Economies of Scale: Producing More in Lesser Cost

Economies of scale may sound like a complex economic concept. But in reality, it’s a fundamental principle with a big impact on how businesses operate. In this article, we’ll explore what economies of scale are, how they benefit businesses, and how companies can achieve them.

One question constantly looms large in the minds of entrepreneurs, executives, and industry professionals: “How can we achieve sustainable growth and maximise profitability in a world where competition is fierce and resources are finite?” The answer to this critical question lies in understanding and harnessing the concept of “Economies of Scale.”

It’s like this. When a business scales up the production quantity, it can reduce production costs. Even on an individual level, when you buy in bulk, you can get the items at a cheaper price.

If you understand this relationship, you will be able to grasp the context of economies of scale that we will explain in detail below.  

Definition of Economies of Scale

Economies of scale refer to the cost advantage that companies experience when increasing their level of output. By saving money on production, they are able to increase profit. 

Effects of Economies of Scale for Businesses

Now you might be wondering, how does this actually affect production costs and benefits businesses?

Reduces Average Costs of Production

When a business produces more units of a product or offers more services, it can spread both fixed costs and variable costs over a larger output. That leads to a reduction in the average cost per unit produced.

Imagine a pizza place that makes 100 pizzas instead of 10. The cost per pizza goes down, making it more profitable.

Allows Businesses to Offer Lower Prices to Consumers

Cheaper production means lower prices for customers. When a business benefits from economies of scale, it can pass on the savings to consumers. This makes its products or services more affordable and competitive. Shoppers often enjoy the benefits of economies of scale when they see prices drop on popular products.

Improves the Efficiency of Production

Producing more also helps companies become more efficient. As they streamline their processes to handle larger quantities, they find ways to reduce waste, save time, and improve quality.  Operational efficiencies are essential. Think of a car manufacturer that fine-tunes its assembly line to produce more vehicles in less time with fewer defects.

Increases the Bargaining Power of Businesses with Suppliers

Bigger businesses have more bulk purchase power. They can negotiate better deals with suppliers because they purchase larger quantities of raw materials and components. This can lead to lower input costs, boosting overall profitability. For example, a massive chocolate company can secure cocoa beans at a better price than a small artisanal chocolatier.

Creates a Competitive Advantage for Businesses

Economies of scale occur when companies become industry giants. Their lower costs allow them to invest in marketing, research, and development, which can strengthen their position in the market. This competitive edge can be challenging for smaller competitors to overcome.

Types of Economies of Scale

In general, there are two primary types of economies of scale: internal and external. They can also sometimes refer to the sources of economies of scale. 

Internal Economies of Scale

Internal economies of scale are cost advantages that a single firm can achieve as it expands its own production and operations. These advantages result from the firm’s own efforts to increase its size, efficiency, and productivity.

Let us explain this in a simpler way. 

One of the most common types of internal economies of scale is related to bulk buying.

When a company produces on a large scale, it has the power to negotiate volume discounts with suppliers. Now that reduces the cost per unit of raw materials. This cost advantage allows the company to either increase its profit margin or offer competitive pricing to customers. So, next time you’re wondering why that family-sized detergent is cheaper per wash, you can thank economies of scale for that!

When it comes to economies of scale, here are some common internal factors. 

Technical Economies

These arise from improvements in production techniques, technology adoption, and process optimisation. Larger firms often have the resources to invest in state-of-the-art machinery and technology. With them, there can be higher productivity and lower per-unit production costs. For example, a larger factory may afford more advanced automated equipment. That will reduce the need for manual labour.

Toyota and Volkswagen benefit from technical economies of scale. They invest in advanced robotics and automated assembly lines, reducing labour costs and improving production efficiency. This allows them to produce vehicles at a lower cost per unit.

Managerial Economies

Larger organisations can afford to hire specialised managers and experts who can improve overall efficiency and decision-making. They may also invest in sophisticated management information systems (MIS) and tools. This objective of improving the management structure within the firm can result in better resource allocation and cost control.

MNCs such as Apple or Samsung can afford to hire skilled or more experienced managers and employ specialised teams for various aspects of their global operations.

Financial Economies

Larger the business, the easier and cheaper it is to access capital. This is because they have a stronger creditworthiness and can negotiate more favourable lending terms. The bigger size of a company may also benefit from lower interest rates and lower financial transaction costs.

Large banking institutions like HSBC or Barclays enjoy financial economies of scale. They can borrow funds at lower interest rates due to their strong creditworthiness. 

