economies-of-scale

What Are Economies Of Scale And Why They Matter

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Economies’ of scale types

Economies of scale can ususlly be of two types:

  • Internal: or if they come from factors within the company.
  • Or external: from factors that are outside the company.

Internal

Internal factors that determine economies of scale are:

  • Cost efficiency coming from scale: as companies scale up, in theory, they can also offer products at a lower cost, and still profit from them. This is at the core of cost leadership, one of Porter’s generic strategies for competitive advantage.
  • Technological development: as companies scale they also start to develop proprietary technologies to tackle key aspects of the business, thus improving efficiency, optimizing processes, and productivity.
  • Better organizational structure: up to a certain size, the scaled company will gain from better organizational efficiency, as management might be able to better coordinate the resources of the scaled company.
  • Improved financial structure: as the company scales it might also be able to improve its financial structure to (see Amazon inventory turnover).
  • More bargaining power: companies that scale also have more negotiating leverage with their supplier, which makes it easy for them to gain better deals, and pass them to final customers in the form of lower prices, and more convenience (see Amazon cash conversion cycle).
  • Network effects for digital platforms.

External

A company with external economies of scale is able to use scale to get a better treatment (perhaps from government or regulators).

For instance, as a company creates jobs in an area, as effect it might get advantages like tax credits, public funds or else.

Beware of diseconomies of scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Diseconomies of Scale represent the opposite phenomenon instead. Where a company has grown too large, the cost per unit increases, thus making the firm no longer able to benefit from its achieved scale.

Connected Business Concepts

pirate-metrics
Venture capitalist, Dave McClure, coined the acronym AARRR which is a simplified model that enables us to understand what metrics and channels to look at, at each stage for the users’ path toward becoming customers and referrers of a brand.
north-star-metric
A north star metric (NSM) is any metric a company focuses on to achieve growth. A north star metric is usually a key component of an effective growth hacking strategy, as it simplifies the whole strategy, making it simpler to execute at high speed. Usually, when picking up a North Start Metric, it’s critical to avoid vanity metrics (those who do not really impact the business) and instead find a metric that really matters for the business growth.
marketplace-business-models
A marketplace is a platform where buyers and sellers interact and transact. The platform acts as a marketplace that will generate revenues in fees from one or all the parties involved in the transaction. Usually, marketplaces can be classified in several ways, like those selling services vs. products or those connecting buyers and sellers at B2B, B2C, or C2C level. And those marketplaces connecting two core players, or more.
network-effects
network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.
platform-business-models
A platform business model generates value by enabling interactions between people, groups, and users by leveraging network effects. Platform business models usually comprise two sides: supply and demand. Kicking off the interactions between those two sides is one of the crucial elements for a platform business model success.
negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 
virtuous-cycle
The virtuous cycle is a positive loop or a set of positive loops that trigger a non-linear growth. Indeed, in the context of digital platforms, virtuous cycles – also defined as flywheel models – help companies capture more market shares by accelerating growth. The classic example is Amazon’s lower prices driving more consumers, driving more sellers, thus improving variety and convenience, thus accelerating growth.
amazon-flywheel
The Amazon Flywheel or Amazon Virtuous Cycle is a strategy that leverages on customer experience to drive traffic to the platform and third-party sellers. That improves the selections of goods, and Amazon further improves its cost structure so it can decrease prices which spins the flywheel.

Read more: Diseconomies Of Scale

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Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which reached over a million business students, executives, and aspiring entrepreneurs in 2020 alone | He is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate | Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy | Visit The FourWeekMBA BizSchool | Or Get The FourWeekMBA Flagship Book "100+ Business Models"