What is Scalability?
Scalability refers to a company's ability to increase its production profitably.
How Does Scalability Work?
Let's assume it costs Company XYZ $1 million to produce 1 million widgets per year ($1 per widget). This $1 million cost includes $500,000 of administrative, insurance and marketing expenses, which are generally fixed. If Company XYZ decides to produce 2 million widgets next year, its total production costs may only rise to $1.5 million ($0.75 per widget) because it can spread its fixed costs over more units. This means Company XYZ has scalability. Although Company XYZ's total costs increase from $1 million to $1.5 million, each widget becomes less expensive to produce and therefore more profitable.
The idea of scalability is based on economies of scale, which refers to the reduction of per-unit costs through an increase in production volume.
Why Does Scalability Matter?
Operational efficiencies create scalability. These efficiencies often are the result of division or specialization of labor, reorganization of key processes, the implementation of new technology, and bulk materials purchases.
Scalability is a huge competitive advantage. A lack of it can discourage new competitors from entering a market or eliminate smaller competitors. This is why it can lead to an oligopoly, where only a few companies produce the majority of an industry's output. Sometimes scalability can even lead one company to dominate an industry; this is called a natural monopoly.