Achieving Economies of Scale
Understanding Why Bigger Can Be Better
Imagine you work for a company in a buoyant sector. Your sales are increasing, and you could sell more of your product if you made more units.
However, you're nervous about the risks of hiring more people – and you'd also need to hire a production manager to run a larger team. Plus, you assume you'd still make the same profit on each item sold. You don't think the increase in volume would offset the cost of extra staff, so you decide to keep producing the same quantity.
Your competitors, however, have had a lesson in economics. They know that growth and increased production could bring their costs down, and therefore increase profit per unit.
What do they know that you don't know? It's called economies of scale, and we'll show you how it works.
Without Economies of Scale
Let's illustrate this with an example: suppose that you manufacture widgets. This is your current cost structure for each unit:
|4 knobs||@||$ 0.50||each||=||$ 2.00|
|2 rods||@||$ 1.50||each||=||$ 3.00|
|5 bolts||@||$ 0.25||each||=||$ 1.25|
|5 spinners||@||$ 1.00||each||=||$ 5.00|
|30 minutes labor||@||$12.00||per hour||=||$ 6.00|
If you produce 300 widgets per month, your manufacturing cost of goods sold (COGS) is $17.25 x 300 = $5,175.
Each widget sells for $25, leaving you with a gross profit of $2,325 per month, which is a 31% gross profit margin.
With the higher demand for your widgets, you could increase production to 600 units per month. To increase production, however, you'll need to hire a production manager to keep operations running smoothly. You'll need a bigger truck to ship your units. You might even have to hire a full-time maintenance manager instead of using a part-time contractor. When you add it up, it seems as though you'll simply decrease your net income:
|300 Units||600 Units|
|Revenue||$7,500||(300 units @ $25)||$15,000||(600 units @ $25)|
|COGS||$5,175||(300 units @ $17.25)||$10,350||(600 units @ $17.25)|
|Shipping||$300||(1 trip/week)||$600||(2 trips/week)|
|Net income||$1,025||(13.7% of sales)||$550||(3.7% of sales)|
What do you do? The market won't allow a price increase. You might lose some customers because you can't meet demand. But, looking at the figures, it doesn't seem to make sense to work more and earn less.
Adding Economies of Scale
Well, if you did some research, you'd quickly realize the following:
- If you increase the size of your raw material orders, your suppliers will give you a discounted price – so the actual cost to produce each unit will go down.
- The shipping company would decrease your per-trip rate from $300 to $250, because bigger orders, and more orders, mean more business for them.
- Hiring production and maintenance managers would increase efficiency, so you could actually produce 675 units, instead of 600 units, with the same labor costs (a 12.5% increase).
Let's look at the new per-unit cost structure with an output level of 675 units:
|4 knobs||@||$ 0.45||each||=||$ 1.80|
|2 rods||@||$ 1.40||each||=||$ 2.80|
|5 bolts||@||$ 0.20||each||=||$ 1.00|
|5 spinners||@||$ 0.80||each||=||$ 4.00|
|27 minutes labor||@||$12.00||per hour||=||$ 5.40|
Variable costs alone have brought down your per-unit cost. Now, look at your income figures again:
|Revenue||$16,875||(675 units @ $25)|
|COGS||$10,125||(675 units @ $15)|
|Net income||$2,750||(16.3% of sales)|
Although your total cost (COGS plus maintenance and shipping) is higher, your average cost per unit has decreased – therefore your profit margin has increased.
|300 units||675 units|
|Cost per unit||$21.58||$20.92|
|Gross profit margin||13.7%||16.3%|
The focus with economies of scale is on the cost per unit, or average cost (AC) – not the total cost. If you take advantage of economies of scale, your unit cost will typically decrease as the number of units increases – so you'll probably earn more.
Growing bigger, and producing more, can yield significant returns. Figure 1 (below) shows a typical average cost curve. As output increases, the average unit cost decreases.
Sources of Economies of Scale
The simple example above illustrates purchasing economies of scale. There are many other sources of economies of scale as well:
Commercial Economies of Scale
These arise when you buy and sell material, products and services in larger volumes. You may do so through bulk purchases, as in our earlier example. Other examples of better purchasing include improving shipping rates because more products are moved with each shipment. They also include using more efficient inventory management practices, such as just-in-time inventory management, to reduce average unit costs.
