Economies of Scale

Updated on April 5, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Meaning of Economies of Scale

Economies of scale is the cost advantage of ramping up production. When a business scales up, production cost per unit comes down—the fixed and variable costs are spread over more number of units.

After scaling up, businesses own superior machinery and get volume discountsVolume DiscountsVolume discount is a discount offered to the buyers to incentivize them when they purchase a large number of products at once i.e. when they place a bulk order. read more on raw materialsRaw MaterialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods.read more. Larger firms have a competitive edge over smaller players who have limited production capacity and higher production costsProduction CostsProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more. In addition to production, businesses can scale up by investing in advertising or Research & Development.

Key Takeaways

  • Economies of scale concept state that an increase in production reduces the production cost per-unit.
  • Scaling up could be internal or external. Internal factors include efficient machinery, specialization of labor, container principle, and bulk-purchase discounts. External factors include tax benefits, government subsidies, improved transportation, and joint ventures.
  • Upscaling is very expensive—could require mergers or acquisitions. Most smaller firms cannot raise that much capital.

Economies of Scale

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Economies of Scale (wallstreetmojo.com)

Economies of Scale Explained

When firms become more efficient in large-scale production, the total production cost increases but their cost per unitCost Per UnitCost 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 declines. This is achieved by using competent machinery and procuring raw material in bulk, at a discounted price. Although there is an increase in production and raw materials, the firm’s 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 remains the same. Therefore, the fixed cost distributes evenly across the entire output. Ultimately profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more increases.

In contrast, small businesses price their goods or services higher than large organizations—low scalability. After all, small businesses cannot afford discounts—the cost of production is high. In addition, most small firms employ labor-intensive processes instead of machinery, inflating their per-unit cost. Similarly, some businesses do not get discounts due to low purchase volume. Upscaling resolves all such issues.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Economies of Scale vs Economies of Scope Video

 

Economies of Scale Examples

Supermarkets are the most common example of economies of scale. Since they buy goods in bulk, they avail discounts. Therefore, they enjoy the benefit of reduced average costAverage CostAverage cost refers to the per-unit cost of production, calculated by dividing the total production cost by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output.read more.

Another example is an airline company that invests millions in buying a new plane. If it had only a few customers, the airline would have to charge very high. Airlines serve millions of customers. By doing so they can recoup expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more despite low charges. Increased volume of production—reduced average cost.

The technology giant Intel Corporation is another good example of upscaling advantages. The company invests massively in semiconductor chips and microprocessors. The company manufactures in large quantities. Therefore, Research & Development costs are very low for one unit.

Graph

Let us consider a hypothetical. Both ABC Enterprise and XYZ Enterprise sell walnuts. For the same quantity, ABC charges $1 more than XYZ. The cost prices and purchase quantities are as follows:

Company NamePurchase QuantityOverall CostCost Per Unit
ABC Enterprise1000 Kg$10000$10
XYZ Enterprise5000 Kg$45000$9

The following graph represents how scalability makes XYZ more efficient:

Economies of Scale - Graph

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Economies of Scale (wallstreetmojo.com)

The graph clearly shows that average cost goes down when the purchased quantity increases. XYZ Enterprise reduced per kg cost by getting bulk purchase discounts.

Internal Factors

Firms can achieve economies of scale by working over internal or controllable factors.

  • High Risk: Large-scale firms can afford bigger risks.

External Factors

Following are external factors that help in upscaling.

Disadvantages

Following are the disadvantages of scaling up.

Economies of Scale Vs. Diseconomies of Scale

The economies of scale principle predict the reduced per-unit cost of production when production is ramped up.

Economies of Scale Vs. Diseconomies of Scale

In contrast, the diseconomy of scaleDiseconomy 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 occurs due to the inefficiency in existing production methods. As a result, the average cost rises when the output is increased. Sometimes, diseconomies of scale occur when firms outgrow their potential. Employee costs, compliance costs, and administration costs get out of hand.

Frequently Asked Questions (FAQs)

What is an example of economies of scale?

A small bakery employs five bakers to prepare cakes, the production is low, and so is the profit. Consequently, the firm expands the business by introducing automation into baking. After considerable investment, the bakery increased production by ten times. Over time, the fixed cost spreads over total increased output—per cake upscaling cost is low.

Who classified economies of scale into internal and external?

It was introduced by Alfred Marshall. Marshall was an English economist from London. He emphasized the distinction between internal and external upscaling.

What causes economies of scale?

Businesses scale up by ramping up production, specializing in labor, procuring raw materials in bulk, advertising, investing in research, and raising capital.

Recommended Articles

This has been a guide to What is Economies of Scale and its Meaning. Here we explain economies of scale along with its graph, examples, internal factors, external factors etc. You may learn more about financing from the following articles –