Translating an inspired idea into a robust business plan
008 Economies of Scale
Economies of scale is an important consideration in business design. For a new business with uncertain demand or uncertainty with regards to the growth in revenue, it is better to have a higher proportion of variable costs, i.e. costs increase in line with revenue. The higher the proportion of fixed costs, the higher the risk. This notion is also at the heart of the concept of break even volumes calculations. A lower break even volume (the volume of sales at which gross profit is equal to fixed costs i.e. the volume of sales at which the business makes neither a profit or loss) the lower the risk associated with not meeting budgeted sales. On the other hand, once a business reaches sufficient scale, i.e. a comfortable level of operating profit (EBITDA), it would be advantageous to replace variable costs with fixed costs. In this way the business captures more of the upside.
The notion of scalability is different. A business which is scalable can operate profitably at different levels of scale i.e. different levels of turnover. This implies that most of its costs are variable costs i.e. it does not normally experience economies of scale.
Business A has high level of fixed costs relative to variable costs and experiences a disproportionate change in profits for a given change in revenue compared to Business B which has a lower level of fixed cost relative to variable costs. Business A experiences excellent economies of scale, whereas B does not.
In the example shown, for business A fixed costs (6,000) amount to 75% of total costs (2,000 + 6,000). For business B fixed costs (2,000) account for only 25% of total costs. Revenue for both business A and B increases by 20%. As a result the operating profit for A increases by 80% whereas it only increases by 40% for B. This is the effect of economies of scale. As business A grows in scale, it is becoming rapidly more profitable.
For example, operating a shop with a fixed rent and staff costs becomes very profitable as sales increase. Of course the effect works in reverse if sales decline.