Economies of Scale – How Has This Approach Changed Over Recent Years?

Back in 2011, I wrote about "Procurement myths: economies of scale and 'bigger is better':" in two parts. Let's take a look at what I said then, and see how that reflects today. 

“This basic belief in economy of scale underpins so much of what goes on in procurement; collaborative initiatives in the public sector, centralisation in large corporates, attempts to standardise specifications.  Yet procurement and organisations generally often don't think very hard about how the concept applies to different markets or suppliers.

'Economies of scale' refers to reductions in unit cost as an organisation's scale of output increases.  And of course, a larger volume on offer will in most cases have some economy of scale benefit.  For a start, the sales cost per unit usually decreases; although it may not if a large contract has a very expensive bidding process attached (as is often the case in the public sector!).

Now that benefit to the supplier can come from a number of sources.  It may be a manufacturing economy or procurement economies in terms of buying raw materials for instance; producing thousands of identical cars, or laptops, has obvious scale efficiencies.  So the ultimate customer can exploit that to get better pricing.  But even those economies may depend on how similar the product is, hence why a generic discount from an auto manufacturer to a large fleet buyer, applicable to anything they buy, will fall well short of what they will offer for a firm order for 1000 identical vehicles.

It may be economies in the sales process; the 'manufacturing' cost of software licenses is basically zero, but you can get a great deal for volume purchases because you save the supplier a lot in terms of their marketing and sales effort, which is a major part of their cost base.  It could be economies in financial terms; a large firm can get access to funds at a favourable rate to finance investment, which enables them again to pass on some of that benefit to the purchaser.

But procurement often makes the mistake of thinking that economies of scale apply everywhere, and in the same sort of manner.  If I can get a 50% discount for volume from the software firm, why can't I get that from the facilities management provider if I offer them a big enough deal? The simple answer is that the direct costs of the FM provider, particularly people, are relatively fixed per unit of output.  The cleaning services provider might buy cleaning fluid slightly better as their volume goes up, but 60% of their price to you is direct labour, probably people working at minimum wage.  Their scope to make economies of scale is limited, as therefore is their ability to offer you a better deal in return for volume”.

Coming back to today, this is relevant to the growth of the large outsourcing firms  in recent years, including Carillion of course. Buyers – not just in the public sector - have tended to go for larger and larger contracts, and have indirectly supported the growth of certain firms.  Yet as we said above, there is little evidence that there are real economies of scale in many of the service activities in particular that we have outsourced to these giant firms.

But there are economies on the procurement side. It is easier to let one single huge national facilities contract than go to all the trouble of splitting the work into separate “lots”, running multiple competitive processes, negotiating many sperate contracts … and of course then managing the range of different contracts and suppliers. There is a genuine cost in that approach for the buying organisation.

However, while it might make some sense at the individual organisational level to aggregate, the long-term result is that we end up with a market that is not dynamic or truly competitive, and huge firms (like Carillion) that cause huge problems if they do fail.

Whilst we have seen this particularly in the public sector, it applies everywhere. The automotive industry rationalised its supply base to a large extent over the past 30 years too. But that has created virtual monopolies or oligopolies and we now see first-tier suppliers to the industry who are more consistently profitable than the brand name car makers!

What is the answer? Well, part of this is simply the need to think long-term, but if the pressure is on procurement resource levels and there is a need to make apparent savings quickly, the temptation is to go for the easy, aggregated, contract option. The fact it often doesn’t deliver genuine savings anyway, as economies of scale are so misunderstood, and leads to these perverse long-term outcomes, is often ignored.

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  1. Daniel Bromley:

    Similiar theme – have often thought that the push to ‘Cloud’ as the panacea against “the Oligopoly” may be viewed as a mistake in the longer term.

    Trading one form of lock-in for another. Fast forward and will we be complaining about the Amazon Web Services monopoly, or the MS Azure monopoly?

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