The False Promise of Scale Economies

This post, written by Tim Laseter, originally appeared on Public Spend Forum

Acquisition professionals often struggle with the tradeoffs of “scale economies” versus “socio-economic goals.” The assumption derives from a false premise that bigger companies and bigger contracts inherently yield lower cost. But, that assumption fails to understand the true source of scale advantages and the inevitable pitfalls of scale’s worst enemy, utilization.

The theory positing the concept of economy of scale dates back over 100 years to a triplet of British economists who built upon Adam Smith’s breakthrough observation, the division of labor. These economists asserted that bigger companies could divide their labor tasks into smaller units, thereby garnering higher productivity, and accordingly cost advantages over smaller companies. Over time, the focus on labor was replaced with a focus on capital equipment and automation. Again, large companies with greater activity volume could afford to build larger, more specialized equipment and facilities, while a smaller company was stuck with manual processes.

Empirical evidence supports the concept of the scale curve. In fact, economists found the data fit an exponential curve—that classically sloping curve that starts steep but gets flatter the further out it goes. Using the curve, they could precisely predict a constant rate of cost reduction for every doubling of capacity. For example, a plant twice the size of a competitor might produce units at 20% less based upon an 80% slope. And, if the next company built a plant yet-again twice as large, the costs would drop another 20% following the same slope. The math simply worked and everyone pursued economies of scale.

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