Economies of Scale Explained: Lower Costs and Increased Profits
Welcome to another episode of Numbers Knowhow, where we break down complex financial concepts into digestible pieces. I'm your host, Mahmood Reza, and today we're talking economies of scale.
You've probably heard the term before, perhaps in boardroom meetings, financial news articles, or even casual business conversations.
But what does it actually mean?
More importantly, how can you, no matter the size or field of your business, harness the power of economies of scale to reduce costs, increase profits, and ultimately grow sustainably?
In the episode, I'll explain this concept through real-world examples, from small bakeries to large airlines, and give you actionable strategies to apply these principles to your own business ventures.
You'll learn why bigger can sometimes be better when it comes to business operations.
We'll explore how buying ingredients in bulk, investing in better equipment, and spreading out costs can make your business run more efficiently.
By the end of this episode, you'll understand the difference between internal and external economies of scale and why small businesses should focus more on the former.
We’ll also delve into advanced topics like the pitfalls of over-expansion and diseconomies of scale, where bigger isn't always better.
Plus, I’ll provide you with steps you can take right now to plan for growth in a measured and effective way, ensuring you're ready to scale up when the time is right.
Timestamped Summary:
[00:00:03] Introduction to Economies of Scale: Definition and importance for businesses of all sizes.
[00:00:56] Cake Shop Example: Explaining economies of scale through a simple, relatable analogy involving cake production.
[00:01:38] Friends and Money Example: Further elaboration using a scenario of dividing a fixed amount of money among friends.
[00:02:40] Broad Application: Discussion on how economies of scale apply to various types of businesses, from handmade jewellery to accounting firms.
[00:03:28] Airline Example: How low-cost carriers benefit from economies of scale, demonstrating the principle in the context of the airline industry.
[00:04:04] Creative Industries: How recording multiple songs or staging multiple productions can reduce costs in creative fields like music and theatre.
[00:05:00] Internal and External Economies of Scale: Introduction to the two types of economies of scale and practical examples for each.
[00:06:15] Real-Life Examples: Deep dive into examples involving a bakery and a theatre company to illustrate cost savings and efficiencies.
[00:08:53] The Limits of Economies of Scale: Discussion on the challenges and limitations, including the concept of diseconomies of scale and the risks of over-expansion.
[00:09:52] Practical Steps to Implementation: Steps to review costs, plan for growth, build partnerships, and integrate technology for better efficiency.
Mentioned in this episode:
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Transcript
A phrase, nay, a concept that's often banded around in the world of
Speaker:business is economies of scale. This is something I strongly
Speaker:believe that all businesses, irrespective of size, should be familiar
Speaker:with and understand. Now, the concept, even though it might be banded around in
Speaker:big conglomerates, large multinationals, it's simpler than it
Speaker:sounds. And by the end of this episode, I'm hoping you're going to be aware
Speaker:of not only what it means, but but how you can apply it to your
Speaker:own business situation. Whether you're in the arts, running a small
Speaker:business, thinking of something new, or a large multinational,
Speaker:there's something for everybody.
Speaker:So let's start off. What are economies of scale? What does
Speaker:that phrase actually mean? Well, in simple terms, it's about saving
Speaker:money, making economies as your business grows. It's a
Speaker:function of growth, it's a function of doing more of the same
Speaker:thing. Now, the bigger your operation, the less it will be, in average
Speaker:terms, to cost of producing each item or delivering each
Speaker:service. Let's throw in an example that we can relate to. Imagine the world
Speaker:of a cake shop. Now, if you're making a single cake, it's going to take
Speaker:time, energy and ingredients to put into making that
Speaker:one single product. Now, imagine the same situation, but Instead of making
Speaker:one cake, you're making 20 cakes. At the same time, you're making going
Speaker:to be using the same oven, generally speaking, you're going to be using the same
Speaker:amount of electricity. You likely to buy flour in bulk. And if
Speaker:you add them all together and take all those costs and relate it to the
Speaker:total 20 cakes you're making, the average cost of each cake
Speaker:will go down. That's economy to scale in action. Another way of
Speaker:viewing this, imagine you're with a bunch of friends. There's 10 of
Speaker:you together, and one of your friends decides to be generous. They've got
Speaker:£100 in their pocket and they decide to share that equally
Speaker:amongst everybody in that circle of friends, each person going to receive
Speaker:£10. Now, if, for example, the number of. Friends doubled and
Speaker:they're now 20 and you shared that out equally, each person
Speaker:is going to receive a smaller amount, 5 pounds per person, as
Speaker:opposed to 10. And conversely, if the number of people in that
Speaker:circle reduced and it was only five, well, each person then is going to
Speaker:receive £20. That effectively is economies of
Speaker:scale working. It's the same amount, but you're dividing it
Speaker:by smaller and larger numbers. Now, economies of scale isn't just
Speaker:about cakes. The principle applies to pretty much every single business.
