Business Size and Economies of Scale

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

When the business size becomes larger, it provides several benefits. Higher profits are among them. Big businesses can generate more revenue. In addition, they can also reduce costs through higher economies of scale. As a result, they can book 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.

Economies of scale, diseconomies of scale, and economies of scope

Increasing economies of scale contribute to lowering operating costs. It’s what 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.

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. In addition, 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 occurring due to factors outside the organization and impacting many companies. For example, when the government grants a tax break, it doesn’t just apply to one company but 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

Diseconomies of scale refers to the increase in long-run average costs when firms increase output. It occurs 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 firms 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.

Firms share resources for different activities and outputs, such as production machinery, distribution systems, and skilled labor. Thus, it optimizes their usage, minimizes idle resources, and reduces costs.

Why business size matters

Business size is about how big the company’s operations are. We can measure it from several variables, such as total production or revenue.

Business size is important because it reflects the dollars earned by the company. I mean, big 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.

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 big 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 it is safer. Their stock prices are relatively more stable than 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. Big business orders large quantities. Therefore, suppliers like it and usually provide discounts or waivers to secure long-term contracts.

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. It represents a resource owned by the business, measured in dollars, and expected to generate future economic benefits. We can see it 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

We can find the total revenue in the financial statements, to be precise, in the income statement. It is located on the top line.

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. Big 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. It is about how many products the company sells. Unlike total revenue, it does not factor in price. It is, therefore, unaffected by differences in pricing strategies by each company.

Market capitalization. This measure 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 get a fair price for their shares easily.

Small business vs. Big 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. In addition, their operations also rely more heavily on labor than capital.

Big businesses have large operating sizes and high economies of scale. And some may target the national market. 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 big business

Going big offers several advantages, including:

• Higher economies of scale, lower costs
• Easier to raise finances because it’s more attractive to investors
• High market power to face competition
• More structured organization through specialization and delegation
• Easier to attract external professionals and talent

However, the big business also has downsides, including:

• Bureaucratic and slow decision making
• Rigid and formal corporate culture
• Less personalized service
• Inflexibility in responding to changes in the business environment
• More limited opportunities for growth

Advantages and disadvantages of small business 

Small business advantages include the following:

• Relatively easy to manage due to small-scale operation
• Create jobs because it is more labor intensive
• Opportunity to grow bigger
• Having more flexible organizations in responding to change
• Higher focus on the targeted market
• Personalized service
• Faster decision making

Small business disadvantages include:

• Low economies of scale and, therefore, the cost per unit is high
• Low capital to support the expansion
• Difficulties in recruiting skilled and professional employees
• Heavy workload due to low specialization
• Insufficient competitive capacity
• High business failure due to low consumer acceptance and heightened competitive pressure
• Difficulty in obtaining cheap financing

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 big business reduces their flexibility in living a private life.

What to read next

1. The Role of Business and Business Functions
2. Sectors Where The Business Operates
3. Starting a Business: Entrepreneurs and Their Roles
4. Organization and Business Ownership
5. Types of Business Organizations
6. Business Objectives
7. Business and Its Stakeholders
8. Business Environment and Its Factors
9. Competitive Strategy
10. Business Size and Economies of Scale
11. Business Growth and Integration
12. Globalization and International Business