Scale and average unit cost

Economies of scale are cost advantages that arise when a business increases output and its average cost per unit falls. Average cost per unit is the key phrase here. Being large doesn’t automatically make a business efficient. Economies of scale occur only when growth makes each unit cheaper to produce, distribute or sell.

Diseconomies of scale are cost disadvantages that arise when output increases and average cost per unit rises. Students sometimes miss this awkward part: growth can make a firm clumsy. Extra sites and layers of management may increase costs, as can more meetings or greater distance from customers.

Picture this as a curve. Average unit cost initially falls as output rises because fixed costs are spread and the business becomes more efficient. Beyond a certain point, however, further growth may make coordination harder. Average unit cost then begins to rise.

Internal economies of scale

Internal economies of scale are economies of scale created by changes within a business as it grows. They apply to that individual firm, rather than automatically benefiting every business in the industry.

Common internal economies include:

• Purchasing economies, where placing larger orders helps a business negotiate lower prices or better credit terms from suppliers.
• Technical economies, where a larger firm can afford specialist machinery, automation or systems that a smaller firm could not justify.
• Financial economies, where lenders may view a larger, established business as lower risk, so finance becomes easier or cheaper to obtain.
• Marketing economies, where the cost of advertising is spread across greater output or a wider customer base.
• Managerial economies, where specialist managers can be employed instead of one person being expected to handle everything.

These aren’t simply examples of “big business is better”. Each point must explain why average cost per unit falls.

External economies of scale

External economies of scale are economies of scale created by growth or improvement in the industry, region or infrastructure surrounding a business. They don’t result from the growth of one firm alone, and several businesses may benefit at once.

Take a cluster of food manufacturers in one region. It may attract specialist suppliers and trained workers, along with logistics firms. A business within the cluster can become more efficient even if little has changed inside the firm itself. The advantage comes from outside the individual business.

Internal diseconomies of scale

Internal diseconomies of scale are diseconomies of scale caused by problems within a business as it grows larger. Typical causes include communication problems and slower decision-making. Work may also be duplicated, while personal control is lost.

An owner of a small restaurant may spot a customer complaint on the same day. In a national chain, that complaint might pass through store staff and area managers before reaching head office or customer service systems. The extra structure may be necessary, but it can make the process slower and more expensive.

External diseconomies of scale

External diseconomies of scale are diseconomies of scale caused by pressures in the industry or area surrounding a business. Once again, the cause lies outside the individual firm.

When many businesses expand in the same city, skilled labour may become scarce, pushing wages up. Roads can become congested. Rents may increase, while suppliers become overstretched. As the whole market grows more crowded, a firm may therefore face higher average costs.

Internal growth

Internal growth occurs when a business expands by developing its own operations instead of joining with or buying another business. It is also called organic growth.

A business might open more branches, increase production capacity, launch new products, sell to new customer groups or move into new locations using its existing resources and capabilities. This route is usually slower than external growth. However, the business keeps control over its culture, brand and decision-making.

Be careful: internal growth does not mean "using internal finance". A business could use a bank loan to grow internally, and it would still count as internal growth because the expansion comes from its own operations. Don’t confuse the method of growth with the source of finance.

External growth

External growth occurs when a business expands by working with, joining with, buying or being bought by another existing business. It is often faster because the business can acquire customers, assets, employees, technology or market access that another firm already has.

There is a trade-off: risk. External growth often causes integration problems, including different cultures, duplicated jobs, incompatible systems and possible conflict between managers, employees, suppliers or customers. Growth therefore provides a strong example of the IB concept of change. It may create opportunities, but it also disrupts existing relationships.

Comparison of internal growth and external growth in business expansion.

Models such as "internal versus external growth" are useful maps, but they don’t describe every business situation perfectly. Contemporary business management often uses hybrid approaches. For example, a firm may open its own stores while also working through alliances, digital platforms and outsourced partners. These categories simplify reality so that we can analyse it clearly.

Why growth may be attractive

A business may pursue growth as its objectives change. At first, a start-up might focus on survival. Later, its priorities may shift towards higher profit, greater market share, wider brand recognition or international expansion. Growth isn’t simply about becoming bigger; it reflects what the owners and managers want the business to become.

Common reasons for growth include:

• Higher market share, where the business controls a larger proportion of total sales in its market. This may strengthen its competitive position.
• Increased sales revenue, as a larger customer base or wider product range can bring in more income.
• Economies of scale, when higher output reduces average cost per unit.
• Greater brand recognition, since larger businesses are often more visible to customers, suppliers and potential employees.
• Improved survival chances, because selling several products or operating in different locations may reduce dependence on one narrow market.
• Access to new markets, particularly when the current market is saturated or growing slowly.
• Greater bargaining power, as larger firms may be able to negotiate more strongly with suppliers, landlords, lenders and distributors.
• Personal ambition of owners or managers, since some leaders seek status, influence or the challenge of building a larger organisation.

Growth and competitive pressure

Competitive pressure can encourage firms to grow. When rivals expand, a business may worry about being left with weaker supplier terms, less shelf space, poorer technology or a smaller brand presence. Competition can therefore help create business knowledge. Firms watch their rivals, try new methods and learn what works.

At the same time, competition may make firms more secretive. Businesses might protect data, patents, recipes, algorithms or customer information. Competition can both produce knowledge and restrict it. This creates a useful theory of knowledge link: business behaviour rarely produces the clean, universal laws sought in the natural sciences.

