Contents
What it is: Economies of scale are the cost savings when a company increases its production scale. An increase in output allows the firm to reap a decreasing average cost of production. Production becomes more efficient because the firm can spread the cost over a large number of outputs.
The opposite condition is called the diseconomies of scale. It occurs when an increase in output results in an increase in average costs.
In a graph, we call the turning point before average cost to the diseconomies of scale (Q*) as the minimum efficient scale.
Under economies of scale, cost savings arise because of the inverse relationship between fixed costs per unit and the quantity produced. The greater output produced, the lower the fixed cost per unit. Not only that, but cost savings also come from other sources. I’ll explain in detail below.
Economies of scale are a source of competitive advantage. Companies have a lower cost structure, enabling them to offer products at a more competitive price than competitors. That way, they can capture a larger market share and profit.
What causes economies of scale
Several reasons explain why companies generate lower unit costs.
First, labor specialization and more integrated technology increase production volume. Both increase productivity so that the company can produce more output using the same input.
Second, the lower unit costs come from bulk orders from suppliers, larger advertising purchases, or lower capital costs.
Third, firms can spread the costs of business functions (such as marketing, finance, production, etc.) to more output, resulting in lower unit costs.
Cost savings from input purchasing
Firms benefit when purchasing inputs such as raw materials in bulk. Of course, that was only possible if they increased the output.
For example, a large purchase of raw materials is attractive to suppliers. They will usually offer a price discount to the company. Discounts ultimately reduce the cost of input per unit of output.
The company previously purchased 100 tonnes of raw material for $300 to produce 50 tonnes of product. So, the raw material price is $3 per tonne. Meanwhile, the cost of raw materials per unit of output is $6 per ton.
Now, the company is increasing production to 100 tons and requires 200 tons of raw materials. Assume a fixed price.
Because they purchased a larger amount, the company received a discount of $50 for the purchase. So, after adjusting for the discount, the company pays $550 ((200 x $3) – $50) to the supplier. If we convert this to output units, the raw material cost is $5.5 ($550 / 100), lower than before the firm received the discount.
The concept also applies to other inputs, such as advertisements. When awarding a large contract to an advertising agency, the company is more likely to get a discount.
Advertising contracts are also often unrelated to a company’s production volume. So, when it produces 10 units or 1,000 units, the company bears the same advertising costs, say $200. When you divide the total advertising cost by the production volume, of course, the advertising cost per unit will be lower when the company produces 1,000 units.
Spreading business function costs
The reduction in average costs also comes from spreading the cost of the business function to more output. Non-production functions such as finance and human resources usually contribute to a firm’s fixed costs. Even if output increases, the total cost for these functions will not change. So, when you divide that total cost into more output, it results in a lower cost per unit of output.
The reduced average unit cost continues until the company becomes immense. After reaching the point of minimum efficient scale, the increasing output will create new problems. Workload increases, leaving some staff demotivated and unproductive. That ultimately increases the company’s costs.
Managerial cost savings
Companies lower costs by simplifying the management structure within the company. The company may hire more skilled or more experienced managers. Implementing a more flexible management strategy can also reduce bureaucratic costs.
More advanced production techniques and technologies
Technological advances have drastically changed the production process to become more efficient. More advanced technology allows more production in less time. In the past, making woven fabrics took daily activities because they had to be manual. But now, it only takes a relatively short time when using the machine.
Division of labor and specialization
Specialization and the division of labor also contribute to lowering costs and achieving economies of scale. Mass production enables the use of specialized equipment and automation to perform repetitive tasks.
The greater the output produced, the greater the opportunities for specialization. When workers do one task, they will become more proficient over time. They can perform tasks faster (experience curve effect).
The difference of economies of scale and economies of scope
Both concepts attempt to explain two sources of cost reduction in production.
Economies of scope describe cost savings through the spread of resources and capabilities to produce two or more products. The critical point here is product variety. Producing two products using the same machine is cheaper than using two machines to produce each product.