External Economies of Scale

External economies of scale refer to cost advantages that accrue to an entire industry or group of firms in a particular geographic area as they grow collectively. These benefits are external to individual firms and arise from factors outside their control. 

One of the most common types of external economies of scale is related to knowledge spillovers. When numerous firms in a particular field coexist in a specific region, something magical happens: they collectively foster an environment where ideas and expertise flow freely.

Let’s look into some of the common external factors when it comes to understanding economies of scale.  

Skilled Labour Pool

When many firms in the industry operate in the same area, it can attract a skilled and specialised labour force. Workers with industry-specific skills may be readily available. That will reduce recruitment and training costs for individual firms.

Read more on what recruitment is.

Silicon Valley is renowned for its concentration of technology companies. The availability of skilled software engineers, designers, and tech professionals in the region makes it easier for startups and established tech giants alike. They can access a talented workforce without extensive recruitment and training costs.

Industry Infrastructure

Clusters of businesses in the same industry often lead to the development of industry-specific infrastructure. This can include shared transportation networks, supply chain hubs, and research facilities. All firms in the area benefit from these shared resources.

Major shipping ports like the Port of Singapore benefit from external economies of scale. The presence of multiple shipping companies and logistics providers in the same area has led to the development of world-class port infrastructure, which benefits all companies involved in import and export.

How to Achieve Economies of Scale

Increase the Volume of Production

The most straightforward way to benefit from economies of scale is to produce more. This endeavour to increase in output might involve expanding your production facilities, increasing workforce, or running production lines for longer hours.

Invest in New Technology

Embracing technology can help streamline operations and reduce costs. Automating tasks, using advanced machinery, and implementing efficient software systems can all contribute to higher production. 

More than 76% of the products customers order are now fulfilled from warehouses within their region, according to Amazon. This is up significantly from prior years as they optimise inventory placement.

Outsource Production

Some businesses choose to outsource parts of their production to specialised companies. It can help reduce costs by taking advantage of the expertise and efficiencies of those better skilled or more experienced suppliers.

Negotiate Better Deals with Suppliers

Building strong relationships with suppliers and negotiating favourable terms can lead to lower input costs, which is essential for achieving economies of scale.

As a business, it is possible to negotiate for lower prices on both fixed costs (like rent or equipment leasing) and variable costs (such as raw materials) when they achieve economies of scale.

Improve the Efficiency of Production Processes

Continuously analysing and optimizing production capacity processes can help identify areas where improvements can be made. Even small changes can have a significant impact on cost reduction.

Challenges of Achieving Economies of Scale

High Initial Investment Costs

Smaller businesses often require substantial initial investments in set-up and production costs as well as technology, and manpower. Smaller businesses may find it challenging to access the resources needed to get started.

Difficult to Manage Large Organisations

Running a larger business comes with its own set of challenges. Coordinating various departments, managing a larger workforce, and ensuring consistent quality without considering the equipment have been falling or similar can be complex and demanding.

Increased Competition from Other Businesses

As the scale of production increases, businesses often attract competition from other companies seeking to enter the market or expand their operations. This can erode some of the advantages gained.

This particular challenge can be averted when companies may opt for risk diversification.  They can do this by expanding into multiple markets or industries instead of running one company in one place. This strategy helps them maintain stability and profitability by leveraging their existing strengths and the benefits of economies of scale across different business areas.

Read about the Systematic risk and unsystematic risk difference. 

Changes in Technology Can Make Existing Processes Obsolete

In today’s fast-paced world, technology evolves quickly. Businesses that do not adapt to new technologies may find their existing processes becoming obsolete, potentially erasing the benefits of economies of scale.

Think of ChatGPT or Generative AI, which are seen as threats to certain internet-based workforce domains. Now, with this rise, there is a shift towards embracing these advanced technologies to supplement job roles. That’s why many are now taking up prompt engineering courses.

Understanding Diseconomies of Scale

If a business is facing increasing average costs and experiencing sluggishness despite growing, it could be due to diseconomies of scale. As a business expands, it may face issues with coordination and communication, which can lead to decreased efficiency and increased costs. 

Additionally, there may be a lack of specialised resources and an inability to adapt to changes in the market or technology mentioned above. These factors can result in a decrease in productivity and an increase in average costs, making it difficult for the business to maintain profitability.

So, you can say that diseconomies of scale represent the opposite of economies of scale, where costs decrease as production increases.

Conclusion 

Economies of scale offer businesses the opportunity to lower costs, increase production efficiency, and ultimately increase profitability. By understanding the various factors and sources that contribute to economies of scale, firms can make strategic decisions to harness these cost advantages.

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