Economies of Scale: Lowering Costs as Your Business Grows

:: 00:00

A phrase, a concept that's often banded around in the world of business is economies of scale. This is something I strongly believe that all businesses irrespective of size should be familiar with and understand. Now the concept, even though it might be banded around in big conglomerates, large multinationals, it's simpler than it sounds.

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And by the end of this episode, I'm hoping you're going to be aware of not only what it means, but how you can apply it to your own business situation. Whether you are in the arts, running a small business, think of something new or a large multinational, there's something for everybody.

:: 00:39

So let's start off. What are economies of scale? What does that phrase actually mean? Well, in simple terms, it's about saving money, making economies as your business grows. It's a function of growth. It's a function of doing more of the same thing. Now, the bigger your operation, the less it will be in average terms to cost for producing each item or delivering each service.

:: 01:01

Let's try in an example that we can relate to. Imagine the world of a cake shop. Now, if you are making a single cake, it's going to take time, energy, and ingredients to put into making that one single product. Now imagine the same situation, but instead of making one cake, you're making 20 cakes at the same time.

:: 01:19

You're going to be using the same oven, generally speaking, you're going to be using the same amount of electricity. You’re likely to buy flour in bulk. And if you add them all together and take all those costs and relate it to the total 20 cakes you're making, the average cost of each cake will go down. That's economy of scale in action.

:: 01:37

Another way of viewing this, imagine you are with a bunch of friends. There's 10 of you together, and one of your friends decides to be generous. They've got a hundred pounds in their pocket and they decide to share that equally amongst everybody in that circle of friends. Each person's going to receive 10 pounds.

:: 01:53

Now, if, for example, the number of friends doubled and they're now 20, and you shared that out equally, each person's going to receive a smaller amount, five pounds per person as opposed to 10. And conversely, if a number of people in that circle reduced and it was only five. Well, each person then is going to receive 20 pounds.

:: 02:12

That effectively is economies of scale working. It's the same amount, but you're dividing it by smaller and larger numbers. Now, economies of scale isn't just about cakes. The principle applies to pretty much every single business that I can think of. Whether you're selling handmade jewellery, running a local theatre company, running an accounting firm, cough, cough, a trading company, all of those businesses can apply economies to scale and experience it.

:: 02:37

Now, the more you produce, the more you deliver, the more efficiently you'll be spreading out those costs. And when your costs go down, you have more choices. You can lower your prices, you can increase your profits, you can keep the prices the same and you'll make more profit as a result. With that extra money that you're generating, you can reinvest it in your business,

:: 02:56

pay your team more and reward yourself even better. Now, understandably, you might be thinking, well, why should I care? What does it really matter? What does it actually mean for me? Well, whether you are an artist, a freelancer, a small business owner, understanding the economies of scale can help you make smarter decisions.

:: 03:13

Let's break it down a little bit more. Now, lower costs means you can compete better on price. If we think about economy airlines, the low cost carriers, as we might call them, they experience economies of scale, so the more flights they can undertake, the costly pilot salaries is not going to change too much. The cost of running the fleet of airlines

:: 03:33

is not going to diminish. The fuel may change and fluctuate, but largely the majority of the costs are running that airline are not going to diminish. So the more flights that can take off and land, the more passengers they carry, then they're going to experience that economy of scale and that reflects itself into better pricing.

:: 03:49

Lower costs means profits will generate accordingly, and without efficiency, you're going to increase capacity, save time and resources, freeing that up for other priorities. Let's visualise the example of the arts. Let's say you're a musician who's recording their first album. Now, renting a recording studio for one day can be quite expensive, but if you plan ahead and you record perhaps a couple of albums or an album and a few songs, then the actual costs involved for each song

:: 04:16

will go down as a result. And that's economies to scale in a creative context. If you're a theatre putting on a production, there are certain costs in putting that production together. So rehearsal time, set up time, running the production. But if you repeated that production and you had an extended run, well the cost of each production will diminish accordingly, some costs will stay static.

:: 04:37

You won't have them again. Other costs will fluctuate. But overall, the cost for each production that you're putting on will diminish. Now if you're running a cafe buying coffee, beans in bulk costs less per bag than buying one at a time. Now there are types of economies of scale and it comes pretty much into two main types: internal, and yes, you guessed it external.

:: 04:57

Let me explain the difference. With internal economies of scale this happens within your business. So for example, buying items in bulk. The flour that we mentioned earlier, the coffee beans for your cafe, it happens by investing in better equipment. So we produce a greater output with less time, less resources.

:: 05:15

We can train staff so they can handle more responsibilities. And then there's external economies of scale. Now this is going to happen because things outside of your business, for example, your industry growing, supplies as a consequence, may reduce their prices. The area in which you operate develops better infrastructure, and its logistics and transportation costs will reduce accordingly.

:: 05:36

Now, the majority of small businesses will focus on the internal economies of scale because they can control that much more easily. The Americans have this phrase called sweat the asset. So if you are operating a building, for example, the more you can use that building somewhere, it's a restaurant or a venue, then you are going to experience economies of scale.

