If you’ve taken an economics class, chances are you learned about “economies of scale.”
Historically, this concept was reserved for the giants of the Industrial Revolution. Economists observed how mass production and efficiency allowed companies like Ford and Carnegie Steel to reduce their average cost of production, increasing their profit margins.
Fast-forward to today’s digital world, and a single business owner can leverage economies of scale thanks to one concept: infinite leverage.
With digital products like software, video content, and ebooks, the production cost after one unit is virtually zero — yet these products can reach hundreds, thousands, and even millions of people. The internet has democratized economies of scale, allowing anyone to create a digital product, produce it once for a fixed cost, and scale it with minimal additional input costs.
This article will explain how you can apply economies of scale in your business, with specific examples of how modern companies use these concepts to grow.
Table of contents:
- What are economies of scale?
- How do economies of scale work?
- Comparing internal and external economies of scale
- Are there limits to economies of scale?
- Economies of scale examples
- How to apply economies of scale to your business
What are economies of scale?
Economies of scale is a term used to describe when the per-unit cost of producing each additional item decreases as the quantity of the product produced increases. This reduction in cost is often due to spreading fixed costs over more units, purchasing materials in bulk, negotiating more favorable contracts with suppliers, and increasing efficiency in production.
How do economies of scale work?
Economies of scale simply means that a business is more profitable at scale. This means that any operational improvement (e.g., efficiency, spreading fixed costs, and bulk purchasing) can result in economies of scale. Below are some of the factors that allow economies of scale to work.
Increasing production efficiency
Henry Ford introduced the assembly line as a way to transform production efficiency. Before, cars were extremely expensive to produce and assemble — each car was essentially a custom build.
By adding ropes and chains to move parts down an assembly line, Ford turned a 12-hour process into one that took 90 minutes. This 700% production increase is a timeless example of economies of scale allowing Ford to grow exponentially.
Spreading fixed costs
Spreading fixed costs refers to the distribution of constant expenses over a greater number of units, thereby reducing the average cost. Fixed costs include rent, machinery, and salaries.
For a bakery owner, baking more loaves of bread doesn’t increase the rent or the oven’s cost. But it does spread those fixed costs over more products that can be sold, reducing the price of making each loaf. If costs remain fixed but revenue increases due to more units sold, then those costs have gone down on a per-unit basis.
A software company might invest in platform development (fixed cost initially). As the company grows in subscribers, the per-user cost decreases because software (unlike raw materials) has infinite leverage.
While bulk purchasing is relatively self-explanatory, it also includes negotiation for variable costs. When you buy something in bulk, it’s guaranteed revenue for the supplier — meaning they’re often willing to apply discounts, especially if they think you’ll choose them over a different supplier.
For example, an ecommerce company selling athletic apparel might take advantage of economies of scale by comparing different suppliers. Say the company is producing less than 10k units per month with an average product cost of $15 but plans to scale to 30k units per month in the next year.
It’d be beneficial to find suppliers willing to offer reduced rates.
This is how much you could save by getting $2 off per unit:
10k units at $15 = $150k
30k units at $15 = $450k
30k units at $13 = $390k
That’s a savings of $60k per month.
Comparing internal and external economies of scale
Because the concept of economies of scale is economic theory, it applies to both microeconomics (businesses) and macroeconomics (the economies of industries).
These two types of economies of scale are generally referred to as internal and external.
Internal economies of scale
Internal economies of scale reflect a specific company’s growth and efficiency.
Here are six avenues to leverage internal economies of scale in your business:
Financial: Larger companies typically have access to financial resources (like debt) at favorable terms — this enables them to fund expansion with ease. For a bank, it’s more likely a large firm will repay a loan when compared to a small business.
Managerial: As a company grows, it can afford to hire specialized employees, which leads to more efficient management. It might take one or two highly skilled software engineers less time to develop software than 10 or more above-average engineers.
Purchasing: By purchasing products in bulk, a company can negotiate better prices, reducing the overall cost of goods sold.
Risk-bearing: Larger firms can take on more risk because of diversification and access to global markets. For instance, a multinational corporation might mitigate risks by setting up shop in several countries.
