Introduction

This article is a part of our moat-series that provides readers with a broad understanding of distinct competitive advantages that encompasses each moat. The first article provided an introduction to economic moats as well as information about several types of moats, while the second and third articles discussed network effects and switching cost moats, respectively. Economies of scale will be examined as a potential source of long-term competitive advantage in this fourth article.

When a company increases its sales, it is more likely to witness lower costs per customer, a byproduct of economies of scale. The fixed costs, such as those associated with administration, are dispersed among a greater number of units of production. Sometimes, a business that enjoys economies of scale may be able to negotiate a reduction in its variable expenses as well.

Definition of Economies of Scale

Economies of scale refer to the cost-benefit a company experiences when its output level increases. The benefit results from the inverse connection between the unit fixed cost and production volume. The smaller the per-unit fixed costs, the bigger the production quantity. With a rise in output, economies of scale also result in a decline in average variable costs. This is the outcome of operational savings and synergies resulting from an increase in production volume.

Companies that are able to sell their products or provide their services at a low cost, often as a result of economies of scale, have a significant advantage over their competitors since they are able to undercut their competitors’ prices. In a similar vein, businesses that operate with lower expenses can sell their wares at prices that are comparable to those of their rivals while still making higher profits.

Because a prohibitively large amount of capital is often necessary to acquire a scale that is needed to be competitive in a market, this kind of moat presents a high barrier to entry. This moat protects the incumbent from new entrants.

WalMart, which trades under the ticker symbol WMT, is perhaps the most prominent example of a business that reaps the benefits of economies of scale. Because of its scale, the company operates with higher efficiency, which helps Walmart maintain its competitive pricing in the retail industry. For instance, due to the company’s size, WalMart is able to make its own purchases more effectively because it operates over 8,000 major locations across the globe. This provides the corporation with an incredible amount of leverage to bargain with its suppliers.

Not only does it obtain its products at lower costs, but also because of its size, it can distribute them at lower costs. In addition to this, it has access to a vast amount of data regarding the preferences of its customers and is able to implement the strategies that have shown to be most successful throughout its whole retail network.

Working of Economies of scale

In general, economies of scale work in different ways, depending on the goods or services being made. Longer operating hours may be all that’s needed to make expensive machinery more effective. With this, a company can lower the cost per unit by making more units. Economies of scale are good for more than just the company that makes the goods. Prices will go down for consumers. When prices go down, more people buy things, which makes the economy grow.

To explain economies of scale, let’s say that Wal-Mart can purchase a DVD from a supplier for $5 whereas a smaller competitor must pay $6. In addition, it costs Wal-Mart $4 to distribute the DVD and cover the overhead of the stores, while the smaller competitor incurs a cost of $5. Then, Wal-Mart may sell the DVD for $9.50 and still make a profit of $0.50. The smaller competitor cannot charge that low of a price since at $11 per DVD, it would lose money.

Types of Economies of Scale

The two primary forms of economies of scale are Internal economies of scale and external economies of scale. Because they take place within the company itself, internal economies are subject to management oversight and control. External economies depend upon external factors. These considerations may include the sector, the location geographically, or the government.

Internal Economies of Scale: Internal economies derive from increased manufacturing volume. Some of the primary forms of economies of scale are discussed below. 

• Technical Economies of Scale: Technical economies of scale are the outcome of production process efficiencies. When a company doubles its output, manufacturing expenses per unit reduce significantly. Larger businesses can benefit from more efficient equipment.
• Monopsony power: Monopsony power occurs when a corporation purchases a product in such large quantities that it can cut its unit costs. Wal-Mart, for instance, can undercut smaller competitors by leveraging its immense purchasing power.
• Managerial Economies of Scale: There are managerial economies of scale when large companies can pay specialists. They manage key parts of the organisation more successfully. A seasoned sales executive, for instance, has the expertise and knowledge to handle large orders. They require a large payment, but it is justified.
• Financial Economies of Scale: Due to financial economies of scale, the business has more affordable access to financing. With an initial public offering, a large firm can raise capital from the stock market. Large corporations have stronger credit ratings and can thus offer bonds with cheaper interest rates.
• Network economies of scale: Network economies of scale are most prevalent in internet enterprises. Existing digital infrastructure supports each extra online customer at a negligible cost. Therefore, most of the revenue from a new consumer is profit for the company.

External Economies of Scale: External economies of scale exist when a company’s size results in preferential treatment. This occurs most frequently with governments. For instance, a state frequently decreases taxes to entice enterprises that create the greatest jobs. Large real estate developers persuade towns to construct roads to support their structures, saving money on infrastructure costs. Large firms can potentially minimise research costs by collaborating with universities on research projects.

From a single point of view, Internal economies of scale cut costs within the firms themselves, and result from the size of the company, regardless of its industry or market while external economies of scale originate outside the firm. They benefit the entire industry, and no single firm has control over these costs.

Conclusion

When a company increases its production, it is more likely to witness lower costs per customer, known as economies of scale. A business that enjoys economies of scale may be able to negotiate a reduction in its variable expenses as well. As businesses expand their customer base, they should consider economies of scale into their business model and improve their key performance indicators accordingly.