Economies of Scale

What Does Economies of Scale Mean?

Economies of scale occur when operational efficiencies are in place that make the business more productive, consequently driving down the cost of every unit. At its most basic level, economies of scale occur due to specialization and the division of labor. This means more can be produced if employees specialize in specific tasks.

Economies of scale can be generated internally, for example, when additions to a manufacturing plant are put in place and a second shift added, thereby increasing manufacturing productivity and unit costs. Economies of scale can also be generated externally such as when there is a new communication system through the Internet for an entire industry. This would allow every company within that industry to realize lower unit costs through the use of such system.

Divestopedia Explains Economies of Scale

Economies of scale, in the context of the purchase and sale of a business, can be a driver of value creation for private equity groups engaged in a "buy and build" strategy. In this strategy, private equity will acquire a sizable company to utilize as a platform for other tuck-in acquisitions. The idea is that by increasing the size of the overall entity and offering similar services/products, significant economies of scale can be realized since the procurement of inputs can be integrated, fixed overheads can be better utilized, and the existing infrastructure can serve the larger organization without having to add significant costs. In turn, this reduces unit costs and significantly improves margins and free cash flow, two key drivers of value creation.