What are Economies of Scale?

Economies of scale is a term used to describe situations when the cost of producing a single unit of product decreases when the total number of units produced increases. There are two sets of costs associated with the production of goods: fixed costs and variable costs.

Economies of scale can be achieved in two main ways:

  • Reducing the fixed cost for the production of one unit. This can be achieved by spreading the fixed costs across a large number of output units.
  • Reducing the variable costs per unit.

The cost centers for the production of any goods are:

  • Land
  • Facility
  • Machinery
  • Labor
  • Automation
  • Energy charges
  • Raw materials

Some of the costs above will fall under fixed costs and some are variable costs.

Reducing fixed costs

The fixed cost of production will include land cost, facility cost, automation, machinery, and labor. When more goods are produced the fixed cost will be spread across a large number of units. This reduces the fixed cost incurred per unit produced. But it is not a straightforward problem of increasing the number of goods produced. It becomes an optimization challenge that can be explained with an example.

Consider a production facility that is built to produce pencils. The facility has an area of 1,000 square feet. Operating one pencil production machine requires an employee and 10 kW of power every day. Each machine needs a space of 100 square feet, thus the maximum number of machines that can be placed in a facility is 10. Each machine can produce 1,000 pencils every day.

The facility has space to produce a maximum of 10,000 pencils every day with 10 machines. Adding machines will add to the capital expenditure for the machines, labor charges for the employee at each machine, and energy charges for 10 kW of power per machine every day. Until the per day sales reach 1,000 pencils, the cost per pencil will decrease. 

Once the factory needs to produce more than 1,000 pencils, another machine needs to be installed. Installing additional machines increases the costs and later gradually reduces the per-unit cost until sales reach 2,000 pencils per day. This will go on until sales reach 10,000 pencils daily. Once that number is crossed, the company needs to build a new facility, which will increase the cost.

This example illustrates that it is an optimization problem to be solved. Along with strong demand for a large number of goods, companies also need robust operations know-how to reduce the fixed costs per item produced.

Reducing variable costs

Energy charges and raw material costs are the most common variable charges incurred in production. When a large quantity of materials is needed or energy is consumed, the manufacturer can put pressure on its suppliers to supply raw materials and energy at lower costs. 

If the supplier is not amenable to the request, the manufacturer can look for other suppliers who will supply the raw materials in bulk at a lower cost. To exert pressure, the manufacturer must comprise a substantial percentage of the supplier’s sales. Ordering raw materials in bulk will help to set favorable terms of payment and eventually will reduce the variable cost per unit of product.

Economies of scale refers to a favorable cost structure achieved when the production volume rises. If the sales are not able to catch up with the production, there will be excess inventory contributing to additional costs, such as the cost of storage. Achieving economies of scale is a function of rising demand and optimal solutions to cost optimization problems.