Economies of scale

A larger business is often able to do things more cheaply than a smaller one, other things being equal. Anything that helps save costs if the scale of operations increases is an economy of scale.

There are many sources of economies of scale, which ones are important depend on the industry (and company) in question. Common economies of scale include:

  • spreading administrative overheads over a bigger operation
  • purchasing power to get better deals from suppliers
  • lower costs in manufacturing - e.g., if a bigger factory has lower costs per unit produced
  • better logistics leading to lower distribution costs
  • cross selling

Economies of scale are often the claimed justification for mergers and acquisitions but it is very difficult for investors to assess the potential savings and the actual savings often disappoint.

In some cases economies of scale may be offset by diseconomies of scale that exist in the same business. Economies of scale are usually more significant.

It is important to remember that economies of scale do not necessarily happen because a business is bigger. For example, combining two completely unrelated businesses is likely to lead to higher costs (by adding an extra layer of management) and worse management (by reducing focus on each business and adding bureaucracy). This is why conglomerates usually trade at a discount to their sum of parts valuation.

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