Technical: This involves innovations and improvements in the production process, such as investing in advanced machinery to speed up production levels (like Henry Ford did with the assembly line).
External economies of scale
External economies of scale refer to entire industries as a whole or the macro environment. A perfect example is Silicon Valley — the clustering of technology companies has created a specialization of labor and shared infrastructure, reducing costs for all businesses in that area.
For instance, the chip giant Nvidia’s location in Silicon Valley has facilitated relationships with leading technology companies focused on AI and machine learning. And by being close to Stanford University, Nvidia has been able to collaborate on research projects and access top-tier engineering talent.
Are there limits to economies of scale?
Unfortunately, economies of scale can’t continue indefinitely. It’s subject to the law of diminishing marginal returns — the point at which adding more production results in a smaller increase in output. The complexities and inefficiencies of managing a large-scale operation are bound to occur, which is known as diseconomies of scale.
One of the best examples of diseconomies of scale is the story of Quiznos. With $1.9B in sales in 2007, its future looked bright. But after scaling to over 4k locations with major inefficiencies like low-profit margins for franchisees, no real competitive advantage, and high operating costs, the company filed for bankruptcy and now has 149 locations as of July 2023.
Economies of scale examples
While it may seem like economies of scale is an outdated concept with digital businesses, there are several large companies that exemplify the concept well.
Amazon’s advanced distribution network leverages economies of scale through a combination of bulk purchasing and optimized shipping routes. By buying products in large quantities, Amazon negotiates better prices with suppliers, getting lower prices.
Additionally, its strategically located warehouses reduce shipping times and costs, allowing products to be delivered quickly and efficiently. Amazon’s big data analytics application forecasts demand and ensures products get stocked when they’re needed most, enhancing cost savings.
Adobe’s transformation into a cloud-based subscription service is a perfect example of using the subset idea of infinite leverage (software-based product) to scale. In the past, Adobe sold physical copies of its products with a tangible production cost.
By shifting to a subscription model, Adobe eliminated the need for physical distribution. Now the main expense is development and iteration. And because additional subscribers add very little to the total costs, Adobe can serve globally without a gigantic backend infrastructure like Amazon.
Plus, Adobe’s model encourages customer loyalty and allows for regular updates without significant investment — demonstrating the power of infinite leverage.
YouTube operates on an economies-of-scale model that benefits both the platform and individual content creators.
For example, take a small-business owner who creates instructional videos on home gardening. Initially, producing and uploading videos may require significant investments of time and money. But once the videos are live on YouTube, they could theoretically reach an unlimited number of people.
Meanwhile, YouTube’s investment in server infrastructure means that hosting millions of videos doesn’t exponentially increase its costs. As more creators upload content and more viewers join the platform, YouTube’s ad revenue grows — but the cost of delivering each video decreases.
This creates a win-win scenario: Creators can reach vast audiences without a corresponding increase in distribution costs (like pay-per-click ads, for example), and YouTube can grow its user base and ad revenue without increasing operating costs.
How to apply economies of scale to your business
For many companies, creating a product with infinite leverage is the fastest and easiest way to implement economies of scale.
For instance, a retailer selling gardening products could offer an accompanying ebook or video course — this would increase average order value without creating ongoing backend production costs.
Whether it’s starting a YouTube channel, investing in complementary software, or building out a blog that reaches thousands of people, using infinite leverage products is the easiest way to implement economies of scale. It’s also an example of economies of scope, which refers to the cost efficiency achieved when producing related products or services.
Next, you could consider increasing output through efficiency. That could mean hiring fewer but higher-quality employees, investing in higher-efficiency machinery, or using software to streamline operations otherwise done by employees.
Bryan Clayton, CEO of GreenPal, an online freelancing platform connecting landscapers to clients, attributes increased efficiency to software and algorithms: “Most people don't know this, but platforms like ours harness powerful algorithms to match vendors with customers based on various parameters, ensuring efficiency at every step. By doing so, we not only achieve cost savings but also enhance user experience.”
Lastly, consider regular audits to identify areas of improvement in these six avenues of internal economies of scale:
By understanding these avenues, any business can grow and enjoy cost advantages in a competitive marketplace.