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Economies Of Scale In Small Businesses
Introduction
Many small businesses, particularly new start-ups, cannot benefit from economies of scale that is practiced and enjoyed by the larger companies. To name a few, this includes bulk purchasing and increased efficiency: all contributing to cheaper costs and increased profitability.
In time, most small businesses will grow to an extent where they can benefit from practicing economies of scale.
However, until then, how can small businesses try to integrate economies of scale today so that they can benefit in the future?
What is Economies of Scale?
In general, a business achieves economies of scale as a result of producing (or selling) more for a reduced average cost. This is gained by distributing fixed costs (costs that do not change as a result in a change of production e.g. rent, staff salaries, insurance, etc) over an increased number of products.
Example 1:
A production line manufactures 500 units each week with a fixed cost for operating (labour, machinery, etc) of £2000. The average fixed cost per unit is:
£2000 / 500 units = £4.00
The manager then presents his thoughts that a second production line could be installed using some of the existing labour and machinery from the original line without affecting current production levels. Some extra machinery and labour will be required but this extra fixed cost will only be £400 per week. The new production line is planned to manufacture 250 units per week.
The average fixed cost per unit would then be:
= £2000 (line 1) + £400 (line 2) / 500 units + 250 units
= £2400 / 750 units
= £3.20 i.e. a reduced fixed cost of 80p per unit.
Example 2:
Say, a business buys 100 products from a supplier for 100 pounds, the cost would be £1.00 per product. The supplier has agreed to sell 1000 products for 800 pounds (bulk purchase):
This would then make the cost per product: 800 pounds / 1000 units = £0.80
There are many ways that a business can gain economies of scale and the above two examples cover perhaps the two most common practices. For small businesses, many of these practices are out of reach due to constraints that are highlighted below.
Benefits of Economies of Scale
Economies of scale is often an incentive for businesses to grow: many small businesses cannot compensate for a sufficient increase in production/sales because of current resources (production space, number of employees, budget, etc) and therefore cannot practice economies of scale.
Because of reduced costs, businesses can price their products to be more profitable: even without changing the price, the reduced cost will instantly create more profit. Practicing economies of scale also allows businesses to be more competitive as the reduced costs, like above, allows prices to be more flexible.
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Introduction
