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Small Business Tips

How economies of scale affect small businesses

Brian Van Buren
Customers ordering at food truck

Small business owners are always looking to grow, but the prospect of taking a profitable business to the next level can be daunting. However, growth has some inherent benefits that savvy business owners can take advantage of.  

One of the ways that growth can be inherently beneficial is due to a concept known as economies of scale. Let’s go over what that means and how your business can benefit from it.  

What is the definition of economy of scale?

Merriam-Webster’s Dictionary defines economy of scale as “a reduction in the cost of producing something brought about especially by the increased size of production facilities.” Basically: The more you make of something, the less it costs to make.  

It is important to realize that economies of scale are not simply tied to producing manufactured goods. Your business may not be involved in manufacturing but can still benefit from economies of scale in the areas of purchasing, specialization, and administration.  

Depending on your industry and location, you may benefit from external economies of scale. These take place outside your business but still have a positive impact on costs.

What are economies of scale in production?

Production is one of the most obvious areas where economies of scale come into play. One of the concepts you need to understand in order to grasp how economies of scale work in production is the difference between fixed costs and variable costs. Fixed costs do not increase with the size of the production run, whereas variable costs do.  

Take the example of a food truck. Purchasing a deep fryer to make French fries is a one-time cost or the cost is fixed. The cost of potatoes may change with market price and volume, so this cost is variable. The cost of your deep fryer doesn’t change if you sell one order of fries or a thousand but the cost of potatoes will.

This effect is best seen in traditional production. The machinery needed to produce manufactured items is a fixed cost. In addition, improvements in production equipment and efficiency can reduce overall fixed costs over time. Therefore, no matter how much production is scaled up, economies of scale will help decrease costs.

There is, however, a point where no greater efficiencies can be gained, and the benefits of economies of scale begin to break down. For example, management policies that served a company well before growth may lead to inefficiencies when scaled up. Or hiring more workers than needed during a period of explosive growth, can lead to diseconomies of scale where the cost of production increases over time.

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What are the types of economies of scale?

Economies of scale are not limited to the production of products. There are many areas where small business may benefit from growth. Growth can open the door to economies of scale in administration and specialization, to buying services, purchasing power and more.

This is called an internal economy of scale. It’s where growth within the business leads to new possibilities that lead to greater efficiency.

Also, small businesses can benefit from external economies of scale even without experiencing growth themselves.  

Using the food truck example, if there are large numbers of food trucks in an area, then a support industry will spring up around them. It may take the form of vehicle service and specialized restaurant supply. In addition, as more food trucks open in an area, more workers with experience in that field will grow. Consequently, business owners can hire experienced workers with less need for training.

Some external economies of scale are tied to location. For example, an area with many office parks or construction sites with limited food options will have a greater need for food trucks and can support more of them. A well-maintained infrastructure is also an external economy of scale. Better roadways lead to better access to customers and less wear on food trucks.

What are the benefits of economies of scale?

There are several different ways that economies of scale can benefit a small business as it grows. Some of these are easy to see, but others aren’t so obvious.  

  • Specialization: When small businesses start out, often one person handles many roles in the company. By hiring dedicated workers to handle those roles, you get the benefit of specialized workers with greater expertise in those roles.
  • Administration: Expanding to multiple locations means hiring new workers but some roles can be centralized. No need for each location to hire its own marketing team when that can be handled centrally.
  • Technical: Manufacturing costs generally fall when production increases. By improving equipment and increasing efficiency over time, fixed costs per unit will go down as well.
  • Purchasing: As your business grows, you will make larger orders, which can give you an edge in negotiations with suppliers. As your order quantity grows, so does your leverage.
  • Buying Services: If you purchase services from other companies, such as payroll and accounting, you can benefit from sophisticated services that would otherwise be too costly for the business itself to use.

Growth can lead to economies of scale

Regardless of the size of your small business, you should always be looking for ways to grow. If you are aware of the inherent benefits of growth, you are more likely to take that next step for your small business.

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