Economies of Scale Meaning
Economies of scale refer to the cost advantage that the business achieves due to large scale of production and higher efficiency level. Generally, larger firms reap out more benefits and cost advantages over small firms as they have larger outputs and can spread their average cost (fixed and variable) over a greater number of units of output.
Explanation
Businesses achieve economies of scale due to the large scale of production. Several other factors that help larger firms in achieving the economies of scale are specialisation in terms of the product line and labour, bulk ordering from suppliers at a reduced price, investment in advertising and research, lowering the cost of capital by borrowing funds cheaply, and so on.
Another related phenomenon is known as diseconomies of scaleDiseconomies Of ScaleDiseconomies of scale is a state that generally occurs when an enterprise expands in size. The average operating cost increases due to inefficiency in the system, employee incoordination, administration & management issues, and delayed decisions.read more, which happens due to inefficiency in existing production or other processes within the firm or entire industry. It will lead to an increase in average cost even after the output is increasing.
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Source: Economies of Scale (wallstreetmojo.com)
Examples of Economies of Scale
- The most common example of economies of scale is the supermarket store; they can buy products in bulk at a lower cost due to their large capacity. Therefore, they enjoy the benefit of reduced average cost.
- Another example can be that of an airline company which invests millions in buying a new plane. If there are only a few customers, the airline will have to charge a very high fee to breakevenBreakevenBreak-even analysis refers to the identifying of the point where the revenue of the company starts exceeding its total cost i.e., the point when the project or company under consideration will start generating the profits by the way of studying the relationship between the revenue of the company, its fixed cost, and the variable cost.read more. However, it serves millions of customers and therefore, can recoup its charges by charging much less. Thus, it results in reduced average cost by an increased level of production of services.
Types of Economics of Scale
There are two main types –
- External Economies of Scale: External economies of scale are achieved due to external factors such as tax reductions, government subsidies, improves transportation network, etc.
- Internal Economies of Scale: Internal economies of scale happens due to factors internal to the firm. For example, investment in highly efficient machinery, hiring of the specialised workforce or holding a patent over something unique like production machinery. It leads to a reduction in average cost and competitive advantage.
Determinants
- Businesses producing at large scale achieve specialisation in their production line generally by breaking down the job into smaller tasks. It leads to increased efficiency and reduced average cost.
- Due to the large scale of production, the firms can negotiate on buying resources at less cost.
- They can borrow funds easily due to the easy availability of collateral.
- They start investing money in research and development.
Benefits
- Reduced Per-unit Cost: They help in the reduction of per-unit costPer-unit CostCost per unit is defined as the amount of money spent by a corporation over a period of time to produce a single unit of a specific product or service, and it takes into account two components in its calculation: variable and fixed costs. It aids in determining the selling price of the company's product or services.read more in the long-term, which consequently helps businesses in increasing their price competitiveness in the market.
- Increased Profits: The reduced cost, increased price competitiveness leads to a higher return on capital employedReturn On Capital EmployedReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed.read more, thus increased profit.
- Growth of Business: Businesses are paved on the path of growth by achieving it, which help them becoming large scale and safe and secure from external threats or hostile takeovers.
- Business Creditability Increases: It ultimately lead to an increase in the credibility of the business in terms of raising finance, and it also leads to an increase in the company’s share price.
- Improvement in Existing Processes: It leads to increased efficiency in existing processes, increased salaries and wages for the employees, and also improvement in the quality of products and services.
Effect
- Economies of scale lead to an increase in total production, which ultimately leads to the distribution of per-unit fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more over total increased output. Therefore, it reduces the fixed per-unit cost.
- Similarly, increased production also leads to a reduction in the variable cost per unitVariable Cost Per UnitVariable cost per unit refers to the cost of production of each unit produced, which changes when the output volume or the activity level changes. These are not committed costs as they occur only if there is production in the company.read more.
- It also impacts the share price of the business, which improves due to increased credibility of the business.
- Price competitiveness, higher wages to employees, improvement in the quality of products are all effects of economies of scale.
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