Meanwhile, economies of scale show you that companies can lower costs by increasing production volume. The critical focus of economies of scale is the volume of production for one type of product.
An example is more or less like this. Automakers can produce two types of products: commercial cars and passenger cars, using the same production facilities. Assume that the raw materials for both products are the same.
If only producing passenger cars, companies can reduce costs through economies of scale. But if the firm produces both at once, it can lower costs through the economies of scope.
Say, the facility’s production capacity is as many as 100 vehicles. Assume the company can produce at 100% capacity (in reality, it is. impossible).
The company may not produce at full capacity because the demand for both types of vehicles is relatively limited. For example, passenger cars’ demand is only 80 units, and commercial cars are 30 units.
A company may achieve economies of scale if it produces as many as 80 passenger cars. However, at this production level, the company still has a remaining capacity of 20 units.
To optimize production facilities, the company can produce as many as 20 commercial cars. Thus, the company not only produces at full capacity but also benefits from a variety of products.
Types of economies of scale
Based on the source of cost savings, economies of scale fall into two categories:
- Internal economies of scale
- External economies of scale
Internal economies of scale
Internal economies of scale are a type of economies of scale where the source of reduction in average costs comes from the internal company. So, it is unique and only for individual companies. It may be the result of company size solely or because of decisions from company management.
Larger firms achieve internal economies of scale because they can buy inputs in bulk, have unique patents or technology, or access large and cheaper capital.
The following is the sources of internal economies of scale:
- Discounts for purchasing raw materials in bulk. Price discounts reduce the cost of raw materials per unit of output. That also applies to various other inputs, such as advertising and office equipment.
- Spreading expensive capital input costs over a large number of outputs. For example, the machine’s cost per unit of output will be cheaper when the firm can produce more output.
- Labor specialization. Companies divide complex processes into specific tasks, enabling workers to be more productive.
- Experience curve. This concept does not only apply to individuals but also the company. Companies can find the most productive way to generate output through learning by doing.
- Investing in human capital. Training, for example, enhances workers’ skills and abilities. Apart from being more productive, it also allows the company to reduce the need for outside technical personnel.
- Capital economies of scale. Large companies usually have better creditworthiness and access to finance than smaller companies. They could raise capital at a lower cost.
External economies of scale
External economies of scale are economies of scale where the source of cost savings comes from outside the company and applies to all. I mean, all companies enjoy the benefits of lowering average costs.
Some of the sources of external economies of scale are:
- Agglomeration. Various industries or factories cluster and set up production facilities in specific areas such as the software business in Silicon Valley. If the government builds a transportation network in the area, all companies will enjoy reduced logistics costs. Likewise, some component suppliers or supporting businesses may relocate their operations close to the area. That, of course, saves costs.
- Tax relief. Often times, governments impose tax breaks for the entire industry, instead of specific companies. Thus, a reduction in tax costs occurred in all companies.
Benefits of economies of scale
The company seeks to quickly achieve economies of scale. A decrease in average costs supports better profit.
Not surprisingly, some new players are usually relatively aggressive in penetrating the market. They sell products at low prices, hoping more and more customers will buy. Increased sales result in reduced costs through economies of scale, compensating for the low-profit margins resulting from penetration pricing.
The following are the benefits of economies of scale, not only for companies but also for others:
- Increased competitiveness – a lower cost structure allows the company to gain a competitive advantage. Also, companies are better prepared if competitors adopt an aggressive strategy of lowering selling prices. Long story short, economies of scale allow companies to gain a competitive advantage through the low-cost structure.
- Provide businesses with a platform to grow. A decrease in average costs leads to higher profits. That way, the company has more money to fund future expansion.
- Lower prices – Reduced unit costs allow companies to offer lower prices. For consumers, it increases their affordability and real income.
- Product variety – Companies are likely to reinvest profits into research and development to produce various products to meet consumer needs.
- Higher wages – Employees can negotiate higher wages as their company profits increase.