Speaker:I can think of whether you're selling handmade jewelry, running a local theater
Speaker:company, running an accounting firm, cough, cough, a trading company. All
Speaker:of those businesses can apply economies of skill and experience
Speaker:it. Now, the more you produce, the more you deliver, the more efficiently
Speaker:you'll be spreading out those costs. And when your costs go down, you have
Speaker:more choices. You can lower your prices, you can increase your
Speaker:profits, you can keep the prices the same, and you'll make more profit as
Speaker:a result. With that extra money that you're generating, you can
Speaker:reinvest it in your business, pay your team more, and reward yourself even
Speaker:better. Now, understandably, you might be thinking, well, why should I care? What does it
Speaker:really matter? What does it actually mean for me? Well, whether you're an artist,
Speaker:a freelancer, a small business owner, understanding economies of scale
Speaker:can help you make smarter decisions. Let's break it down a little
Speaker:bit more. Now, Lower costs means you can compete
Speaker:better on price. If we think about economy airlines for low
Speaker:cost carriers, as we might call them, they experience economies of
Speaker:scale. So the more flights they can undertake. The costly pilot
Speaker:salaries is not going. To change too much. The cost of running the fleet of
Speaker:airlines is not going to diminish. The fuel may change and fluctuate,
Speaker:but. Largely the majority of the cost of running that airline are not going to
Speaker:diminish. So the more flights that can take. Off and land, the more
Speaker:passengers they carry. Then they're going to experience that economy of scale, and
Speaker:that reflects itself into better pricing. Lower costs means profits will
Speaker:generate accordingly. And with that efficiency, you're going to increase
Speaker:capacity, save time and resources, freeing. That up for other
Speaker:priorities. Let's visualize the example of the arts. Let's say you're
Speaker:a musician who's recording their first album. Now, renting a recording
Speaker:studio for one day can be quite expensive. But if you plan ahead and you
Speaker:record perhaps a couple of albums or. An album and a few songs,
Speaker:then. The actual cost involved for each song will go down
Speaker:as a result. And that's economies of scale in a creative context. If
Speaker:you're a theater putting on a production, there are certain costs in putting that
Speaker:production together. So rehearsal time, setup time, running the
Speaker:production. But if you repeated that production and. You had an extended run,
Speaker:well, the. Cost of each production will diminish accordingly. Some costs
Speaker:will stay static, you won't have them again, Other costs will fluctuate.
Speaker:But overall, the cost for each production that you're putting on will
Speaker:diminish. Now, if you're running a cafe, buying coffee beans in Bulk costs
Speaker:less per bag than buying one at a time. Now there are types of economies
Speaker:of scale and it comes pretty much into. Two main types,
Speaker:internal and yes, you guessed it, external. Let me explain the
Speaker:difference with the internal economy to scale. This happens within
Speaker:your business. So for example, buying items in bulk, the
Speaker:flour that we mentioned earlier, the coffee beans for your cafe, it happens
Speaker:by investing in better equipment so you produce a greater output
Speaker:with less time, less resources. We can train staff so they can handle more
Speaker:responsibilities. And then there's external economies of scale.
Speaker:Now this is going to happen because things outside of your business, for example
Speaker:your industry, growing suppliers as a consequence may reduce their
Speaker:prices. The area in which you operate develops better
Speaker:infrastructure and its logistics and transportation costs will
Speaker:reduce accordingly. Now the majority of small businesses will focus
Speaker:on the internal economies of scale because they can control that much more
Speaker:easily. The Americans have this phrase called sweat the asset. So if
Speaker:you are operating a building, for example, the more you can use that building,
Speaker:so whether it's a restaurant or a venue, then you are going to experience economies
Speaker:of scale. Certain costs in running that building, the rental, perhaps the cost
Speaker:of the salaries that you've got, the underlying repairs and maintenance,
Speaker:electricity in the main utility costs will be largely constant
Speaker:and fixed. So the more usage you can get from the building, the more usage
Speaker:you can get from that space. Then you have those economies of scale. Let's look
Speaker:at a few more examples of that economies of scale working in a real life
Speaker:situation that we can all relate to. Our first example is looking at
Speaker:a small bakery. Don't ask me why. We talk about food a lot. I
Speaker:do like food. Most of us can relate to that. Now imagine a small bakery
Speaker:just asking out. In the beginning, they're buying those ingredients from a local shop.
Speaker:Now as time goes on, assuming that they maintain their quality threshold,
Speaker:they may find that is slightly more expensive. We all had that experience
Speaker:of going down to the corner shop to buy something. It's convenient, it's great.
