Economies of scale.

Definition and Examples of Economies of Scale

How Economies of Scale Work

Types of Economies of Scale

Definition and Examples of Economies of Scale

Economies of scale are cost reductions that occur when companies increase production. Fixed costs, such as management, are spread over more units of production. Sometimes, a company benefiting from economies of scale can negotiate to reduce its variable costs as well.

Any time a company can reduce costs by increasing the volume of goods it produces, that is an example of economies of scale. There are several reasons that lead to lower production costs as volume increases.

For example, by maintaining a production line focused on a single product, companies may save on costs associated with switching raw materials and tools to produce different products. Basic examples are management and administrative costs – there’s no need to hire additional managers just because your workers start producing more items per day.

Disadvantages of Scale

Sometimes a company pursues economies of scale to such an extent that it becomes too large. This excessive growth is called negative economies of scale. There comes a time when maximum efficiency is reached. Any units produced thereafter will increase the cost per unit instead of decreasing it.

Negative economies of scale are not always related to actual production efficiencies. For example, it may take longer to make decisions, making the company less agile. Communication breakdowns may occur, especially if the company becomes global. The acquisition of new companies may lead to clashes of corporate cultures. These conflicts will slow down progress if they do not learn how to manage cultural diversity.

How Economies of Scale Work

The specific way in which economies of scale work depends on the goods or services being produced. It could be as simple as extending operating hours to get more use from expensive equipment. Any way a company can improve the unit cost by producing more units is how economies of scale work.

Economies of scale benefit not only the organization producing the goods. Consumers can enjoy lower prices. The economy grows when lower prices stimulate increased demand.

Note: Economies of scale also give a competitive advantage to larger entities over smaller ones. The larger a company is, whether it is commercial, non-profit, or government, the lower its costs per unit will be.

How to Make Economies of Scale Work for You

You don’t have to be a company to benefit from economies of scale. Think about how larger families typically buy in bulk. Each box of detergent costs less per wash because you can buy it wholesale. The manufacturer saves on packaging and distribution. Then, it passes the savings on to you. You also save on travel costs by making fewer trips to the store.

Note: Governments and non-profit organizations can also benefit from economies of scale. These benefits occur whenever an entity produces more and becomes more efficient, thereby reducing costs as a result.

Economies of Scope

Economies of scope are similar to economies of scale, but they occur when a company diversifies into multiple product lines to combine efficiencies and business functions. For example, most newspapers have diversified into similar product lines, such as magazines and online news. In other words, economies of scale focus on a single product (scale), while economies of scope encompass multiple products (diversity).

Types of Economies of Scale

There are two main types of economies of scale: internal and external. Internal economies are controllable by management since they are internal to the company. External economies rely on outside factors. These factors include the industry, geographical location, or government.

They generate

Internal economies result from an increase in production volume. There are five types of internal economies of scale. You usually see them in large enterprises.

For example, large companies can buy in bulk. This economy lowers the unit cost of the materials they need to produce their products. They can use the savings to increase profits. Or they can pass the savings on to consumers and compete on price.

Technical economies of scale

Technical economies of scale result from efficiencies in the production process itself. Manufacturing costs decrease by 70% to 90% every time a business doubles its operations. Large companies can take advantage of more efficient equipment.

For example, data mining software allows a company to target profitable market gaps. Large shipping companies reduce costs by using giant carriers. Finally, large companies achieve technical economies of scale because they learn by doing. They significantly outpace their smaller competitors on the learning curve.

Monopoly power

Monopoly power is when a company buys so much of a product that it can lower its costs per unit. For example, Walmart can undercut its smaller competitors by using its massive buying power.

Managerial economies of scale

Managerial economies of scale occur when large companies can afford specialists’ costs. They manage specific areas of the company more effectively. For example, an experienced executive has the skills and expertise needed to handle large orders. They demand high salaries, but they are worth it.

Financial economies of scale

Financial economies of scale mean that the company has cheaper access to capital. Large companies can raise funds from the financial market through initial public offerings. Large companies enjoy higher credit ratings and can offer lower interest rates on their bonds.

Network economies of scale

Network economies of scale primarily occur in online businesses. It costs almost nothing to support each additional online customer with the existing digital infrastructure. Therefore, any revenue from the new customer is pure profit for the company.

External economies of scale

A company experiences external economies of scale if its size creates preferential treatment. This often happens with governments.

For example, the state often reduces taxes to attract companies that create the most jobs. Large real estate developers convince cities to build roads to support their buildings, which saves developers those infrastructure costs. Large companies can also benefit from shared research with universities to reduce research and development costs.

Small businesses do not have the ability to take advantage of external economies of scale but can aggregate them. Small companies can cluster similar businesses in a small area. This allows them to benefit from geographical scale economies. For example, art studios, galleries, and restaurants benefit from being located together in an artsy downtown area.

Key Takeaways

Economies of scale occur when a company increases production in a way that reduces unit costs. Internal economies of scale can result from technical improvements, managerial efficiencies, financial capacity, monopoly power, or access to large networks. External economies depend on companies’ ability to influence economic priorities, often leading to preferential treatment from governments. Negative economies of scale can occur when a company increases production beyond an optimal efficiency level and starts to experience rising per-unit production costs.

Source: https://www.thebalancemoney.com/economies-of-scale-3305926