Scaling Up: Understanding Business Size, Economies of Scale, and Their Impact

Companies expand to make more profit. They pursue internal growth or external growth strategies to scale their operations.

When a business grows in size, it provides several benefits, including higher profits. Large businesses can generate more revenue and reduce costs through higher economies of scale, resulting in higher revenues at lower costs.

In addition, the business size also matters in the competition. Large businesses have a stronger market position than small businesses because they have more resources. Conversely, small businesses must struggle to survive when more established companies adopt more aggressive competitive strategies.

Why business size matters

Business size refers to the size of the company’s operations. We can measure it using several variables, such as total production or revenue.

Business size is important because it reflects the dollars earned by the company. I mean, a large business can make a lot of money because it can sell more output.

In addition, business size also affects the company’s capacity to compete in the market. Large companies have a greater competitive capacity to face competitors than small companies.

Also, ownership structure (public vs. private) influences competitiveness. Public companies with access to capital markets can invest heavily in R&D, marketing, and acquisitions, fueling innovation and market expansion. Private companies, though lacking easy access to capital, benefit from flexibility and agility, allowing them to adapt quickly and potentially disrupt larger players.

Stakeholders also consider business size in their economic decisions. Here are examples:

Government. On the one hand, governments may assist small businesses because they create jobs and absorb low-skilled labor, which large companies are unwilling to do. For example, they provide subsidies or tax breaks.

On the other hand, the government provides bailouts to large financial companies rather than small-scale financial companies because they have an enormous impact on the economy. Their failure causes systemic risk and far-reaching implications.

Stock investors. Some investors prefer to invest in large companies because they are safer, and their stock prices are relatively more stable than those of smaller companies.

Creditors. They prefer to deal with large companies because they have a more stable cash flow. In addition, large companies also apply for large loans, allowing them to make more money from the interest rate.

Customer. Customers may prefer to deal with large companies because they have a strong reputation. Large companies are also interested in maintaining their image by improving quality and providing superior service.

Supplier. Large businesses order large quantities, so suppliers like this usually offer discounts or waivers to secure long-term contracts.

Economies of scale

Economies of scale are when the long-run average cost decreases as the volume produced increases. Several reasons explain why the cost reduction occurred.

Economies of scale fall into five different types, and they explain how cost reduction occurs. They are:

1. Technical economies of scale. Larger companies can use more efficient production techniques and higher specialization, such as automation. They can also spread expensive fixed costs over more output.
2. Managerial economies of scale. When operations are more significant, companies can hire specialist staff to oversee production, aided by more sophisticated equipment. Thus, it cuts managerial costs per unit because staff can work on more tasks. They also spread administrative expenses related to business functions such as finance and human resources over more outputs.
3. Financial economies of scale. Large companies are considered more established and less risky than small companies. Thus, they find it easier to raise capital, such as by borrowing from a bank or issuing bonds, at a lower cost.
4. Marketing economies of scale. Large companies spread marketing costs over more output, lowering marketing costs per unit. For example, a company incurs one-time advertising costs for its output. If it produces more output, its advertising costs per unit will also fall.
5. Purchasing economies of scale. Large businesses have high bargaining power over suppliers. They can ask for discounts or other waivers for buying inputs in large quantities. On the other hand, suppliers are also interested in securing long-term orders. Thus, they are willing to give such a discount.

Internal economies of scale vs. external economies of scale

Economies of scale are also divided into two:

• Internal economies of scale
• External economies of scale

The examples above are internal economies of scale. Cost reduction occurs only in a single company. And management has control over these cost reductions.

Meanwhile, external economies of scale are cost reductions caused by factors outside the organization and impacting many companies. For example, when the government grants a tax break, it applies to many companies.

Another example is agglomeration. When businesses in different industries are located in a particular area, they mutually benefit from each other and can share resources and opportunities. As a result, these companies get external benefits to lower costs.

Diseconomies of scale

Increasing economies of scale contribute to lowering operating costs, which motivates businesses to get bigger. However, at some point, when they have achieved a minimum efficient scale, a further increase in output results in an increase in average cost. This is what is called diseconomies of scale.

Diseconomies of scale refer to the increase in long-run average costs when companies increase output. They occur when production has passed the minimum efficient scale.

The minimum efficient scale is on which the long-run average cost is the lowest. Thus, an increase in output further increases the cost per unit.

Diseconomies of scale can also be:

• Internal diseconomies of scale
• External diseconomies of scale

Internal diseconomies of scale occur due to internal factors and apply only to a single company, not other companies. Bureaucracy and management complexity are among the causes.

Other causes include:

• Increased storage costs due to bulk purchases
• Slow decision-making due to a long chain of command
• Inflexible organization due to large size

External diseconomies of scale occur due to factors outside the organization and impact many companies. The reason could be due to the following:

• Tax increase. An increase in the corporate profits tax exposes all companies in the economy.
• Resource constraints. Resources deplete as they are used by many companies, making them scarcer and more expensive.
• Logistics bottlenecks and disruptions. Agglomeration causes trouble due to too high density and, ultimately, increased costs.

Economies of scope

Economies of scope are cost savings when a company produces two or more products using the same resources. The company shares resources for different activities and outputs, such as production machinery, distribution systems, and skilled labor. Thus, they optimize their usage, minimize idle resources, and reduce costs.

