What do you mean by economics of scale explain the economics of large scale production?

Economies of scale is the cost advantage of ramping up production. When a business scales up, production cost per unit comes down—the fixed and variable costs are spread over more number of units.

After scaling up, businesses own superior machinery and get volume discountsVolume discount is a discount offered to the buyers to incentivize them when they purchase a large number of products at once i.e. when they place a bulk order. read more on raw materialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods.read more. Larger firms have a competitive edge over smaller players who have limited production capacity and higher production costsProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more. In addition to production, businesses can scale up by investing in advertising or Research & Development.

• Economies of scale concept state that an increase in production reduces the production cost per-unit.
• Scaling up could be internal or external. Internal factors include efficient machinery, specialization of labor, container principle, and bulk-purchase discounts. External factors include tax benefits, government subsidies, improved transportation, and joint ventures.
• Upscaling is very expensive—could require mergers or acquisitions. Most smaller firms cannot raise that much capital.

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Source: Economies of Scale (wallstreetmojo.com)

Economies of Scale Explained

When firms become more efficient in large-scale production, the total production cost increases but their cost per unitCost per unit is defined as the amount of money spent by a corporation over a period of time to produce a single unit of a specific product or service, and it takes into account two components in its calculation: variable and fixed costs. It aids in determining the selling price of the company's product or services.read more declines. This is achieved by using competent machinery and procuring raw material in bulk, at a discounted price. Although there is an increase in production and raw materials, the firm’s fixed costFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more remains the same. Therefore, the fixed cost distributes evenly across the entire output. Ultimately profit marginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more increases.

In contrast, small businesses price their goods or services higher than large organizations—low scalability. After all, small businesses cannot afford discounts—the cost of production is high. In addition, most small firms employ labor-intensive processes instead of machinery, inflating their per-unit cost. Similarly, some businesses do not get discounts due to low purchase volume. Upscaling resolves all such issues.

Economies of Scale Examples

Supermarkets are the most common example of economies of scale. Since they buy goods in bulk, they avail discounts. Therefore, they enjoy the benefit of reduced average costAverage cost refers to the per-unit cost of production, calculated by dividing the total production cost by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output.read more.

Another example is an airline company that invests millions in buying a new plane. If it had only a few customers, the airline would have to charge very high. Airlines serve millions of customers. By doing so they can recoup expensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more despite low charges. Increased volume of production—reduced average cost.

The technology giant Intel Corporation is another good example of upscaling advantages. The company invests massively in semiconductor chips and microprocessors. The company manufactures in large quantities. Therefore, Research & Development costs are very low for one unit.

Graph

Let us consider a hypothetical. Both ABC Enterprise and XYZ Enterprise sell walnuts. For the same quantity, ABC charges $1 more than XYZ. The cost prices and purchase quantities are as follows:

The following graph represents how scalability makes XYZ more efficient:

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Source: Economies of Scale (wallstreetmojo.com)

The graph clearly shows that average cost goes down when the purchased quantity increases. XYZ Enterprise reduced per kg cost by getting bulk purchase discounts.

Internal Factors

Firms can achieve economies of scale by working over internal or controllable factors.

• Division of Labour and Specialization: Each worker should have a particular task. Specialization improves the efficiency of individual personnel.
• Commercial: Like Walmart, many companies purchase goods in sizable quantities to avail discounts.
• Container Principle: If the area of production or storage is increased by 100%, the volume accommodated will increase by 200%. This way, the benefit of expansion is twice that of construction costs.
• Marketing: Spending heavily on advertising and promotion is another up-scaling strategy. Accelerated sales can easily recover the marketing cost. The marketing expenditure per unit is miniscule.
• Technical: Technology-based companies spend excessively on Research & Development. But they recover the investment when a successful product or service takes the market by storm.  
• Financial: Large-scale businesses can get leveraged funds at a lower cost due to established relationships and goodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more. Also, big firms can release initial public offerings (IPOs)An initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more to raise capital.  

• High Risk: Large-scale firms can afford bigger risks.

External Factors

Following are external factors that help in upscaling.

• Tax Reduction: When the government relaxes the tax liabilities on certain products or services—demand can shoot up—higher profits for the business.
• Government Subsidies: Producers of certain goods or services receive subsidies from the government—low production cost.
• Superior Transportation Network: Companies can take advantage of transportation facilities by speeding up raw material procurement and finished goods distribution.
• Skilled and Talented Labour: If labor marketsThe labour market, also known as the job market, is a well-studied market that operates on the supply and demand dynamics of people looking for work (workers) and organizations/people providing work (employers).read more become efficient, companies can employ talented workforce at nominal wages.
• Joint Ventures and Partnerships: The fastest way to scale up is via mergersMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more and acquisitionsAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more.

Disadvantages

Following are the disadvantages of scaling up.

• Diversification Risk: When firms expand their business operationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more across different industries, some of the subsidiaries might underperform.
• Huge Capital Investment: Scalability is expensive—most small firms cannot raise that much capital.
• Limited Market Demand: Customer preference is unpredictable; therefore, the demand for a particular product can fall unexpectedly. In such a scenario, ramped-up production can result in huge losses and dead stock.
• Requires Higher Degree of Control and Management: Scaling up results in a new team of individuals—it takes time for them to function smoothly. Mergers and acquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read more often result in contrasting work cultures.

Economies of Scale Vs. Diseconomies of Scale

The economies of scale principle predict the reduced per-unit cost of production when production is ramped up.

In contrast, the diseconomy of scaleDiseconomies of scale is a state that generally occurs when an enterprise expands in size. The average operating cost increases due to inefficiency in the system, employee incoordination, administration & management issues, and delayed decisions.read more occurs due to the inefficiency in existing production methods. As a result, the average cost rises when the output is increased. Sometimes, diseconomies of scale occur when firms outgrow their potential. Employee costs, compliance costs, and administration costs get out of hand.

Frequently Asked Questions (FAQs)

What is an example of economies of scale?

A small bakery employs five bakers to prepare cakes, the production is low, and so is the profit. Consequently, the firm expands the business by introducing automation into baking. After considerable investment, the bakery increased production by ten times. Over time, the fixed cost spreads over total increased output—per cake upscaling cost is low.

Who classified economies of scale into internal and external?

It was introduced by Alfred Marshall. Marshall was an English economist from London. He emphasized the distinction between internal and external upscaling.

What causes economies of scale?

Businesses scale up by ramping up production, specializing in labor, procuring raw materials in bulk, advertising, investing in research, and raising capital.

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