Economics of Scale

What Are Economies of Scale and Why Do They Matter?

Economies of Scale or Economics of Scale
When a firm achieves economies of scale, it means that each subsequent unit produced, distributed, or sold has a lower cost than those that came before it. This is the reason a large business will often enjoy higher profit margins than a smaller one. Cultura RM/Ingolf Hatz / Cultura / Getty Images

Economics of scale, or economies of scale as the term is more often known, is a phrase used to describe a phenomenon that causes the cost-per-unit of service or product to decrease the more volume a manufacturer, supplier, distributor, or retailer moves across its fixed cost structure.  As this point is reached, it has the effect of more and more of a firm's revenue falling to the bottom line, resulting in greater free cash flow.

This increased free cash flow then allows the firm to entrench its position.  For example, it has more money to spend on marketing and advertising.  It can afford better lawyers to protect its intellectual property.  It can negotiate more favorable lease rates from landlords as a result of lower default risk or secure discounts through the bulk purchase of raw materials.  It can pay more for talented employees.  All of these things, in turn, increase per unit profit further.  The virtuous cycle often results in a handful of businesses coming to effectively dominate an entire industry.  This leads to better efficiency, lower prices for consumers, and higher profits for investors provided there is sufficient regulatory oversight to prevent things like price collusion.

A real-world manifestation of economics of scale would be the consumer staples sector.  Consider that Colgate-Palmolive, Procter & Gamble, Johnson & Johnson, Clorox, Unilever, Kimberly-Clark, and a select few other businesses manufacture a vast majority of the total revenues brought in by cleaning, personal care, beauty, and hygiene products.

 They were all founded in the 18th and 19th centuries.  Their early successes permitted the economies of scale that allowed them to acquire competitors, lower unit costs to the point each firm could sell to the end customer cheaper than many startups can manufacture the good in question, influence behavior (with help from Madison Avenue), and pump out what has proven to be, for all intents and purposes over a long period of time, an ever-rising stream of dividends for stockholders.

 (Indeed, as I demonstrated the other day when examining Johnson & Johnson, investors who were smart enough to reinvest dividends ended up getting even richer.)

Perhaps no better industry demonstrates economies of scale than pharmaceuticals.  It's the reason behind the observation, "The first pill off the assembly line costs $1 billion, every one that follows, a few cents."

There Are Different Ways a Firm Can Generate Economics of Scale

There is an entire industry built around identifying ways businesses can be more efficient, producing greater economies of scale.  The foundation of this discipline goes back to a lesson called specialization; a lesson first identified by a famous economist named Adam Smith in a book called Wealth of Nations (Smith's famous pin factory, which every first-year economics student will recognize) and brought into the modern era by industrialist Henry Ford, who put the theory to work by requiring every person on an assembly line to master a specific job.  .

Ford's method had the happy by-product of each position becoming proficient in its work; fast and accurate due to repeated practice, allowing the father of the Model T to sell cars for a much lower price than had been possible.

 Even the color choice - Ford only sold black cars - was decided upon after determining pursuing early economies of scale was more important than customer satisfaction.

In some cases, economies of scale can result in permanent structural shifts that benefit certain businesses.  When gasoline became the predominate form of transportation fuel following the rise of the automobile, service stations across the country, and later, world, were raised in devotion to it.  Huge amounts of money were spent building convenience stores and truck stops in practically every town on the map so that no one seriously had to plan whether or not they had enough gas for a road trip - they could be assured there'd be somewhere to fill up the tank wherever they drove.  These days, electric cars have a harder time traveling long distances because there aren't charging stations as readily available.

 This causes consumers to buy fewer electric cars, which keeps the total number of charging stations relatively low.  An early advantage, combined with the economics of scale, cemented the role of oil majors such as ExxonMobil and Chevron as geopolitical forces.

Diseconomies of Scale are the Opposite of Economics of Scale

It's not all milk and honey.  When a firm finally achieves real economies of scale, it is also likely to find itself fighting against things like bureaucracy and bloat, a disconnect from the consumer, an inability to push changes through the organization quickly, battling fiefdoms between different departments, and a host of other problems that, in many cases, can lead to the firm's demise.  

There are many ways around this.  In the case of Johnson & Johnson, the corporation uses a parent holding company to achieve many of the benefits of economics of scale while running each of the 265 operating companies as individual businesses with their own management, employees, legal structures, and marketing, alleviating the problems of diseconomies of scale as each unit is clearly identifiable; judged on its own successes and failures, creating accountability.