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 discounts of raw materials. Larger firms have a competitive edge over smaller players who have limited production capacity and higher production costs. 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.
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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 unit 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 cost remains the same. Therefore, the fixed cost distributes evenly across the entire output. Ultimately profit margin 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.
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 cost.
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 expenses 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 Name | Purchase Quantity | Overall Cost | Cost Per Unit |
|---|---|---|---|
| ABC Enterprise | 1000 Kg | $10000 | $10 |
| XYZ Enterprise | 5000 Kg | $45000 | $9 |
The following graph represents how scalability makes XYZ more efficient:
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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.
- Division of Labour and Specialization: Each worker should have a particular task. Specialization improves the efficiency of individual personnel.
- Commercial: Like Walmart, many companies purchase goods in sizable quantities to avail discounts.
- Container Principle: If the area of production or storage is increased by 100%, the volume accommodated will increase by 200%. This way, the benefit of expansion is twice that of construction costs.
- Marketing: Spending heavily on advertising and promotion is another up-scaling strategy. Accelerated sales can easily recover the marketing cost. The marketing expenditure per unit is miniscule.
- Technical: Technology-based companies spend excessively on Research & Development. But they recover the investment when a successful product or service takes the market by storm.
- Financial: Large-scale businesses can get leveraged funds at a lower cost due to established relationships and goodwill. Also, big firms can release initial public offerings (IPOs) to raise capital.
- High Risk: Large-scale firms can afford bigger risks.
External Factors
Following are external factors that help in upscaling.
- Tax Reduction: When the government relaxes the tax liabilities on certain products or services—demand can shoot up—higher profits for the business.
- Government Subsidies: Producers of certain goods or services receive subsidies from the government—low production cost.
- Superior Transportation Network: Companies can take advantage of transportation facilities by speeding up raw material procurement and finished goods distribution.
- Skilled and Talented Labour: If labor markets become efficient, companies can employ talented workforce at nominal wages.
- Joint Ventures and Partnerships: The fastest way to scale up is via mergers and acquisitions.
Disadvantages
Following are the disadvantages of scaling up.
- Diversification Risk: When firms expand their business operations across different industries, some of the subsidiaries might underperform.
- Huge Capital Investment: Scalability is expensive—most small firms cannot raise that much capital.
- Limited Market Demand: Customer preference is unpredictable; therefore, the demand for a particular product can fall unexpectedly. In such a scenario, ramped-up production can result in huge losses and dead stock.
- Requires Higher Degree of Control and Management: Scaling up results in a new team of individuals—it takes time for them to function smoothly. Mergers and acquisitions often result in contrasting work cultures.
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.
In contrast, the diseconomy of scale 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)
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.
It was introduced by Alfred Marshall. Marshall was an English economist from London. He emphasized the distinction between internal and external upscaling.
Businesses scale up by ramping up production, specializing in labor, procuring raw materials in bulk, advertising, investing in research, and raising capital.
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