:: 05:55

Certain costs in running that building, the rental, perhaps the cost of the salaries that you've got, the underlying repairs and maintenance, electricity in the main utility costs will be largely constant and fixed. So the more usage you can get from the building, the more usage you can get from that space,

:: 06:10

then you have those economies of scale. Let's look at a few more examples of that, economies to scale working in a real life situation that we can all relate to. Our first example is looking at a small bakery. Don't ask me why we've talked about food a lot. I do like food. Most of us can relate to that.

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Now, imagine a small bakery just starting out. In the beginning, they're buying those ingredients from a local shop. Now, as time goes on, assuming that they maintain their quality threshold, they may find that it's slightly more expensive. We all had that experience of going down to the corner shop to buy something.

:: 06:41

It's convenient, it's great, but actually the cost of buying that same item somewhere else, perhaps if we have the transportation, the time to go to a supermarket or a wholesaler, it's going to work out cheaper. Now as the bakery grows and more customers are coming to buy and experience it wares, they're going to buy those ingredients in bulk from a wholesaler, and suddenly the cost per loaf of bread drops. As time goes on,

:: 07:03

the bakery may invest in a larger oven, a much more efficient oven. That means they can batch bake, they can make more product in the same given period of time. They may also experience labour cost savings in terms of the time it takes the bakers and their assistance to produce the bread and produce the cakes becomes less and less, and therefore those savings will come from those different directions.

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Let's look at another example, a theatre company. Now imagine that small theatre company putting on a play. The first production, costumes are hired in sets are constructed, marketing, promotion, all of it expensed and pretty much all from scratch for the second production. Some of those sets that have been built, some of those costumes that have been used can be repurposed.

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Those costs will not have to be expensed again. They've already been spent. They're there to use for subsequent productions. They may get better relationships with suppliers who will offer them discounts if they're hiring venues for rehearsals, for example. Maybe if they bulk book, they can get some reductions on that as well.

:: 08:02

The more the audience grows, some of the marketing might change in substance here, so the marketing cost per ticket will reduce as well. The more people that come and see the shows, then the lower the price will be to the theatre. You've got a combination now of internal and external economy to scale. The theatre is saving money within its own operations, and as time goes on, audiences build up,

:: 08:23

it benefits from those lower costs. Now there are challenges and there are limits. Economies of scale themselves aren’t a magic wand. Bear this in mind. Not every single business can scale up, so if you are a bespoke jewellery maker perhaps, each piece that you make is unique and handmade to suit the customer's requirements.

:: 08:42

If you're a service-based business offering things, let's say for example, specialised tax advice, each client's needs are going to be unique and different. Mass production may not be possible, but there are certain elements that will replicate themselves in terms of processes, procedures. As mentioned in a previous podcast on overtrading, growing too quickly can come back and bite you where it's going to hurt.

:: 09:05

Expanding without proper planning will lead to inefficiencies. Staff will be overworked, quality will diminish, and you have now what's called diseconomies of scale. The third consideration is you need resources. You need that money to invest at the beginning to invest in equipment, to buy those large quantities of materials, which is why it's really crucial when you are planning a pivot, when you're planning an expansion, when you're planning a startup,

:: 09:30

make sure you figure out what your setup costs will be, as well as your day-to-day operating costs as well. So why economies of scale are a fantastic way to grow, approach them carefully with a clear strategy in mind. Now, as we get to the end of this week's podcast, let me share with you some practical steps as to how to get started.

:: 09:49

Review your costs. I've deliberately not given titles and labels to the cost that we have here. I'm going to expand on this in another episode, but as a spoiler alert, those costs which largely remain unaltered, unaltered by activity over a period of time are called fixed. Now, identify those areas where scaling would reduce your expenses.

:: 10:09

So for example, the materials that you buy. Certain costs will be unaffected by ramping up, by an increase in activity such as rent and salaries that you pay. Second, think ahead. Planning is not just for the big. Planning should be something that's embedded into your mindset, irrespective of the type of business you are, and irrespective of size.

:: 10:29

Plan for growth in stages, far rather think ahead as opposed to getting caught out and surprised. Start small. But have that vision for how you can scale up when the time is right. Thirdly, build partnerships. You may be able to sell some cooperative. You may be able to collaborate with people in your space where you can buy in bulk and you can share those discounts amongst you.

:: 10:52

Better purchasing power is always going to come with strength. And lastly, where you can blend your human activity with technology. Processes and systems can be streamlined and automation and software will help with that process, saving you time and money as you grow. So what can we sum up folks? Well, to sum up,

:: 11:11

economies of scale are a powerful way to make your business more efficient and competitive. Whether you're in the field of the arts, running a small business, a social enterprise, it matters not. Understanding how to scale will help save you costs, increase your profits, and grow sustainably. Who doesn't want that?

:: 11:28

I hope you found this useful and that you're going to start looking at your own business through the lens of economies to scale. If you've got questions, you've got thoughts you want to share, feel free to get in touch. Don't forget to subscribe and share this episode for anyone who you feel will find it useful.

:: 11:43

Until next time, folks, keep planning, growing and thriving. Plan it. Do it. Profit.