As your business output increases, so do your cost advantages, which is the basis for the term economy of scale. To put it another way, when you produce more units of a product with fewer input costs, you achieve economy of scale. If your small business reaches economy of scale, it indicates you’re running efficiently.
When your business makes a product, it involves both fixed and variable costs. As more units of the product are produced, the fixed cost becomes an increasingly lower portion of the total cost. Also, operational efficiencies and synergies sometimes drive down variable costs as more units are produced, lowering costs even more.
Let’s say you own a business that produces books. You can print 1,000 books for $10,000, which means the per-unit cost is $10. Based on your business’s cost structure for each printing run, perhaps you can print 2,000 copies for only $16,000, driving unit prices down to $8. Further, if you print 3,000 copies, the total cost is only $18,000, or $6 per book. The lower per-unit price is an example of economy of scale. At the end of the day, if your business cannot lower the per-book price below $10, regardless of how many units you print, it is not experiencing economy of scale.
The economy of scale can be both internal or external. In situations when a company reduces costs and increases production, this is considered internal economy of scale. On the other hand, external economy of scale occurs at the industry level. Any factors that affect the efficiency of a particular industry, such as an infrastructure improvement, also increase the economies of scale for all businesses in the same industry.
As production increases, your business should naturally experience economy of scale. If it doesn’t, this could indicate that something is wrong with your business’s cost structure and that it’s time to sit down and investigate the root of the problem.