How Investors Use Economies of Scale to Evaluate Companies
February 8, 2025
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Investors can evaluate economies of scale to determine if a company can increase profitability and stay competitive as it grows. This happens when a company reduces production costs by producing more units, which can spread fixed costs or enhance operational efficiencies. Understanding how companies scale operations helps investors assess their growth potential and competitive position. Companies using economies of scale often have better prospects for outperforming competitors.
A financial advisor can also help you leverage economies of scale by identifying companies that gain cost benefits through increased production.
Economies of scale is an economics principle that shows how businesses can reduce costs by increasing production.
Here’s how it works: When a company produces more, it spreads fixed costs like rent and salaries over more units, thereby lowering the cost per unit. This reduction allows the company to either become more competitive or increase profits without raising prices.
Economies of scale also help established companies prevent new competitors from entering the market. Companies with lower costs can set prices that are difficult for new entrants to match, protecting their market share and maintaining their dominance over the industry.
Economies of scale can be broadly divided into internal and external categories.
Internal economies of scale arise from efficiencies within a company, such as better resource allocation or technology improvements. External economies of scale, by comparison, result from factors outside the company, like industry collaboration or regional advantages.
Both types help reduce costs but operate through distinct mechanisms and scales of impact. Here are some key distinctions for both.
Internal economies of scale occur within a company as it grows and optimizes its operations. These cost advantages are often tied to strategic decisions and investments that improve efficiency. Key types of internal economies of scale include:
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Purchasing economies: Discounts and better terms achieved through bulk buying of materials or supplies.
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Managerial economies: Enhanced efficiency through the hiring of specialized managers and division of labor.
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Technical economies: Cost reductions from investing in advanced machinery or technology that increases productivity. Patents can also provide technical economies.
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Financial economies: Access to lower borrowing costs or better financing options due to a company’s size and creditworthiness.
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Marketing economies: Spread of advertising and promotional costs over a larger volume of output.
External economies of scale arise from factors outside the company that benefit entire industries or geographic areas. These may include improved supplier networks, shared infrastructure or workforce development initiatives.
For example, companies located in industrial clusters often benefit from reduced transportation costs and access to skilled labor pools. Unlike internal economies, external economies depend on collective advancements and collaboration within an ecosystem, helping businesses lower costs and grow sustainably.
Companies that effectively utilize economies of scale typically demonstrate declining marginal production costs as they expand, resulting in stronger margins and improved competitiveness. As a result, investors can use economies of scale as an indicator of a company’s potential for sustainable growth and profitability.
To evaluate economies of scale, investors can analyze financial metrics such as gross margin, operating margin and cost of goods sold (COGS) as a percentage of revenue. A company with strong economies of scale typically exhibits improving margins over time, signaling efficient cost management. Additionally, comparing these metrics with industry peers can reveal how well the company leverages its size.
Qualitative factors also play an important role. Investors should assess whether the company has advantages like advanced technology, a skilled workforce or strong supplier relationships that support cost efficiencies.
Growth does not always promote efficiency. While economies of scale lead to cost savings as production increases, diseconomies of scale can also occur when a company’s growth results in higher per-unit costs.
Diseconomies of scale often emerge when inefficiencies arise due to overly complex operations, mismanagement or communication breakdowns within large organizations. For example, as a company expands, it may face challenges like slower decision-making, redundant processes or logistical inefficiencies.
Common causes of diseconomies of scale include poor coordination across departments, increased bureaucracy and difficulties maintaining quality control. These issues can erode profitability and diminish the advantages of growth.
Examples of economies of scale can be found across various industries. In manufacturing, a car company like Tesla achieves purchasing economies by sourcing raw materials like steel and lithium in bulk, reducing input costs. Similarly, technological advancements in its assembly lines exemplify technical economies of scale, boosting efficiency and lowering per-unit costs.
Retail giants like Walmart demonstrate economies of scale through their massive distribution networks. By purchasing goods at significant discounts from suppliers and spreading logistics costs across thousands of stores, Walmart can offer competitive pricing to customers. This is an example of both purchasing and marketing economies of scale.
Another example can be seen in cloud computing, where providers like Amazon Web Services (AWS) benefit from external economies of scale. As the industry grows, shared infrastructure and regional investments reduce operational costs for all players. These examples highlight how economies of scale enable businesses to lower costs, increase competitiveness and enhance profitability in diverse markets.
Economies of scale can show how businesses become more cost-efficient as they grow. By lowering costs per unit through better production methods, bulk buying and working with other companies, businesses can increase their profitability and competitiveness. However, if growth is not managed well, it can result in diseconomies of scale, where inefficiencies cancel out any cost savings. Understanding this balance is important for investors to assess a company’s ability to scale and its long-term potential in competitive markets.
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