We're obsessed with growth.
If you talk to any entrepreneur about their goals over the next 5 years, you'll hear visions of massive growth, more hiring, and the development of better products and services to solve their customer's problems.
The dream of a lot of entrepreneurs is to achieve scale through fast growth.
Scaling a business involves creating a substantial increase in revenue without a significant increase in resources. It's hypergrowth, which is difficult to achieve and equally challenging to manage.
How do you know how much growth you need? How big is "big enough" for your business? Is growth like this even worth it?
Companies that grow big enough can achieve things that smaller businesses can't.
Businesses are at their most profitable and most productive when they grow into an inflection point that allows them to provide a product or service at a lower cost without a significant increase in resources.
That's an Economy of Scale: a competitive advantage that can be leveraged by almost any business to set a target for their growth goals.
Welcome back to The Profit Plot, a podcast where we help small business owners unlock the story behind their profitable business by unpacking one complex financial topic at a time. I am your host, Jeremy Millar.
"Economy of scale" is a buzzword, or rather, phrase, that gets thrown around quite a bit in the offices of startups and small businesses. But what does it mean? And more importantly, how can you harness this concept to grow your small business? That's what we're unpacking today.
At its core, an economy of scale refers to the cost advantage a company gains as it increases its production level.
It's the idea that the more you produce, the less each unit costs. Think bigger quantities, smaller price tags.
Let's say you're manufacturing apparel. As a new small business owner, you only have the funds to manufacture 1,000 units at a time. Let's say that each of these units costs $50 to manufacture, ship, and sell.
The exciting thing about manufacturing a physical product is that, with larger order quantities, it becomes increasingly cheaper to manufacture each unit.
For example, an order of 10,000 units might cost your business $25 per unit to manufacture. Ordering at $50 a piece means spending $50,000, whereas 10,000 units at $25 a piece means you'll be forking out $250,000.
Think about it!
Let's say your item costs $150 for a customer to purchase. We know that, for a 1,000-unit order, you'll make $150,000 in gross revenue, with a $100,000 gross profit. That's $100 per unit in profit.
However, if you sell the same product at $150, a 10,000-unit order means you'll make $1.5 million in gross revenue, with a $1.25 million gross profit. That's $125 per unit in profit.
These numbers are incredibly simplified, but in this example, you can make 25% more on each sale with the ability to purchase more products by simply ordering in larger quantities.
In the same vein, as your business grows and you produce more, you should theoretically be able to decrease the cost per unit of whatever you're making or selling.
Achieving economies of scale isn't just about ramping up production or making massive purchases; it requires strategic planning. Often times it means improving your supply chain, investing in technology that automates processes, and reducing the waste in your business.
Growing smart is better than just growing fast.
The specific way an economy of scale works highly depends on the goods or services produced. For example, manufacturing a physical product like our apparel example is wildly different than a service-based business.
For example, let's say you're running a mortgage brokerage instead of a product-based business. You hire loan officers and pay them a commission based on their ability to close loans for new homeowners. Your profit is a flat fee per loan that your team originates.
It costs money to keep your business running. You've got an office, you've got support staff, and you've got a lot of other expenses to support your team. This business costs you $20,000 per month to keep afloat!
On average, your group of 10 loan officers generates $2,000 per person per month for your business, leaving you right at your break-even figure.
This is a tricky situation because your business is alive, but not making much money. There's not a lot of leverage to scale up your team without increasing your costs, right?
Service businesses like these must create an economy of scale that allows you to supply your service and continue growing without a significant cost increase.
You've got to build your business around systematized processes and leverage technology to create a foundation for continually hiring new loan officers to originate more loans without drastically increasing your overhead costs.
If you can create a process for how new leads are generated, implement technology and training that helps your team close those leads quickly, you can repeat that process over and over. Maybe you can slowly increase the average number of loans each person closes or even raise the money you receive on each deal!
As you make small changes, you create opportunities for more profit, which allow you to slowly expand your team, lowering the costs required to support each loan officer and ultimately creating a higher level of efficiency and profit in your business.
Bulk purchasing, process streamlining, and investing in technology are the three main ways to achieve an economy of scale that allows your business to grow without the burden of massively increased costs.
But scaling is a double-edged sword; wield it wisely.
It's important to be cautious. Increasing production levels or rapidly scaling your business can have major pitfalls if not done correctly. You'll have to manage increased complexity, ensure quality doesn't dip, and keep an eye out for diseconomies of scale, where costs per unit start to increase.
That's right, a diseconomy of scale.
When a business surpasses the inflection point at which its returns are highest, unit margins become worse. The larger an organization grows, it has the potential to become less flexible and ultimately less efficient.
And there we have it, folks—a deep dive into the transformative power and the potential pitfalls of economies of scale. Whether you're selling a physical product or running a service-based business, remember that scaling isn't just about growing bigger; it's about growing smarter.
It's about turning each dollar you invest into multiple dollars of value. Not understanding your scaling strategy could end up costing you.
So, what's your next move? What changes can you implement right now to start scaling your business efficiently? We want to hear from you.
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Join us again soon as we venture to unlock the financial story behind your profitable business. Looking forward to having you here with us next time, on The Profit Plot.