economies of scale

What is Economies of Scale?

Economies of scale is not only a really important concept to understand, but it is useful to be aware of and can be applied to numerous aspects of business; logistics, puchasing, marketing, production, and even process analysis in operations research to name a few. At its basic core, it loosely means a company realizes a cost benefit as a result of business volume; the increased volume reduces cost on a cost per unit basis. However, by definition economies of scale is:

The cost advantage experienced by a firm when it increases its level of output. The advantage arises due to the inverse relationship between per-unit fixed cost and the quantity produced. The greater the quantity of output produced, the lower the per-unit fixed cost. Economies of scale also result in a fall in average variable costs (average non-fixed costs) with an increase in output. This is brought about by operational efficiencies and synergies as a result of an increase in the scale of production.

Note that this definition is primarily in reference to a production environment, which is to help visualize and illustrate how it is applied in the "real world" business environment, but it has other applications as well.

Economies of Scale Examples

A production environment is the "easiest" way to illustrate economies of scale- you have machines running, people processing, accountants crunching numbers, and all your other necessary resources contributing to the process (regardless of how many widgets are produced that day the business will incur these costs); but what if they can produce just 50 more widgets per a day in the same hours worked? What if they could do it consistently every day for a week? For the purposes of this illustration I'm going to disregard the consequences of over producing, or increasing production rate (with all the costs associated with unsold inventory sitting on a shelf... with no demand).

With all things being equal, and assuming costs are fixed per a day, say the company spends $4,000 per day to operate and on average they produce 1,000 widgets per day - cost per widget is $4 ($4,000/1,000 = $4 per widget). Let's say you rally the troops and motivate them because you're a great leader and production increases by 50 widgets a day. Let's do the math- it still costs $4,000 per day for operations, but now you have 1,050 units getting produced - cost per widget is now $3.81 ($4,000 / 1050 = $3.809). This slight increase in production leads to a decrease in cost per unit (about a 4.8% reduction)! This reduction could be leveraged in multiple ways for the business. You could pass this cost reduction to your sales team and they could use it as leverage to negoatiate more sales with exisiting customers, or maybe they want to try and win new business and offer this reduced cost to new prospective customers. Or, you could keep the realized reduction internal and enjoy the benefit of improved margins... which go to your bottom line. Alternatively, maybe the company has been discussing a new marketing strategy and this increased profit could be allocated to a new marketing campaign. As you can see, there are significant implications for recognizing economies of scale and the opportunities that result from capturing them!

In this next example the concept is used more loosely, but at its core the company will see a benefit from capturing improved economies; greater volume resulting in reduced cost per unit. Say you're fresh out of college and you've taken a position that requires heavy data entry and analysis in Excel. Your predecessor implemented a process using Excel and it was very, very basic (no Vlookups, no macros, no sumifs) and it was extremely manually intensive. You begin to learn the process and find it takes about four hours a day to do the work required under the current process; there has to be a better way. As you become more comfortable with the process you start changing it and implementing more automated functions, now you can do bulk uploads of the data rather than individual data entry. As a result of your changes you can now do the work in 1 hour, where it used to take 4, and you have created a process where it doesn't matter how many records you receive (whether its 5 or 100), it takes the same amount of time to process them. Not only did you improve efficiency for the company, but you have been able to capture economies of scale in how you are processing data! This improvement will help the bottom line because there is a cost associated with your labor, and by improving the volume (or production capacity of your personal throughput), you have reduced the cost per unit of the task you are completing.

A third example- Shoeburger Company has a distribution supply chain for moving their delicious burgers throughout the country. As a new manager on the team you are responsible for loading the trucks that go out to the restaurants. As time goes on you recognize that a few of the trucks will often go out half empty (or half full... it's all a matter of perspective, right?). The truck shipment is going to cost the same whether there is 1 burger on there or 1,000 because the cost is fixed based on miles traveled. You speak with the logistics planner and mention that it doesn't seem very efficient and you'd like to help improve efficiency. You two sit down and evaluate the daily routes and determine there are two trucks that could actually be consolidated due to proximity and load ratio's. This consolidation improves the number of units on the truck, reduces the number of trucks required, and the cost/benefit shows that there will be a savings in mileage cost. This change, this improvement, helped the business realize greater efficiency... the increased volume by improving truck capacity loads decreased the cost per unit rate. This is an example of realized economies of scale in a real-world scenario.

Why Are Economies of Scale Important?

This concept can be applied to many areas of business, and all are associated with reducing cost. Driving down costs is a major concern for business managers as this will impact the bottom line and make the company more profitable. Being aware of how economies of scale can leverage a business process, and finding ways to improve volume, regardless of the task, will strengthen the company's financial position. This improved financial position will allow business decision makers to assess how this cost reduction will be leveraged within the company.

As you can see, economies of scale can be applied to numerous business situations and what it comes down to is improving volume to realize a per unit cost reduction. Understanding this concept and being able to not only apply it, but recognize an opportunity when it presents itself, will help you grow in any role you fill in an organization.