Economies of Scale

One of the reasons organizations look to expand is to experience economies of scale. This simply means taking advantage of the cost advantages due to expansion.

While utilizing economies of scale can be the difference between two somewhat successful organizations (or even two somewhat unsuccessful organizations) and one, larger very successful organization, it’s important to understand, it doesn’t work in all industries or for all organizations.

An example of two businesses that might benefit by economies of scale would be two grocery chains. If they combine into one organization, they can most likely take advantage of better purchasing power (companies that purchase larger quantities can frequently negotiate better prices), combined HR, IT, Finance departments etc. To use somewhat random numbers, if each chain has HR departments of 10 people, most likely, when they combine, they can get by with only needing 15 people all together so that would be a savings of 5 salaries plus all other expenses associated with those 5 people (computers, office space, benefits, training). Through economies of scale, they would be able to reduce costs, increase efficiencies and increase profitability (in theory).

On the other hand, if these two grocery chains come together and continue to operate as completely separate businesses, they lose the economy of scale and most likely will increase expenses because while they are running as separate businesses, there would still be a few people overseeing both and that would result in greater costs.

General Motors, for years, operated each of their divisions (Buick, Cadillac, Pontiac etc) as completely separate entities and as such didn’t get to benefit from the economies of scale.

A school can benefit from economies of scale by expanding their current offerings. For example, a business school could expand and start to offer international business, entrepreneurial training etc. Costs would increase but, if done properly, they could still benefit from economies of scale by utilizing the same back end staff. On the other hand, if, instead of expanding their businesses school they decide to add a new medical school, while it might be successful, it most likely will not be utilizing their economies of scale.

When looking to expand, try to do it in a way that doesn’t force you to duplicate work (or workers) and see if you can find ways to make things more efficient rather than bigger for the sake of being bigger.

Have a great day!

Lawrence

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