Growth, ethics and sustainability

Growth may support sustainability by giving a business the resources to invest in cleaner technology, better employment practices or circular business models. A circular business model is a business model that aims to reduce waste by reusing, repairing, recycling or remanufacturing resources rather than following a simple take-make-dispose pattern.

However, growth isn’t automatically ethical or sustainable. Faster output, longer supply chains and pressure to cut costs may harm workers, communities or the environment. A well-managed business asks two questions: "Can we grow?" and "Should we grow in this way?"

Small can be a deliberate choice

Staying small doesn’t mean a business has failed. For some firms, a smaller size suits their objectives, market and values. A family-owned design studio, local bakery or specialist repair service may simply decide that expansion would bring complications it doesn’t want.

Reasons for staying small include:

• Personal control, since owners may prefer to stay directly involved in decisions, staff relationships and customer service.
• Customer focus, as a small firm can often provide personalised service and respond quickly to individual needs.
• Niche market strength, when a market is too specialised or limited to make large-scale expansion worthwhile.
• Lower risk, since growth may involve borrowing, hiring, new premises, new systems or unfamiliar markets.
• Avoidance of diseconomies of scale, particularly communication problems and reduced flexibility.
• Lifestyle objectives, when owners place more value on independence, manageable working hours or community ties than on profit maximisation.
• Quality protection, as rapid expansion may make consistent standards harder to maintain.

Staying small and competitive advantage

A niche market is a small, specialised part of a larger market that serves customers with specific needs. Small businesses can perform strongly in niches. They often know their customers well and don’t need mass-market sales volumes to survive.

Measurable and non-measurable objectives meet here. A small firm might earn less profit than it could through expansion, yet preserve its reputation, trust, craftsmanship or staff loyalty. These benefits are difficult to measure precisely, but they still have value. Not everything that matters in business fits neatly into a spreadsheet.

Ethical and sustainable reasons to limit growth

Some owners restrict growth because they believe expansion would harm the features that make their business responsible. A local food producer, for example, may avoid national distribution if that would increase transport emissions or require lower-quality ingredients. Ethical behaviour can support long-term sustainability by maintaining trust with customers, employees and the community.

Balance matters. Growth may suit one business but not another. To evaluate the decision, ask what the business wants, which resources it has, the market it serves and the risks that growth would create.

The main external growth methods

External growth isn't a single method. The syllabus covers five: mergers and acquisitions, takeovers, joint ventures, strategic alliances and franchising. Make sure you know the differences, as they’re easy to confuse.

Comparison of the five main external growth methods.

Mergers and acquisitions

A merger is an external growth method where two or more businesses combine to form one integrated business. The combined organisation may be stronger than the firms were separately, perhaps because it has a larger market share, lower costs or shared expertise.

An acquisition is an external growth method where one business buys another and takes control of it. The acquired business might retain its brand name, though the buyer may instead absorb it into its own operations.

Mergers and acquisitions bring businesses under common control through combination or purchase. They’re often shortened to M&As.

These methods can provide quick access to customers, locations, staff, technology, products or brands. However, there may be culture clashes, redundancies, high purchase costs or legal challenges. Customers can also be disappointed when integration is handled badly.

Takeovers

A takeover is an acquisition where one business gains control of another, often by purchasing enough shares to control its decisions. If the target business agrees, the takeover is friendly. If it resists, the takeover is hostile.

Speed makes takeovers attractive. Rather than building market share slowly, the buyer acquires a business that already operates in the market. An unwanted takeover, though, can cause resentment among managers and employees. That may make the promised benefits harder to achieve.

Joint ventures

A joint venture is an external growth method where two or more businesses set up a separate business entity for a shared project, while the original businesses remain independent. Firms often use one to share risk, knowledge, finance or access to a market.

This arrangement can work well when the partners contribute different strengths. One partner might understand the local market, for example, while another supplies technology or capital. Problems arise when partners disagree about control, profits, responsibilities or the venture’s future direction.

Strategic alliances

A strategic alliance is an external growth method where two or more businesses cooperate for mutual benefit but remain separate organisations and don't create a new business entity. That separates it from a joint venture: the firms cooperate, but there is no new jointly owned business.

The firms may share research or technology, use co-marketing, establish distribution agreements or gain access to each other’s customers. Strategic alliances are usually more flexible than mergers. That same flexibility can make them fragile if trust breaks down.

Franchising

Franchising is an external growth method where one business lets another operate using its brand, products and business model in return for fees or a share of revenue. The original business is the franchisor, which grants the right to use its brand and operating system. The operator is the franchisee, the business or individual that purchases the right to run the franchise outlet.

For the franchisor, this method can support rapid expansion with less direct investment. Franchisees supply much of the local capital and management effort, while the franchisor may receive initial fees, ongoing royalties and wider brand presence.

The franchisee gets a business format that has already been tested. Its brand, products, training and operating procedures remove some start-up uncertainty. Independence is limited, however. Franchisees usually have to follow rules covering pricing, layout, suppliers, products and service standards.

There’s also reputational risk. Poor service at one outlet may lead customers to blame the entire brand rather than just the local operator.

Choosing between methods

No external growth method is always best. A merger can bring scale, but it carries a high integration risk. A joint venture shares costs but may lead to disputes. Strategic alliances offer flexibility, though they can be unstable. Franchising can expand a brand quickly while reducing direct control over the customer experience.

Stakeholder conflict often appears here. Employees may fear losing their jobs after a merger, while customers may worry about changes in service quality. Suppliers could lose contracts. Owners may disagree about risk. Growth changes a business, and change almost always produces winners, losers and uncertainty.