Economies of Scale

We briefly talked about Economies of Scale when we discussed Barriers to Entry, but I thought I’d delve into it a bit more since it relates to so many things in business.

Economies of Scale basically means buying in bulk is always cheaper. It’s how Wal-mart, Sam’s Club, and Costco stay in business. It’s why we buy the package of toilet paper that has 36 rolls, or anything that is buy one get one free. The more we buy at one time, the less it costs us for each thing. It’s your grandmother’s adage of “everything is cheaper by the dozen”.

For example, Wal-Mart can buy truckloads of toothpaste from Colgate, while a mom and pop may only be able —or need— to buy a case of toothpaste. I can pretty much guarantee you that Colgate is going to give someone buying a truckload of toothpaste a way better deal than someone who only needs a case. Thus, economies of scale can prevent a mom and pop from even thinking about starting a little store because they’re going to have to sell their toothpaste for a $2.59 (for example, guessing here), while Wal-Mart can sell the same thing for $1.19. And thus, economies of scale become barriers to entry.

How does this relate to your small business? Well, my darlings, it’s all about Cost of Sales/Cost of Goods Sold. An increase in sales means that your cost of sales/cost of goods sold is going to to also increase (remember direct costs). However, with Economies of Scale, your costs of sales actually DECREASES as your sales INCREASE, ultimately leaving more dollars in the Net Income bucket at the end of the day.

Let’s go back to our gift basket company. Mary owns a gift basket company and when she first starts out she can’t quite afford the baskets she really wants because the cost of the really cool basket increases her Cost of Goods Sold to the point that she’s not making enough money on each sale to give her enough profit. So, for the first year she uses a basket that is “good enough”, until she can afford better.

Fast forward a year and Mary’s sales are now triple what they were when she first opened the company. Now, she can buy the baskets she really wanted to begin with because she can buy enough of them at a time to get the same price per basket as she had to pay for the baskets that were just “good enough”. In the business world we would say that her “cost per unit” decreased.

Let’s say you sell muffins and for every four dozen muffins you make you need a dozen eggs. A dozen eggs costs you $3.99. But, if you can make eight dozen muffins, then you can buy the bulk package of 2 dozen eggs at $1.99. Thus, cutting your costs in half and decreasing your gross margin substantially. And as we know, if you decrease your gross margin you INCREASE your profit margin!

And THAT is the ultimate benefit of Economies of Scale: Increased Profits. As your sales increase what you have to pay to make those sales decreases because you can buy in bulk, putting more pennies in your pocket at the end of the day. Who doesn’t like that? ☺

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