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Economies of scale refer to cost savings per unit manufactured as production increases. This can be achieved through bulk purchasing of raw materials, strategic location of facilities, and spreading fixed costs over a greater number of units. Diseconomies of scale occur when negative factors impact the benefits of economies of scale. Finding the right balance between cost and profitability is essential.
Economies of scale are the amount of cost savings per unit manufactured relative to the level of production. In general, an economy of scale will indicate that with the production of additional units, the average cost of production for each unit will decrease, due to the distribution of some of the cost factors over a period of time. An economy of scale can also apply to situations where a company reduces the average cost of operation by opening additional facilities or expanding the operating aspects of the business in some way.
In terms of producing individual units for sale, a company has to purchase raw materials, build a production facility, obtain machinery and equipment, and hire employees to participate in the manufacturing process. Some of these initial costs are fixed and will not change no matter how many units are produced. For example, equipment may be used to produce one thousand units or ten thousand units with no change in the purchase price of that equipment. If more units are produced, the cost of the machinery is spread over a greater number of goods produced, making the cost per unit lower as output increases.
The ability to purchase raw materials in bulk also presents an example of economies of scale. Many suppliers offer materials at lower costs if large quantities are purchased. Therefore, if a company can purchase larger batches of raw materials, there is the potential for a significant reduction in price, sometimes as much as fifty percent. That lower cost for raw materials translates into a lower production cost for each unit that is created using those materials.
One of the other types of economies of scale has to do with the strategic location of the company’s facilities to adequately serve customers. Many retail companies establish large distribution centers that allow stock to be transported to their outlets in a much more cost-effective manner than constantly shipping products from a central remote location. By operating several distribution centers that serve several stores in a given location, transportation costs and other relevant factors are significantly reduced, resulting in more favorable economics for the business.
Along with a basic definition of economy of scale, it’s also a good idea to understand what is meant by diseconomy of scale. While the application may differ slightly from one environment to another, the underlying concept is the ability to identify situations that have a negative impact on economies of scale. This could be situations where there are inflated prices for raw materials or the construction of distribution centers that are too close together. When situations of this type arise, the benefit to the company decreases, thus decreasing the economic viability of following those strategies.
Determining what the economy of scale is in a given situation requires taking a close look at all operating costs, identifying what can and cannot be done to increase profitability while incurring the least amount of cost, and finding the right balance. . Whether referring to industry economies of scale or balancing economic factors in operating on a household budget, the idea is always to produce the most benefit for the least amount of cost.
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