What it means
Every business has fixed costs that stay the same however much it sells, such as a factory lease or a software platform, and variable costs that rise with each unit made. When volume grows, the fixed cost per unit shrinks.
A factory costing $200,000 a year adds $20 to each of 10,000 units, but only $5 to each of 40,000 units. Fixed costs are not the only source of savings.
Large buyers can negotiate lower prices from suppliers, bigger firms can afford specialised machinery and staff, and shipping in bulk is cheaper per unit. Some savings arise because a large company can raise money at lower interest rates than a small one.
The reverse can also happen. Beyond a certain size, a business may suffer diseconomies of scale, where average cost rises again because of layers of management, slower decisions and poor communication.
The most efficient size is therefore not always the biggest one. Economies of scale shape strategy and pricing.
A company with lower unit costs can cut prices to win market share and still earn a profit, while a smaller competitor cannot follow without making a loss. This explains why industries such as airlines, retail and cloud computing tend to be dominated by a few large players.
It is important to separate internal economies, which come from the company's own growth, from external economies, which come from the industry growing around it. A cluster of suppliers and skilled workers near a manufacturing hub lowers everyone's costs, not just those of one firm.
Timing and investment matter as well. Scale savings rarely arrive for free, because a company usually has to spend money on a bigger factory, more staff or new systems before volume rises.
Finance teams therefore weigh the upfront cost against the expected fall in unit cost, and they test what happens if the extra demand does not appear.
In practice
Real-world examples
Example 1
A supermarket chain with 500 stores negotiates a 6% lower price from a cereal supplier than a single-store grocer can obtain. The chain passes part of the saving to customers in lower prices and keeps the rest as margin. The independent grocer cannot match its prices on staple goods.
Example 2
A software company spends $5,000,000 developing a product and then sells it to 100,000 customers at almost no extra cost per copy. Each additional customer brings in revenue with very little added cost. The average cost per customer falls sharply as the user base grows.
Example 3
A regional bakery doubles its output by adding a second shift on the same ovens. The rent, ovens and management salaries do not change, so the cost of each loaf falls. The owner uses the saving to win a contract with a hotel group.
Think of it
Economies of scale means bigger is cheaper per unit-your costs go down as volume goes up.
Formula
Calculation
Average cost per unit = (Total fixed costs + Variable cost per unit x Units produced) / Units produced
Suppose a manufacturer has fixed costs of $200,000 a year and a variable cost of $20 per unit.
At 10,000 units: total cost = 200,000 + (20 x 10,000) = 200,000 + 200,000 = $400,000, so average cost = 400,000 / 10,000 = $40 per unit.
At 40,000 units: total cost = 200,000 + (20 x 40,000) = 200,000 + 800,000 = $1,000,000, so average cost = 1,000,000 / 40,000 = $25 per unit.
Quadrupling output has cut the average cost by $15 per unit, or 37.5%, because the fixed costs are shared across four times as many units.Case study
Seen in the real world
Tidewater Plastics is an illustrative, fictional manufacturer of food containers producing 2,000,000 units a year at an average cost of $0.80 per unit. A national supermarket asked for a large contract at $0.65 per unit.
The finance director calculated that fixed costs were $800,000 a year and variable costs were $0.40 per unit. By raising output to 5,000,000 units, total cost would be $800,000 + $2,000,000 = $2,800,000, or $0.56 per unit.
At $0.65 the contract was profitable, and the company accepted it after confirming that the machines could handle the volume. The illustrative lesson is that a price below current average cost can still make sense when volume spreads fixed costs, provided capacity and cash are available.
Watch out
Common mistakes
- Assuming bigger always means cheaper, when diseconomies of scale can raise average cost beyond a certain size.
- Using the average cost at high volume to price small orders, which ignores the fixed costs still needed to run the business.
- Confusing economies of scale with simply having higher revenue, when the concept is about falling cost per unit.
Questions
People also ask
What causes economies of scale?
The main causes are spreading fixed costs over more units, buying in bulk, using specialised equipment and labour, and accessing cheaper finance.
What are diseconomies of scale?
They are the rise in average cost that can occur when a business becomes so large that coordination, bureaucracy and communication problems outweigh the savings.
How do economies of scale differ from economies of scope?
Scale savings come from producing more of one product, while scope savings come from producing several products together.