What are Economies of Scale?

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economies of scale

What Are the Economies of Scale?

Economies of Scale Definition

“Economies of scale refers to an increase in the magnitude of goods produced where the average cost of production decreases. In other words, the price to make an additional unit of product comes down as the company grows.”

Economies of scale are cost benefits a business gains by scaling up production. This gain is because the per-unit fixed cost incurred gets distributed over increased production units. 

The per-unit cost and production quantity share an inversely proportional relationship. 

For the increased production scale, purchasing the material in bulk leads to a lower per-unit price and thus adds up to the economies of scale. 

Economies of scale is a metric that reflects successful production strategies. 

Economies of Scale

What Are the Types of Economies of Scale?

There are two types of economies of scale: 

Internal Economies of Scale 

Internal economies of scale are the unique economies of the organization. They are related to large businesses. 

For example, big companies can afford to purchase in bulk for large-scale production, which lowers the per-unit cost of the raw materials. 

Now, you can directly draw out this gain in cost or put it into product improvement to compete in the market. Both are internal economies of scale. 

External Economies of Scale 

External economies of scale refer to the gain in costs due to external factors. These factors affect the whole industry and not just any few companies. 

For example, there are tax concessions for those companies that generate mass-scale jobs. 

Or if a govt imposes heavy duties on foreign companies, that will benefit the local industry as the competition will decrease. 

What Are Three Sources of Economies of Scale?

The three sources of gain in costs through economies of scale are the following categories: 

Purchasing 

Lowering of per-unit cost of raw materials by bulk purchasing. Thus saving the costs through scaled-up production.

Managerial 

Better cost management and savings through the improved managerial structure. 

Technological 

Cost-effective technologies that reduce the production costs and scale up the number of units produced.

What Are the Factors That Cause Economies of Scale?

The four major factors that cause economies of scale are as follows:

Specialized Labor:

Firms that are growing will focus on employing trained laborers. This way, firms can divide the tasks and allocate them to experienced workers. 

The cost of hiring trained workers can be high, but the results outweigh the cost incurred. 

Skilled laborers can finish more work with fewer people, which helps reduce cash and production costs. 

Having specialized workers in your team will boost economies of scale because you can produce more goods in less time. 

That way, workers will also have time to discuss how to improve production.  

Impact of Capital and Technology: 

Having capital refers to the financial resources a firm has available to them to better its operations. Then, these firms can efficiently use the money to experience economies of scale. Firms can buy machines that can help with increasing production capacity. 

And when utilized at the highest capacity, these machines can also lower per-unit production costs. 

Technology can help companies commit fewer errors and increase the production process. Some of the modern technological items companies use are:

  • Computers
  • Software
  • Robotic equipment
  • Internet

Another benefit of having efficient capital is that these firms do not have to focus on generating cash but pay more attention to operations. 

Cheap Materials Due to Power of Negotiation:

Companies collaborate with other parties like the government, financial institutions, unions, vendors, and suppliers. 

Experienced firms are in a better position to negotiate when purchasing raw materials. They can deal and get discounts by purchasing raw materials in bulk. This way, the material cost during production decreases. 

Since workers are ready to work for minimum wage in large companies, the firms can also negotiate there. 

Banks and other financial institutions will be more willing to give loans to a large firm, which acts as economies of scale. 

Learning Lessons:

A well-established firm has an efficient structure and production process in place. That helps them to learn and grow with experience. Large firms have better access to conduct research and bear the costs than young firms. 

Research can help them learn better ways to produce goods and use formulas that will help lower the cost of production per unit. 

Significance of Economies of Scale 

Economies of scale is a handy metric as it can support your production and sales strategy by indicating the best phase to scale up the production. 

Economies of scale also help in cost management. Calculating the economies of scale provides important information about approaching and managing production to gain the most cost benefits. The data of economies of scale provides an answer to when you should scale up and up to what extent. 

You can use the economies of scale formula to determine the cost with a change in output. Cost elasticity or cost output elasticity is the formula mainly used to calculate the economies of scale. If the value is less than one, your firm enjoys economies of scale. 

The economies of scale formula:

Cost of elasticity = % change in total costs / % change in output

You can also use the economies of scale formula excel to calculate the economies of scale in the excel sheet. 

What Are the Benefits of Economies of Scale?

Benefits of Economies of Scale to the Firms Are:

  • There is a reduction in long-term unit costs, which can help firms improve their competitiveness in prices globally.
  • Economies of scale can help firms generate profits, get a higher return on their investments, and give the company space to expand.
  • Economies of scale can help businesses grow and are less threatened by competitors.

Some of the Benefits of Economies of Scale for Customers Are:

  • Access to affordable goods
  • Updated products
  • Good and higher wages for workers

What Are the Examples of Economies of Scale?

To begin with the example of economies of scale, we could say that an XYZ company bought an airplane worth $25 million. If they have only one passenger, they charge them $25 to receive the costs incurred during production. On the other hand, if they get a million passengers, their rate would be only $20. 

Now let’s look at the example of economies of scale, considering the two types of economies of scale. 

Internal Economies of Scale Example:

Financial institutions will offer loans to well-established firms. A young local store or market is at risk of failing compared to a Starbucks or Mcdonald’s. 

Apple has various design, software, production, and assembly departments. Hence, there is a division of labor. 

External Economies of Scale Example: 

An example of the external economies of scale s is when surrounding companies benefit from the well-established firms around them. 

Silicon Valley is an excellent example of economies of scale. Neighboring firms can enjoy the extensive infrastructure and other benefits. 

The bottle companies that collaborate with coca-cola are situated near the coca-cola factory. This way, both the company and the suppliers can benefit from the cheaper costs of the raw materials. 

Economies of Scale vs. Diseconomies of Scale

Economies of scale refer to the concept that suggests a company greatly benefits when the volume of production increases. 

The average cost of production goes down too. 

And some factors cause economies of scale:

  • Firms buy in bulk
  • Efficiency in capital and production
  • Expansion in risk
  • Lower storage and transportation costs

Diseconomies of scale refer to the opposite phenomenon of the economies of scale. It is a phenomenon when an additional item produced costs more even as the company grows.

The businesses that are growing will notice diseconomies of scale due to:

  • No to less communication between teams
  • Bad leaders and management
  • Overwhelmed workers and managers as the company are growing very quickly
  • Not handling change very well
  • No sense of direction

An example of diseconomies of scale could be when a company introduces new technology. 

It will require time for training and getting used to this new tech. 

If a department has to switch from handwritten bookkeeping to using excel sheets, then they will require more time to understand and train the workers to understand the concept of computers and excel sheets. 

FAQs 

Q: How do you determine economies of scale?

A: Suppose an increase in output results in a decrease in the per-unit cost of raw materials. In such a case, it gives a gain in price to the firm. That is called economies of scale. Cost elasticity value also indicates the existence of economies of scale. If the cost elasticity ratio is less than one, economies of scale exist. 

Q: What are diseconomies of scale?

A: It refers to the overgrowth of a company by economies of scale. These cost disadvantages attribute to scaling up the production and increasing per-unit cost. It is the stage beyond the saturation of economies of scale due to uncontrolled production.

Q: Which scenario corresponds with economies of scale? 

A: A scenario that best describes economies of scale would be as follows:

Two companies with similar interests can merge and benefit from having a single office headquarters. For example, when media channels AOL and Time Warner came together, they witnessed economies of scale.

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