Measuring business size

Classifying a business as small, medium and large can use several variables such as:

• Number of employees
• Total assets
• Total revenue
• Invested capital
• Production volume
• Sales volume
• Market capitalization

The number of employees. Small businesses employ fewer workers than large businesses because they operate on a small scale. The number of employees with which a business is categorized as small and large varies between countries.

For example, the OECD categorizes businesses into four based on their number of employees.

• Micro-sized business: less than 10 employees
• Small business: 10-49 employees
• Medium business: 50-249 employees
• Large business: more than 250 employees

Total assets represent a resource owned by the business, measured in dollars, and expected to generate future economic benefits. They are shown on the balance sheet in the financial statements.

Total revenue. It is the dollars the company earns after adjusting for a deduction factor. Its value depends on two factors:

• Price charged
• Sales volume

The total revenue is located on the top line of the income statement, which is the financial statement’s most important section.

Invested capital. Classifying business size can also be based on how much capital the business has. Capital comes from equity capital and debt capital. Equity capital comes from shareholders. Meanwhile, debt capital comes from creditors.

Production volume. Company size is based on how much output the company produces. Large businesses have large outputs with more sophisticated production techniques, machines, and equipment.

In contrast, small businesses often rely on labor rather than high-tech machines. Thus, their production volume is relatively small.

Sales volume is about how many products the company sells. Unlike total revenue, it does not factor in price, so it is unaffected by each company’s different pricing strategies.

Market capitalization is based on the total value of shares issued by the company. We calculate it by multiplying the current share price by the number of shares outstanding.

• Market capitalization = Current share price x Number of outstanding shares

Unlike the variables above, classifying businesses by market capitalization is only available for public companies. Their shares are traded on the stock exchange, so we can easily get a fair price for them.

Small business vs. Large business

Small businesses have small operating sizes. As mentioned earlier, definitions vary between countries. For example, some definitions say they have less than 50 employees.

Small businesses are usually privately owned by individuals or small groups. They usually only rely on one production facility and target the local market. Their operations also rely more heavily on labor than capital.

Large businesses have large operating sizes and high economies of scale. Some may target the national market, while others target the international market in addition to serving the domestic market.

Large businesses may have several factories. They usually rely on significant capital and sophisticated technology and production techniques. They also have more access to financial capital, and it is easy to attract specialists or professionals.

Advantages and disadvantages of large business

Large businesses enjoy several advantages:

• Economies of scale: Lower costs due to bulk purchasing and efficient operations.
• Financial strength: Easier to attract investors and secure financing.
• Market power: Greater influence in the market to negotiate with suppliers and competitors.
• Structured organization: Clear hierarchy, specialization, and delegation of tasks.
• Talent acquisition: Ability to attract high-caliber talent and professionals.

However, large size also comes with drawbacks:

• Bureaucracy: Slow decision-making due to complex hierarchies and procedures.
• Corporate culture: Rigid and formal culture that can stifle innovation.
• Customer service: Difficulty offering personalized service at scale.
• Adaptability: Less flexibility to adapt quickly to changing market conditions.
• Growth challenges: Limited opportunities for significant internal growth within established markets.

Advantages and disadvantages of small business

Starting a small business can be an exciting endeavor. Here’s a breakdown of the key advantages and disadvantages to consider:

Pros:

• Manageability: Smaller size allows for easier day-to-day management and quicker decision-making.
• Job creation: Small businesses are a significant source of job creation, often relying more on manpower.
• Growth potential: Smaller businesses have the opportunity to establish themselves and expand into larger markets.
• Flexibility: Their less rigid structure allows them to adapt and respond more readily to changes in the market.
• Market focus: Small businesses can cater to niche markets and develop a more personalized connection with their customers.
• Personalized service: The ability to provide a higher level of personalized attention to each customer.

Cons:

• Limited economies of scale: Smaller businesses may struggle to achieve cost savings through bulk purchasing, leading to higher production costs per unit.
• Financial constraints: Limited access to capital can hinder expansion plans or investment in resources.
• Talent acquisition: Attracting highly skilled professionals can be challenging for smaller businesses.
• Workload: Owners and employees can face a heavy workload by wearing multiple hats and managing a wider range of tasks.
• Competitive challenges: Limited resources can make it difficult to compete effectively against larger businesses.
• Higher failure rate: New businesses face a higher risk of failure due to various factors, such as market saturation or lack of funding.
• Financing difficulties: Securing financing for growth or operational needs can be more challenging for smaller businesses.

Reasons some businesses stay small

Some businesses stay small and find it challenging to increase their size. Several reasons explain this. First, small businesses often serve niche markets, which are small in size. As a result, opportunities to expand operations are low because they are limited by market size.

Second, small businesses typically provide personalized services like those offered by hairdressers and plumbers. They target the local market and have close contact with customers.

Personalized service makes it difficult for small businesses to scale economies and produce large numbers. If they grew too big, they would find providing that kind of service challenging.

Third, another reason is the owner’s goal. Some owners prefer to keep their businesses small and make only a satisfactory profit. They may want to escape the stress and worry of running a large company, or they feel a large business reduces their flexibility in living a private life.