Economies Of Scale & Minimum Efficient Scale

by Paul Simister on October 27, 2011

Today I want to step away from differentiation and look at the cost side of strategy and in particular the impact that economies of scale can have on an industry and how, in some markets, size really does matter in business strategy.

Background To Business Strategy

I have looked at what is strategy and why strategy is important,  and at the wider economic environment with PEST Analysis and the Five Forces.

I’ve also written about the generic competitive strategies and how you have a choice between differentiation and cost leadership.

But it would be a big mistake to think that a company that differentiates doesn’t have to worry about cost. It does. No business can afford to be wasteful if it is focused on customer value and shareholder value.

The Basis For Economies Of Scale

Bigger businesses usually have lower costs per unit produced/sold and that means they can make bigger profits.

The formal name for this concept is “Economies of Scale” – as the business grows bigger, the unit cost to provide the product or service reduces.

There are no surprises in that basic concept but you may not be aware of all the sources for economies of scale.

The Origins Of Economies of Scale

Let’s take a journey back in history to the start of the 20th century and the early industrialisation.

Times were very different.

Demand was high and the problem was building enough supply capacity.

Market power rested with the supplier.

A good example is Henry Ford and his Model T Ford.

Remember the famous quote “Any customer can have a car painted any colour that he wants so long as it is black”.

This quote shows the weakness of customer power because Henry Ford did not need to cater for the natural desire to be different.

While Ford’s vision was customer centric in terms of “bringing cars to the mass public”, he did not tune into the detailed desires of car buyers.

What made Ford so special was his determination to reduce the cost of making a car, year after year by introducing mass production techniques made possible by selling higher volumes.

This created a wonderful virtuous circle – lower costs meant lower prices which created more volume which led to lower costs.

What Causes Economies Of Scale

  1. Inputs are lumpy
    Lumpy doesn’t sound very technical but it communicates the meaning better than the economics term of “indivisibilities”.
    If you need to produce a product which requires a machine and the machine can produce up to 1,000 units per day, the cost of having the machine available (owning or leasing) is the same regardless of the volume produced. It doesn’t matter if you produce 1, 10, 100 or 1,000 units, the total cost is the same. What does change is the unit cost.  The more you produce, the lower the average cost per unit as the fixed cost is spread over more units.
  2. Specialisation
    The more volume you have, the more opportunity you have to use specialised assets – both people and machines.
    This creates a productivity advantage because specialised assets are very good at what they do. Specialised assets don’t have to make the compromises that more generalised assets do so they can work faster.
    The small supplier has to choose resources based on the need for flexibility and the ability to perform several tasks satisfactorily. The larger supplier chooses the specialised resource where output is higher and unit costs fall.
  3. Additional buying power
    The most compelling reason for a customer to receive a purchase discount is additional volume. The seller wants to sell and will be eager to win the big accounts.
    It is inevitable. The more you buy, the stronger your negotiating position with a supplier who wants your business and that strength leads to lower prices.
    It is easy to see how economies of scale can apply to a production company but the impact of economies of scale can be just as great for the service sector.

Economies of Scale In Service Industries

Two areas where the big companies get a massive benefit from economies of scale are branding (consider how much the major consumer brands spend on advertising and imagine having to compete) and innovation/research/development (e.g. pharmaceuticals, computer software).

Economies of scale arise where costs of a certain level of service are largely fixed. The more units of sale, the lower the unit cost. It is a simple matter of arithmetic.

For example take a computer software company who produces a new software application. It may cost £1 million to write the software code. If the company expects to sell ten copies because it is written for a very specialised niche market, the unit cost of development is £100,000 and is a major factor in the pricing.

If the software business expects to sell a million copies, the unit cost of development falls to £1 and has little impact on pricing.

Minimum Efficient Scale

Some industries have characteristics that mean they are dominated by one or two companies while others encourage businesses to be small and flexible.

This is a factor in where an industry is located in the BCG Advantages Matrix. At its core is a concept called Minimum Efficient Scale.

The Minimum Efficient Scale (MES) is the minimum size of business that will be able to compete effectively with low costs.

It is easiest to look at MES in a production example.

Imagine a market where businesses had to have two machines.

1. Machine A was most efficient when it was producing 10% of the market volume.

2. Machine B was most efficient when it was producing 15% of the market volume.

What is the Minimum Efficient Scale for the factory?

It is a factory with 3 machine As and 2 machine Bs producing 30% of the market volume. Each machine is operated at its optimum efficiency and costs are lowest.

Any smaller and at least one machine isn’t working to its best level so costs can be improved.

Economies Of Scale And The Value Chain

One of the advantages of value chain analysis is looking at the different activities in the business in terms of cost and asking yourself whether you’re getting economies of scale or diseconomies of scale. This helps to restructure the business and leads to evolutions in the industry value chain as technology developments and globalisation to disaggregate and to be put back together in different ways.

Economies of Scale Create Barriers To Entry

Large economies of scale from existing technology create very powerful barriers to entry for any new business competing in a new market.

If you can’t sell at close to the minimum efficient scale, you will experience higher costs.

What Limits Economies of Scale?

Fortunately for smaller businesses, success isn’t automatic as larger size also brings diseconomies of scale:

1. Complexity increases as the product range increases. This makes it difficult to coordinate all the activities.

2. Transaction costs can increase. For example transport costs for a physical product may counteract savings made from a centralised factory.

3. Bureaucracy, poor morale and difficult labour relations cause employees to be less productive.

How You Can Use The Concept Of Economies Of Scale

We will look at this in more detail in articles on the Growth/Share model and the Strategic Environments Matrix but the concept is simple.

If you are in a business that offers major economies of scale, it may be worthwhile to invest in building volume and market share to drive down costs ahead of actual cost savings.

This may involve aggressive sales pricing policies or major advertising and promotion expenditure but it is fraught with risks so do the arithmetic very carefully and think about how competitors will react.

You don’t want to increase competitive rivalry so that it creates a price war that removes all the future profit from the industry.

Paul Simister is a business strategy coach who helps business owners to differentiate their businesses and develop winning strategies. Get your free copy of my ebook The Six Steps Profit Formula.

The Best Of The Differentiate Your Business Blog

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