What is... | September 26, 2018

What is an economy of scale?

Size really does matter, although the effect isn't always positive. Jessica Exton explains.

Amazon delivers huge numbers of products to customers at all times of the day and night, but those delivery vans may not be full. How can it do this, and still remain profitable?

Part of the answer is through the idea of economies of scale. This means, in Amazon’s case, that the cost of delivering each item can be reduced by increasing the total number of units processed. So when people order more goods, they can be placed in the same vans that are already driving out each day.

Amazon can do this because it is a large company. There are other ways to get economies of scale, but in each case the outcome is the same: when more is produced or processed, the overall cost to produce each specific item decreases. This can make a company more profitable and give them an advantage when competing against other companies.  

Thinking efficient
In business, getting economies of scale is usually thought to be a good thing. This is because it can boost efficiency and, hopefully, the ultimate end user – customers like you or me – will get better value products, or more bang for their buck.

One reason is that, when there are more things being produced in a warehouse, people can start to specialise in what they do. Rather than having to do lots of different tasks, a team member can be assigned one job, passing the product along to someone else for the next step. This is called labour specialisation and can help companies boost the amount they can produce.

Sometimes, as a result, machines can play more of a role. And as technologies like machine learning and artificial intelligence (AI) continue developing, machines will be able to do more and more. Investing in the most efficient technology and methods of production helps businesses become more competitive, with the process typically helped along by economies of scale.

Cost of existence
 Almost all businesses have some tasks that still need doing even when nothing is actually being sold – such as accounting and management. These costs are usually connected to the number of individual products sold by the company, but when there are more, the cost falls per item. The cost of setting up a business is typically high as well – especially in the early stages when money may have been borrowed to invest.

Sometimes the effect of economies of scale is smaller than anticipated. This often happens in today's global trade arrangements.

Larger production runs, by reducing cost per unit, mean set-up costs be divided among many units. When more is produced, a smaller amount to cover the start-up costs needs to be added to the cost of each individual item.

But the economies of scale concept goes beyond factories. Internet-based businesses can enjoy network economies of scale. In fact, online companies can develop large economies of scale as it can cost almost nothing to add customers to their infrastructure, once set up.  

It doesn't always work
There can be a down side. Sometimes the effect of economies of scale is smaller than anticipated. This often happens in today's global trade arrangements, when supply chains are composed of many different businesses. When organisations outsource and share providers, their costs tend to even out regardless of their size.

The opposite can also happen: costs can rise as production volumes grow. This is known as diseconomies of scale. An example might be when a company becomes less efficient or flexible because it has grown too large. The company might become very slow to act, because it takes management a long time to make decisions, or it might struggle to communicate clearly with its staff or business partners.

Meanwhile, risk aversion can increase, and play a role in preventing the business from reaching its goals.

When more is better
Meanwhile, people everywhere want the best products at the best prices – so competitive pricing is an essential component of business success. To do this, companies often try to reduce the average cost of what they do at each stage of production, and achieving economies of scale is one factor that can help. 


Jessica Exton
Jessica Exton

Behavioural scientist at ING
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