Economies of scale for small businesses

You may have heard the term ‘economies of scale’ when talking about advantages enjoyed by larger business. But economies of scale can take different forms, and contrary to what you might think, it’s not just the big players that can benefit: small businesses can reap the rewards too. Here’s how you can get the most out of economies of scale for your business.

What does ‘economies of scale’ actually mean?

‘Economics of scale’ describes the situation when the cost-per unit of goods sold goes down as your output increases. In other words, it’s a way in which a business becomes more profitable as it grows. Often, this is because businesses have ‘fixed costs’ that aren’t affected by the amount of sales, such as office overheads or machinery. As the business grows, fixed costs remain static, leading to a lower cost per unit.

Ways that small businesses can benefit from economies of scale 

The good news is that most small businesses have a huge opportunity when it comes to growth.  However small your business is, you are likely to be rewarded with greater profitability as you grow, thanks to economies of scale. Here are some of the different types of economies of scale, and how you can benefit from them:

Specialisation of Labour

With a higher turnover, budget can be allocated more efficiently by paying for specialist labour. For example, say you currently employ one member of support staff to cover finance, HR, marketing and admin. But as turnover increases, you might be able to add three staff, with one covering each function. This is likely to be more than four times profitable, since a specialist employee will be more efficient and be able to add more value than a generalist.

Technical

Typically, manufacturing costs per unit fall as output is increased. This is because you can invest in more sophisticated equipment to increase efficiency. Even if you don’t have the capital, you can still tap into this by renting equipment or buying equipment using finance. You can also outsource services to suppliers that may offer a lower price for a ‘slimmed down’ service offering.

Administration

Businesses with multiple locations can centralise their core business functions. For example, a clothes store may employ a marketing manager working from a serviced office. If they go on to add another two stores, that same marketing manager can deal with marketing across all three stores. This will reduce both the marketing cost per unit and office overheads per unit.  

Purchasing power

The larger your business gets, the more orders you’ll be making, and therefore greater the leverage you’ll have with suppliers to negotiate better prices. You can benefit by buying stock in bulk from suppliers where possible. It may be necessary to use finance to do so, such as a business loan or bank overdraft, if cash is not immediately available.

Network

Also called the ‘Network Effect’, a business may have a network where every time a new user joins, the whole network becomes more valuable. This is typical of many online business models, where it costs little to add a user to the network, but they can add great value. Take Airbnb – the more people who list properties on its site, the more customers it will attract. This in turn means it will attract more properties, and so on, all of which increases revenues.

However, network effects aren’t just for big digital companies. If you have a community of users, an online forum, hold events or have any network where people contribute in some form, you could benefit as it scales. The key here is that for every new addition to the network, it improves things for everyone else.

External economies of scale

So far we’ve discussed ‘internal’ economies of scale, ie related to a firm’s internal operations. However, you can also benefit from external economies of scale, where the growth of an entire industry leads to benefits for businesses in that industry. For example, the growth in popularity of artisan coffee shops has resulted in better coffee suppliers competing for business, which could benefit a small business owner who is opening a coffee shop.

Furthermore, you can also use outsourcing to tap into the economies of scale of supplier companies. It might be cheaper to outsource payroll and invoicing rather than employing someone. The payroll company will be able to offer a cheaper service due to their economies of scale.

Achieve economies of scale with finance

Finance can be key for helping small businesses to achieve economies of scale. It allows access to what large businesses have in abundance: capital. And unlike equity funding, where investors give you cash in exchange for a share in the business, you won’t have to give away ownership to get there.

With a capital injection, you could hire specialised staff, purchase machinery or software to help increase efficiency, expand to new locations, or buy your stock in bulk. Economies of scale can lead to other gains too. The larger and more profitable you become, the easier you may find it to access more capital cheaply. This could help you grow faster and realise your business ambitions.

Who can’t benefit from economies of scale?

Economies of scale are not an inevitability. Some businesses models don’t lend themselves to economies of scale, such as those relying mainly on specialised labour. A carpenter that hand crafts ornaments may find it difficult to scale their business, because the business cost (materials plus labour) increases in direct proportion to the number of products sold.

There’s also a limit to economies of scale. Over a certain size, businesses might experience diseconomies of scale, where they become less profitable as they grow, not more. This might be due to factors like slow communication between departments or regions, lower motivation of workers in large companies, or difficulty in adapting to new circumstances.

Could your business benefit from economies of scale? If so, a cash injection could help you grow. Check if you qualify for a business loan or line of credit at fundingcircle.com.