Economies of Scale Explained: Types, Benefits, and Examples

Key takeaways

As businesses grow and the volume and efficiency of production increase, you can find opportunities for cost savings, known as economies of scale. Here are some important facts to know:

• In economies of scale, a business becomes more profitable as it grows because the cost of producing each unit decreases when the number of products produced increases.

• Due to the cost savings with economies of scale, larger businesses have a competitive advantage over their smaller counterparts.

• You can apply economies of scale in a variety of industries, such as manufacturing, retail, and even your marketing strategy.

Knowing how to capitalize on the benefits of economies of scale can help your business improve its profit margin. If you’re ready to start learning more about cost analysis and making intelligent business decisions, you can earn the Unilever Supply Chain Data Analyst Professional Certificate. With this certificate program, you have the opportunity to learn about developing growth strategies, managing resources efficiently, identifying savings opportunities, and more.

What is economies of scale?

Economies of scale is a term describing the cost savings that can occur when a company increases its production output. Increasing production and simultaneously reducing the cost per good produced is not only beneficial for improving profit margins, but can also allow you to pass on savings to the consumer, since lower production costs enable you to offer your product at a lower price point. This can lead to a competitive advantage over other businesses that can’t match the same level of production, and therefore don’t experience the same cost savings.

Why bigger can mean cost savings

More production can equate to cost savings because it allows you to divide your fixed expenses, such as rent, insurance, or property tax, across a greater number of units produced, resulting in a reduced average cost. Additionally, larger-scale production opens up the opportunity to purchase items in larger quantities. This often leads to better pricing from suppliers, further reducing your production expenses.

Types of economies of scale

The two types of economies of scale are internal and external economies of scale. Internal refers to the various factors you can control and implement to experience cost savings, while external economies of scale result from factors outside of your control that impact the industry as a whole, not just your business.

Internal economies of scale

Internal economies of scale describe the changes you make within your business that lead to lower costs. Examples of internal economies of scale include:

• Borrowing money at lower interest rates

• Purchasing items in bulk

• Opening a larger production facility

• Purchasing better machines and technology

• Hiring more efficient managers

External economies of scale

External economies of scale are changes that affect your entire industry. Although external economies of scale can help lower your costs, since their impact is industry-wide, they won’t give you the same competitive advantage as internal economies of scale. These external factors can include: 

• Increase in available skilled labor

• Government subsidies and tax reductions

• Decreased shipping costs or transport efficiency

• Increase in the availability of resources and materials

What are three sources of economies of scale?

Three potential sources of economies of scale include upgrading software and hardware equipment to produce products more efficiently, buying products at a lower cost per unit, and hiring specialized employees who can improve business processes.

Economies of scale examples

Economies of scale are beneficial across various industries, including manufacturing, technology, e-commerce, and retail stores. Explore examples of how these industries can take advantage of economies of scale:

• Manufacturing: Manufacturers can achieve economies of scale by investing in the latest technology to improve the efficiency of the manufacturing process. 

• Technology: In the technology industry, moving toward selling cloud computing products rather than physical products is more efficient. You can sell software without developing a unit for each point of sale, similar to selling a computer, for example.

• Marketing: When running large-scale marketing campaigns, companies benefit from the ability to reach a larger audience. Although a larger campaign comes with higher costs, it also reaches far more people, leading to sales growth. 

• Retail: A retailer that chooses to purchase products in bulk has the advantage of reducing its cost per unit, which makes it possible to lower pricing to attract customers, or maintain prices and improve profit margins.

Benefits of economies of scale

The primary benefit of economies of scale is an increase in profit. Since economies of scale allow you to lower your cost per unit, your profitability ultimately grows. In addition to profit margins, another benefit of economies of scale is the potential competitive advantage you can gain in your industry. Lowering your cost per unit gives you the ability to offer products at a lower price than your competitors, allowing you to increase your market share.

Challenges of economies of scale 

Sometimes, in an effort to optimize economies of scale, a company may grow too much, or improperly, and experience diseconomies of scale, when the cost of production actually increases. This is because increasing production doesn’t automatically mean the price per unit will go down—sometimes the increase in cost is more substantial than the savings it creates. 

Organizational inefficiencies that can lead to diseconomies of scale include unproductive employees, poor leadership and miscommunication, unsustainable growth, oversaturated markets, and labor shortages.

Economies of scale vs. economies of scope

While economies of scale indicates that increasing the output of a product leads to a decrease in the cost per unit, economies of scope reduce the cost of production by increasing the variety or range of goods produced. For example, a company that sells scarves could expand its business, using the same material to create other products like blankets and sweaters. 

How do big businesses benefit from economies of scale?

To begin experiencing the benefits of economies of scale in your business, one accessible method you can use is data analytics. By gathering meaningful insights from data such as transaction patterns, customer feedback, and user behavior, you can work on streamlining operations. 

Additionally, analyzing market trends and assessing demand can allow you to optimize your pricing models based on market conditions. This, in turn, can help you maximize resources and efficiency during periods of high demand. 

Another effective way to capitalize on economies of scale is to sell a complementary product, such as software or an e-book, to accompany your regular products. Because these accessory products don’t require a new product iteration for each sale, you can sell the same product repeatedly, increasing the average order value. 

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