Economy of Scale

Financial Dictionary -> Investing -> Economy of Scale

Economies of scale are factors which cause the average cost of a unit to fall as the amount of output increases. So in a table factory the cost to make one table decreases as more wood is bought and more tables are made. This often happens as companies receive discounts when buying materials in bulk. The opposite of this is known as diseconomies of scale.

When a company grows there are certain things it can do more efficiently. The group term for these factors is 'economies of scale'. When a company experience economies of scale their production costs fall. For example:

A game console company can produce 100 consoles for $30 each, but when they hit the 1000 mark, they can make them for $25 each because of economies of scale. If the console sells in stores for $100 then the company will see the profit margin rise from $70 to $75 per console.

Economy of scale is therefore, in effect, a benefit of being a big company that can produce products to the masses. This is often why small businesses cannot keep up with the big commercial brands, because they don't see the same savings.

Bulk buying and the ability to take on long term contracts are the most common form of economy of scale, but there are others. These include Technical Economies (where larger companies can afford to invest in more efficient technology and machinery), Managerial Economies (when big companies can employ very specialized staff), Financial Economies (banks and lenders are more likely to give loans to large companies) and marketing economies (when bigger companies have more money to use on more effective marketing methods).

On the flipside diseconomies of scale might occur when one supplier can no longer meet a company's high demand, so they have to go to a more expensive alternative or when expanding means utilizing more expensive machinery to meet demand.