Economies of scale that occur inside the business and are within its control are known as internal economies of scale.
Internal economies of scale occur when the cost per unit of output depends on the size of a firm. By operating on a larger scale, a business can reduce its average costs of production.
1. Purchasing economies of scale
Often called and known as ‘bulk-buying economies of scale’.
When firms buy in bulk, they can save money per unit purchased. Large firms can lower their average costs by buying resources in bulk as they usually buy greater quantities of inventory (i.e. raw materials, components and semi-finished goods) than what smaller businesses buy. The more materials purchased at one time, the larger the savings that leads to lower cost of production.
Suppliers will often offer substantial discounts for large purchases as better deals are offered for greater quantities ordered. In general, small businesses do not benefit from purchasing economies of scale as much as large businesses. Although small firms can also gain from purchasing economies because of those bulk-buying discounts, the larger the order, the greater the discount.
It is obviously cheaper for suppliers to process and deliver one large order for one customer rather than several smaller ones for several different customers. Also, suppliers will obviously be keener to keep a very large customer happy due to big profits made on the large quantities sold.
Big firms usually employ specialist buyers who travel both nationally and internationally to visit various suppliers of inventory. Their job is to strike the best deals at the lowest prices possible.
2. Financial economies of scale
Large businesses have a few advantages when it comes to raising finance.
Big firms can borrow very large amounts of money from banks and other lending institutions at lower interest rates. Consequently, lower interest payments mean higher Net Profit After Interest and TAX. Interest rates charged to these big firms are often lower than the interest rates charged to small businesses (especially start-up businesses) because lenders consider them less risky. Large firms with strong balance sheets are more likely to pay back loans on time and in full, and have more collateral to offer in case they default on repaying those loans. Lenders show most preference for lending to a big business with a proven track record and a diversified range of products. In general, smaller firms not only tend to struggle to raise external finance, but are also charged higher interest rates on their borrowings.
There is strong competition amongst the financiers to lend to large businesses, therefore a large and established business looking to borrow money will probably choose a lender that offers the most attractive (the lowest) interest rates.
Raising money by ‘going public’ – changing the type of business organization from a private limited company to a public limited company – is a very expensive process due to, e.g. prospectus publishing fees, roadshow expenses, fees for an underwriting investment bank that will ensure that the company satisfies all regulatory requirements, etc. Paying those costs to raise capital from the general public will be lower for larger firms which are selling millions of dollars’ worth of shares.
3. Marketing economies of scale
Marketing costs rise with the size of a business, but not at the same rate.
While total marketing costs increase as a business grows, they do not rise proportionally to sales. If a business doubles its sales, it will perhaps not have to double its marketing costs. This means that the average cost of marketing falls as sales increase.
Example 1: The costs of employing an advertising agency such as WPP or Omnicom Group to design, arrange and execute promotional campaigns for existing and new products, can be spread over a higher level of sales for a big firm.
Global firms such as The Coca Cola Company, Adidas or Starbucks can spread the high costs of promotion by using the same marketing campaign across the whole world for all of their products. Very often, these multi-nationals will promote their brand rather than each single product from their vast product portfolios.
Large firms can benefit from lower average costs by selling in bulk, thus benefiting from reduced time and transactions costs. A small retail outlet will have to spend a lot more time and effort to sell 10,000 bottles of Pepsi to hundreds of different individual customers than for PepsiCo to sell 10,000 bottles of Pepsi in one transaction to a single wholesaler.
4. Technical economies of scale
Modern technology enables businesses to produce very high levels of output at much lower unit costs than smaller businesses.
Large businesses own sophisticated machinery to mass produce their output using flow production. They are able to justify huge investment in flow production lines because thanks to working at a high-capacity level, they can significantly lower unit costs. Because this method of production uses expensive technical equipment, only very large businesses can afford the level of capital investment required. High output makes high Fixed Costs (FC) to be spread over millions of products. So, improved technology leads to more productivity which reduces average costs.
Because flow production lines usually cannot be purchased in smaller models with a lower total capacity, small businesses do not find it possible to use such technology. Even if small businesses could afford that kind of equipment, they would be unlikely to keep it operating continuously because of lower demand. And this would raise the unit costs.
Example 2: Due very large scale of production, the Foxconn factory in Taiwan, China produces complete iPads and iPhones. The high Fixed Costs (FC) of their equipment and machinery are spread over the huge scale of output being produced for Apple, thereby reducing their average costs of each product.
5. Managerial economies of scale
Large firms can attract the best managers who can create a better work environment and encourage higher efficiency from workers. As people cannot be equally good at everything, specialization leads to higher productivity which then leads to lower average costs.
As a firm expands, it can afford to hire specialist managers for different functional areas of the business such as Marketing, Finance, Production / Operations and Human Resources (HR). These specialists will be operating more efficiently than the sole trader who would have needed to perform a range of different management functions that he may not be specializing in. Sole traders who have to perform many different tasks will not be efficient at any of those tasks, therefore will not be benefiting from this economy of scale.
The skills of specialist managers which allow them to do the job faster and without costly mistakes (because of their knowledge, skills and experience) is a potential economy for larger organizations. Specialist managers improve the quality of business decisions comparing with non-specialist managers.
Through growth, a business can avoid duplication of tasks in planning, communication, marketing, distribution and production processes, and this increases efficiency.
6. Specialization economies of scale
This results from division of labor of the workforce rather than the specialization of management in each different business function.
Division of labor happens when the production process is split up into different tasks and each worker performs one of these tasks. When workers are trained in just one task and specialize in it, efficiency and output can be increased because they the worker are able to complete their assigned task faster. Also, less time is wasted moving from one workbench to another.
Example 3: The car producer Honda which uses mass production can benefit from having specialist employees such as car designers, car production staff, engineers and sales representatives. These specialists are responsible for a single part of the production and delivery process. Their unique expertise brings greater productivity to the company.
7. Risk-bearing economies of scale
These savings can be enjoyed by a conglomerate which is the corporation made up of a number of different businesses in unrelated industries. Conglomerates own other businesses with a diversified product portfolio in different markets.
Conglomerates can spread their Fixed Costs (FC) such as Research and Development (R&D), accounting, recruitment or advertising across a wide range of operations.
Unfavorable trading conditions for certain products in one market can be offset by more favorable trading conditions in other markets, or countries. A loss in one industry, or in one market, does not jeopardize the overall existence of the conglomerate.
Example 4: It takes considerable degrees of investment and significant time for research to develop new medicine with no guarantee of final success. Therefore, this process can only be undertaken by large pharmaceutical companies with significant resources such as Novartis, Merck, AstraZeneca, Pfizer, Sanofi or GlaxoSmithKline.
All in all, when a firm grows and expands, the firm is able to lower production costs and overheads. With lower average costs the firm can lower prices. Lowering prices attracts more customers. More customers lead to more sales and Net Profit After Interest and TAX. Retained Profit can then be used to expand the firm and take further advantages of internal economies of scale.
In the next article, the second type of economies of scale, which are external economies of scale, will be discussed. These economies occur within the industry and are largely beyond an individual firm’s control. They are cost-saving benefits of large-scale operations arising from outside the business.
