Generally, in a business, it is assumed that the more the number of units produced, the more the production cost will be. However, that is not necessarily true because fixed costs remain fixed over a certain period, irrespective of the sales. When a company produces more and more units, the average fixed cost reduces.
Meaning of Economies of Scale
Economies of scale refer to the benefits a company receives because of increasing production units. For small businesses, the sales are lower and the fixed cost is heavy to bear. But if the production increases, it calls for benefits such as discounts from suppliers, bulk sales, distribution channels etc. When the production units increase over time, the average fixed cost reduces.
One way to understand the economies of scale is the cost advantage a company has because of its scale of operations. It depends on the product value, and when the cost per unit gets reduced, the scale increases. In a market-based economy scale, market control depends on infrastructure and technical and organisational factors.
The economies of scale are able to manage business and organisation situations on various levels, such as in a production plant. When production increases, the average price drops and the cost increases, there are savings on a scale.
Returns to Scale
While economies of scale are the benefits after production, return to scale is the change in productivity due to an increase in the inputs.
Suppose a savoury product manufacturer adds an extra spice or condiment to its product that enhances the taste, and the demand for the product will increase. The return to scale is the proportionate increase in revenue due to the additional spice or condiment.
However, sometimes, these returns can be detrimental also.
Types of Economies of Scale
Various factors affect the economies of scale of a company, which can benefit from rankings due to its internal capabilities and external reasons. Therefore, it is essential to know how a company can leverage resources internally and externally.
Internal Economies of Scale
Internal resources of a company help derive the internal economies of scale. If the company makes the best utilisation of resources, it can help generate rankings. Some of the internal economies of scale can be as follows –
1. Production equipment/machinery
3. Labour/manpower efficiency
4. Bulk purchase of raw materials
While internal economies to scale are controllable and manageable by the company, external economies are dependent on external sources. Let us have a look.
External Economies of Scale
External economies are the factors that often affect a company and the whole industry. These cannot be generated but used in the best possible way. Some of the external economies of scale can be as follows-
1. Geographical location of the business
2. Local governments
3. Industry-specific policies
4. Technological advancement
Factors Influencing Economies of Scale
Economies of scale provide cost advantages to a company. Besides, it has an impact on other segments of the business too.
1. Purchasing Power
Suppose a company has sufficient capital to purchase the material required for production. In that case, they can buy larger quantities and thus avail discounts. If a company doesn’t have enough money, it may resort to external borrowings such as loans, overdrafts etc.
The infrastructure at manufacturing units, the machines, and the equipment can directly affect the outputs and productivity. Besides, equipment and machinery also need maintenance and repair.
3. Business Vertical
The business vertical of the company also influences the economies of scale of the company. Specific verticals have tax exemptions or receive subsidies or may have lower production costs and higher demand in the market. That also helps in deriving the scales.
Any business runs on its human resource, and that human resource, no matter how skilled may it be, needs to be trained. If the company’s human resources, be it the labourers, wage workers or even the clerical staff, are trained well, it increases their productivity and thus the overall output.
5. By-Products and Waste Management
When any product gets manufactured, there is a lot of waste generated. Sometimes, the company can use the trash to make other products. Such products are referred to as by-products. When in production, one cannot convert production waste into by-products; you can sell it out to other industries where such debris can be helpful to the company. Such utilisation of waste can generate money and add to revenue.
Economies of Scale – Examples
Above, we had an overview of the economies of scale and how they are derived. Now we will see some examples to know practically how they are-
1. Suppose a company ‘A’ needs money to expand its production. It doesn’t have enough capital but holds good credibility and can quickly raise funds through investors.
2. A company’s manufacturing unit wants to produce 100 units daily, requiring ten workers to achieve that output. However, it has only eight workers, and hence only 80 units can be made. However, if they pay each worker the overtime wages and get the work done, they wouldn’t have to compromise on the outputs.
3. Suppose a company ‘X’ wants to produce some unique item for which it requires a rare material that is not readily available. But it has connections with the distribution chain of that material, negotiates it and procures the material. The production will not hinder, therefore. Thus, one can generate more sales.
4. Another example is that suppose a manufacturing unit requires purchasing heavy machinery for the factory. And the government has declared tax exemptions on the purchase of machinery for such units, and it can generate purchasing power for the company.
When a company’s production increases, its average fixed cost becomes lower, providing cost advantages to the company. Besides, other factors such as capital, labour efficiency etc., aid in generating economies to scale. Thus, it is crucial to understand what causes economies of scale and how the resources can be utilised to generate maximum revenues.