You may also see, for example, marketing economies of scale, where the fixed costs of developing marketing materials are spread over larger numbers of prospective clients.
Technical Economies of Scale
These result when you make elements of the production process more efficient. If you're producing sufficiently large quantities of products, it may be worth reconfiguring machines, purchasing new machines, using better technology, and optimizing capacity. The larger the volume of products you make, the more you can invest to make the production process more efficient, and the more cost-effectively you can make each individual product.
Large, modern facilities that automate production can reduce unit costs, despite the initial capital investment that's needed. This is because fixed production costs (such as electricity, rent, and fuel) are spread over more units – so the average cost of each unit is reduced.
Capital-intensive industries must use technical economies of scale to be profitable. Building only 100 cars per year would result in huge fixed costs spread over very few units – and it would be difficult, if not impossible, for sales to offset those costs.
Managerial Economies of Scale
Similarly, the larger the number of units produced, and the more units you can spread staff costs over, the more you can invest in specialist expertise. Hiring a finance or customer service manager might seem expensive at first. However, professional managers can improve quality and increase production using the same amount of inputs. Therefore, higher labor can often be more than offset by improved productivity and quality.
Specialized labor can also lead to increased efficiency. People who do the same task repeatedly tend to do it faster than those who do the task only occasionally. Therefore, if you divide work into smaller steps, you may significantly improve efficiency. In our widget example, if you use specialized labor for each stage of work, rather than general labor for the entire unit, you may decrease total labor to 20 minutes per unit.
Financial Economies of Scale
Financing a larger amount usually leads to a lower cost of borrowing. For example, mortgage rates are generally lower than commercial lending rates for automobiles. Also, larger companies have more assets to use as collateral, so the interest rates they pay are usually lower. And larger companies can typically raise equity financing more easily than smaller companies. The servicing costs of this type of financing are significantly lower than borrowing from banks or other financial institutions.
Risk-Bearing Economies of Scale
The more a company diversifies its activities, the less overall risk it assumes in any one line of business. Producing a wide variety of products, and operating in many geographic locations, are ways to spread risk, but they also need a significant initial investment. Large-scale growth and diversification strategies can pay off by taking a long-term perspective and using economies of scale. Spreading the risk of research and development costs is another benefit for large firms.
External Economies of Scale
The economies of scale discussed above are all internal. They each relate to how an individual company operates. But there are also external economies of scale that impact an industry as a whole. A company may gain advantages as a result of what's happening in the industry and external environment. Here are some common examples:
- Industry growth may allow access to specialist or lower-cost suppliers.
- Low demand and large supply may bring down the cost of supplies.
- Where many similar companies are operating in the same area, this may mean that there are many, pre-trained people who can be recruited.
- Industry infrastructure may already be in place to support growth.
- Training facilities may be available.
- A good transportation network may be available.
- Improved technology may drive down all costs.
External factors can also create disadvantages. For example, as more companies move into a location, rents may rise, unemployment rates may drop, and workers may demand higher wages.
Minimum Efficient Scale
All of these economies can occur as a company grows, and increases its production.
However, what happens if it grows too much? Very large companies sometimes suffer from decreased efficiency. They may have once had efficient labor specialization, but now there are simply too many people doing the same thing. Too many layers of management, too little control, too many locations, and too many products – these are all potential sources of ‘diseconomies' of scale.
There's a point at which average costs stop falling as production increases, which may also be the point at which costs start to rise as a result of this inefficiency. This point is the company's Minimum Efficient Scale (MES).
This is illustrated in the U-shaped curve shown in Figure 2: here, the bottom of the curve is the optimal place to be. At production volumes higher than this, the company's size is no longer an advantage.
By taking advantage of the opportunities that come from larger size and increased output, companies can reduce their average unit costs, and increase their profits. They can also create many internal opportunities simply by growing. And sometimes the external environment also provides economies of scale, based on things like industry size or geographic location.
Organizations must be careful about outgrowing their economies of scale and getting too big. Average unit costs usually decrease with increased output, but only to a certain point. After that, costs may begin to rise again as the company creates unwanted inefficiencies. These ‘diseconomies' of scale can also result from external events, so an organization should continuously monitor its size and growth to seek its optimal level of efficiency.
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