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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Economies of Scale

What it is:

Economies of scale is a term that refers to the reduction of per-unit costs through an increase in production volume. This idea is also referred to as diminishing marginal cost.

How it works (Example):

Let's assume that it costs Company XYZ $1,000,000 to produce 1 million widgets per year (or $1.00 per widget). This $1,000,000 cost includes $500,000 ($0.50 per widget) of administrative, insurance, and marketing expenses, which are generally fixed, as well as $500,000 ($0.50 per widget) of variable costs.

Now, let's suppose that XYZ decides to produce 2,000,000 widgets next year. In this case, the variable costs will double, because the number of items produced has doubled. Thus, variable costs will rise from $500,000 to $1,000,000 (2 million x $0.50 each = $1,000,000). However, the firm's fixed costs will not change regardless of the number of widgets manufactured. As such, fixed costs will remain at $500,000.

In this example, the total cost to produce 2 million widgets will rise to $1,500,000, and therefore the cost per widget will fall to $0.75 ($1.5 million/2 million widgets). Because the fixed costs have been spread over a larger number of units, the net cost per unit will decline from $1.00 to $0.75.

Obviously, if XYZ decided to increase its production capacity to 3 million widgets, then its per-unit costs would fall even further. Variable costs would increase to $1,500,000 (3 million widgets x $0.50 each = $1,500,000). But again, fixed costs would be unchanged at $500,000. Therefore, the total cost to make 3 million widgets would rise to $2,000,000, but the per-unit cost would drop to just $0.66.

As production ramps up, total costs will also rise. However, because XYZ can spread its fixed costs over more units -- or scale its business model -- it is able to reduce the costs incurred to produce each widget. However, note that the first 1 million increase dropped the price by $0.25 each (from $1.00 to $0.75), but the next increase only resulted in a $0.09 decline (from $0.75 to $0.66). Thus, costs are said to be decreasing at a decreasing rate. As such, as volume levels rise, the cost savings impact on each new unit is slightly smaller than the one before. This concept is closely related to the law of diminishing marginal returns. In any case, the firm's costs can never fall below $0.50 per unit, unless the company can also find a way to decrease its variable production costs.

Why it Matters:

When a company can effectively scale its business and cut costs on a per-unit basis, this often gives it the flexibility to:

  • Drop its prices (thereby attracting more customers)

  • Charge the same amount and pocket a higher profit

...or some combination of the two. Spreading fixed costs over a larger production base is one way to generate operational efficiencies. Other ways include specialization of labor, reorganization of key processes, implementation of new technology, or the purchase of materials at bulk prices.

Managers often calculate projected economies of scale in order to determine appropriate production levels. Although economies of scale are often an incentive to expand production, the creation and manufacture of new products often turns out to be less efficient than expected. The need for additional managerial expertise or personnel, higher raw materials costs, a reduction in competitive focus, and the need for additional facilities can actually increase a company's per-unit cost. When this happens, it is commonly referred to as diseconomies of scale. Furthermore, there is no guarantee that the extra units will ever be sold, and the capital used to produce them might be tied up in slow-moving inventory.

However, when executed correctly, economies of scale can help companies gain significant competitive advantages. Not only do they often lead to greater profitability, but they can also eliminate less-efficient competitors or discourage potential rivals from entering the market. Occasionally, economies of scale can even lead to an oligopoly, where only a handful of companies produce the majority of an industry's output. In rare cases, they can even lead to a monopoly-like environment.

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