Economies of scale

Every en­tre­pre­neur is in­ter­est­ed in making their business more prof­itable, and therefore more suc­cess­ful. However, there are different ap­proach­es to achieving this aim. Whereas on the one hand you can try to expand the range of products on offer and profit from economies of scope, on the other hand you can increase your output while limiting your product range.

In order to increase the prof­itabil­i­ty of an in­dus­tri­al company, many managing directors strive to achieve the greatest possible success with the least possible effort. Economies of scale describe exactly that. Various elements are required for producing goods; in addition to the raw materials, the input elements include labor and machinery. In order to profit from economies of scale, you have to sig­nif­i­cant­ly increase the output by spe­cial­iz­ing in a certain pro­duc­tion process, with only a marginal increase in input.

The idea behind economies of scale is that by in­creas­ing pro­duc­tion, the costs per unit produced become rel­a­tive­ly low. The reasons for this are, for example, lower costs due to higher purchase margins for raw materials, more efficient uti­liza­tion of machinery capacity, or well-es­tab­lished logistics. Improving the pro­duc­tion process itself can also lead to a positive result. Pro­duc­tion can be increased by dividing large processes into smaller, easily re­peat­able steps. In the past, assembly line pro­duc­tion has also led to an increase in output with little in­vest­ment in input.

In addition to reducing fixed costs through better capacity man­age­ment, in­creas­ing the size of the business itself is also an aspect of economies of scale. A larger workforce, more work­places, and more machinery should in­evitably lead to higher output. When the upscaling is carried out ef­fec­tive­ly, the quantity of goods produced can increase and the cost per item can decrease.

Depending on the level of success achieved, a dis­tinc­tion can be made between three types of economies of scale. The decisive factor in the clas­si­fi­ca­tion is the re­la­tion­ship between the growth of the input and output. Pro­duc­tion theory, a branch of economics, uses the term “scale elas­tic­i­ty” to describe this re­la­tion­ship.

Constant returns to scale is when input and output increase at an even rate. The scale elas­tic­i­ty is therefore exactly one, since the output increases by one percent when the input increases by one percent. In practice, this type of economy of scale is rare.

Dis­ec­onomies of scale means the scale elas­tic­i­ty is less than one: following an input in­vest­ment, the output increases com­par­a­tive­ly little or not at all. This can happen, for example, in agri­cul­ture due to natural yield lim­i­ta­tions. Even if more fer­til­iz­er is used, the soil can only yield a certain amount of crops. Dis­ec­onomies of scale can also occur when the farm is expanded if the ad­min­is­tra­tive costs of the business become so high that they can no longer be offset by the increased output.

The in­creas­ing returns to scale – with a scale elas­tic­i­ty of more than one – is the result every en­tre­pre­neur wants, since the output is greater than the input in­vest­ment. Such an effect can not only be achieved by ef­fi­cient­ly expanding the business, but also via de­creas­ing pro­duc­tion costs, stan­dard­iza­tion, or by ex­ploit­ing pur­chas­ing power.

In­creas­ing returns to scale – the dis­pro­por­tion­ate increase in output, although relative to the increase in input – often lead to the emergence of mo­nop­o­lies, or at least an en­vi­ron­ment where few companies dominate the market. This can be explained by the fact that a company that has grown sig­nif­i­cant­ly due to in­creas­ing returns to scale can produce more than, for example, two small companies. This trend continues to the point where one company, or very few companies, dominate the market.

Like economies of scale, both economies of scope and economies of density can be leveraged for corporate success. However, the means and ap­proach­es used differ.

Economies of scale aim to increase input while si­mul­ta­ne­ous­ly in­creas­ing the output as dis­pro­por­tion­ate­ly as possible. This requires a com­bi­na­tion of fixed cost de­gres­sion and business expansion. Economies of density, on the other hand, draw their positive effects ex­clu­sive­ly from fixed cost de­gres­sion: unit costs decrease because the con­cen­tra­tion of customers in a certain ge­o­graph­i­cal area increases. In this case, supply routes are shortened – for example for logistics companies – and therefore costs are reduced.

Unlike economies of scale, economies of scope have nothing to do with in­creas­ing pro­duc­tion of a single type of unit, but instead with range. By offering the consumer a larger range of products, sales increase. This does not nec­es­sar­i­ly mean that entirely new products have to be created. It can be more effective to adapt existing products, using existing pro­duc­tion methods, in order to tap into new target audiences with minimal ad­di­tion­al costs.

The internal economies of scale, as we have described so far, are dis­tin­guished from external economies of scale. While the former refer to the growth of one company, the latter covers an entire industry, or even society as a whole. In short, external economies of scale reduce pro­duc­tion costs for several market players si­mul­ta­ne­ous­ly. There can be multiple and varied reasons for this. However, it is generally con­sid­ered helpful for an industry when, for instance, companies are based ge­o­graph­i­cal­ly near one another. This way, suppliers can offer better prices.

It also breeds a lively and largely informal exchange of knowledge, ensuring new in­no­va­tions which advance the industry as a whole. Finally, it en­cour­ages a pooling of skilled workers, making it easier for employers to find suitable workers. Meanwhile, there are also de­vel­op­ments in creating economies of scale across in­dus­tries. For instance, almost every sector benefits from the expansion of the internet.

The in­tro­duc­tion of the assembly line in Henry Ford’s factories is a prime example of in­creas­ing returns to scale. This technical in­no­va­tion – an input in­vest­ment – greatly ac­cel­er­at­ed pro­duc­tion and increased output, while reducing costs. Assembly line pro­duc­tion, having initially been an internal economies of scale effect, evolved to become a clear example of external economies of scale. Virtually all in­dus­tries have since benefited from the in­no­va­tion.

More recently, many companies have been able to develop in­creas­ing returns to scale in the wake of glob­al­iza­tion. By re­lo­cat­ing pro­duc­tion fa­cil­i­ties abroad, companies can often sig­nif­i­cant­ly reduce their costs. The same applies to pur­chas­ing raw materials, which are often cheaper in other global markets.

The examples mentioned above led to major economic rev­o­lu­tions. But even on a small scale, changes can be made that lead to in­creas­ing returns to scale. For example, investing in office supplies like new IT systems can lead to higher pro­duc­tiv­i­ty and therefore increase output. This provides a com­pet­i­tive advantage and can lead to further growth and economies of scale. As a result, op­er­a­tions can then be expanded, allowing even more efficient economies of scale to be exploited.

Click here for important legal dis­claimers.