have the resources to afford specialists, they can manage different divisions of the company more effectively and optimally.
4. Financial Economies of Scale
Larger businesses usually have better credit scores compared to smaller organizations as they generally have more assets that can be used as collateral.
The lower interest rates mean that it costs them less to borrow, driving more profit. Also, a larger company will be able to be funded from the stock market simply with an initial public offering.
5. Diversifying Economies of Scale
As a company diversifies its activities and spreads its costs, there is less risk assumed in any one separate line of business, lowering the costs per unit. Larger companies can more effectively market and advertise products and create new items when branching out to meet the current demand.
External Economies of Scale
External economies of scale relate to outside factors where the company's size creates preferential treatment, such as when governmental policies favor larger companies. An example of this is when a state reduces its taxes to attract companies to the area that will provide the most jobs.
When large companies take advantage of joint research with university departments, this partnership can lower company expenses when shared between the two or more parties.
Though smaller companies don't have the leverage to experience these benefits, they can cluster their businesses together when in similar industries in a small area. This allows them to take advantage of a geographic economy of scale, like creating mutual benefits of being in the same area (for example, small locally-owned gyms and healthy-cafes).
Additional benefits of external economies of scale include-
- Lower-cost supplies.
- Recruiting pre-trained people when similar companies operate in the same region.
- Infrastructure in the industry can be already present to support company growth.
- Availability of training facilities.
- Transportation networks for labor and production may be available.
- Improved existing software and other technology can lower costs.
The Growth Paradox- Diseconomies of Scale
When large companies grow too much, the overgrowth is referred to as a diseconomy of scale. This leads to decreased efficiency if there are too many people working in one area of the company, too many management layers, complex communication methods, and important information being lost in the process.
It could take longer for decisions to be made and miscommunication is a common risk with global companies. There is a threshold that is reached when average costs will stop decreasing as production increases, which could be where costs will rise as a result of inefficiency.
Economies of Scales Examples
The following examples highlight different economies of scale in the real-world.
- Internal Technical Economy of Scale - Splitting up workers to specialize in tasks when producing motor vehicles will require less training of workers and more production efficiency.
- External Economy of Scale - A pharmaceutical company teaming up with a local university to share costs of research for the development and production of a new drug.
- Diseconomy of Scale - A cafe scenario where more cooks in a small space will inhibit efficiency and prevent orders from being fulfilled effectively.
Developing economies of scale initiatives gives companies a competitive advantage when it comes to enlarging the profit margin through increased savings. With lower per-unit costs and production expenses, companies can benefit from this effective growth strategy.
- Value Chain Analysis & Competitive Advantage- Guide for Businesses
- Competitive Advantage in Business- Techniques and Examples
- External vs. Internal Economies of Scale- Definitions and Examples
- What is Product Differentiation? How Businesses Can Stand Out
- Average Profit Margin Per Industry & How to Calculate Them
- How to Account for Inventory Obsolescence In Your Business