Speaker:But actually the cost of buying that same item somewhere else, perhaps if we
Speaker:have the transportation occasion, the time to go to a supermarket or a wholesaler, it's
Speaker:going to work out cheaper. Now, as the bakery grows and more
Speaker:customers coming to buy and experience its wares, they're going to buy those
Speaker:ingredients in bulk from a wholesaler and suddenly the cost per loaf of bread
Speaker:drops. As time goes on, the bakery may invest in a larger
Speaker:oven, a much more efficient oven. That means they can match, bake,
Speaker:they can make more product in the same given period. Of time. They may
Speaker:also experience labor cost savings in terms of the time it
Speaker:takes the bakers and their assistants to produce the bre. To produce the
Speaker:cakes becomes less and less and therefore those savings will come from
Speaker:those different directions. Let's look at another example, a theatre
Speaker:company. Now imagine that small theater company putting on a play. The first
Speaker:production, costumes are hired in, sets are constructed, marketing,
Speaker:promotion, all of. It is expensed and pretty much all from
Speaker:scratch. For the second production, some of those sets that have been built, some of
Speaker:those costumes that are being used can be repurposed. Those costs will
Speaker:not have to be expensed again. They've already been spent, they're there to
Speaker:use for subsequent production. They may get better relationships with suppliers
Speaker:who will offer them discounts. If they're hiring venues for
Speaker:rehearsals, for example, maybe if they bulk book, they can get some
Speaker:reductions on that as well. The more the audience grows, some of the marketing
Speaker:might change in substance here. So the marketing cost per ticket will reduce as
Speaker:well. The more people that come and see the shows, then the lower the price
Speaker:will be to the theatre. You've got a combination there of internal and
Speaker:external economies of scale. The theatre saving money within its own
Speaker:operations, and as time goes on audiences,
Speaker:it benefits from those lower costs. Now there are
Speaker:challenges and there are limits. Economies of scale in themselves aren't
Speaker:a magic wand. Bear this in mind. Not every single business can scale
Speaker:up. So if you are a bespoke jewellery maker, perhaps each piece
Speaker:that you make is unique and handmade to suit the customer's
Speaker:requirements. If you're a service based business offering things, let's say for
Speaker:example, specialized tax advice, each client's needs are going to be
Speaker:unique and different. Mass production may not be possible, but there
Speaker:are certain elements that will replicate themselves in terms of
Speaker:processes, procedures. As mentioned in a previous podcast on
Speaker:overtrading, growing too quickly can come back and
Speaker:bite you where it's going to hurt. Expanding without proper planning
Speaker:will lead to inefficiencies. Staff will be overworked,
Speaker:poverty will diminish, and you have now what's called
Speaker:diseconomies of scale. The third consideration is you need resources.
Speaker:You need that money to invest at the beginning to invest in equipment
Speaker:to buy those large quantities of materials. Which is why it's really crucial
Speaker:when you are planning a pivot, when you're planning an expansion, when
Speaker:you're planning a startup, make sure you figure out what your setup costs will
Speaker:be as well as your day to day operating costs as well.
Speaker:So while economies of scale are a. Fantastic way to grow. Approach them
Speaker:carefully with a clear strategy in mind. Now, as we get
Speaker:to the end of this week's podcast, let me share with you some practical
Speaker:steps as to how to get started. Review your costs. I've
Speaker:deliberately not given titles and labels to the cost that we have here. I'm going
Speaker:to expand on this in another episode, but as a spoiler alert,
Speaker:those costs which largely remain unaltered, unaltered by activity
Speaker:over a period of time are called fixed. Now. Identify those areas
Speaker:where scaling would reduce your expenses. So for example, the
Speaker:materials that you buy certain costs will be unaffected by a ramping
Speaker:up by an increase in activity, such as rent
Speaker:and salaries that you pay. Second, think ahead. Planning is
Speaker:not just for the big Planning should be something that's embedded into
Speaker:your mindset irrespective of the type of business you are and
Speaker:irrespective of size. Plan for growth in stages far
Speaker:rather think ahead as opposed to getting caught out and surprised.
Speaker:Start small, but have that vision for how you can scale up when
Speaker:the time is right. Thirdly, build partnerships. You may be
Speaker:able to set up some cooperative. You may be able to collaborate with
Speaker:people in your space where you can buy in bulk and you can
Speaker:share those discounts amongst you. Better purchasing power is always
Speaker:going to come with strength. And lastly, where you can blend
Speaker:your human activity with technology, Processes and
Speaker:systems can be streamlined and automation or software will
Speaker:help with that process, saving you time and money as you grow. So what can
Speaker:we sum up folks? Well, to sum up, economies of scale are a
Speaker:powerful way to make your business more efficient and competitive. Whether
Speaker:you're in the field of the arts, running a small business, social enterprise,
Speaker:it matters not. Understanding how to scale will help
Speaker:save you costs, increase your profits, and grow sustainably. Who
Speaker:doesn't want that? I hope you found this useful and that you're going to start
Speaker:looking at your own business through the lens of economies of scale. If you've
Speaker:got questions, you've got thoughts you want to share, feel free to get in touch.
Speaker:Don't forget to subscribe and share this episode for anyone who you feel will
Speaker:find it useful. Until next time folks. Keep planning, growing and
Speaker:thriving. Plan it. Do it. Profit.
