What happens when there is economies of scale?
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Economies Of ScaleEconomies of scale (ES) can be defined as a decrease in the average costs of production when there is an increase in the scale of production of a company, it refers to a situation when the number of production surges and the cost per unit dips. It occurs when there is a reduction of costs given a proportional rise in production. Economies of scale enable a firm to sell its products at more competitive prices and to capture a considerable share of the market. Read More..LATEST UPDATES ON ECONOMIES OF SCALE
Understand the Economies of Scale Concept Economies of Scale occur when the production costs on a per-unit basis decline as the output increases, resulting in cost savings and higher profit margins. Table of Contents
Economies of Scale DefinitionAs a company’s revenue (and production volume) increases, the per-unit costs decrease as expenses are spread across a higher number of units. The concept of economies of scale focuses on the relationship between the cost advantages received by a company and its rate of output (i.e. the volume of units produced and sold).
All else being equal, if the output of a company rises, there should be a proportional reduction in the cost per unit of production. Why? The average cost per unit decreases as more output units are produced due to the total costs being able to be spread across a higher quantity of goods. Cost Structure and Economies of Scale ImpactCompanies incur two types of costs:
As a company continues to grow in size, companies with a higher percentage of fixed costs in their cost structure benefit from seeing these fixed costs being spread out over a higher number of produced units, translating into lower fixed costs per unit on average. On the other hand, those that operate in industries where the marginal cost of each unit cannot be reduced as output increases – i.e. service-oriented industries (e.g. hospitality, consulting) whose cost structures are more skewed toward variable costs – do not see the type of reduction in average costs. Therefore, companies in industries with high fixed costs benefit the most from economies of scale, creating barriers to entry for potential competitors and protecting their profitability. Economies of Scale BenefitsSince unit costs per product decline as volume increases, new entrants come into the market at a significant cost disadvantage from the start. The clear benefit of economies of scale is the positive impact on the profit margins of a company, which most companies strive to achieve with greater scale. In effect, the company should be capable of selling its products at lower prices and capturing more market share – as well as protecting itself from new entrants attempting to steal customers via price cuts. Not all companies that have reached a high level of scale are low-cost providers like Costco and Walmart, but most have the flexibility to:
Economies of scale create a barrier to entry that can deter new entrants, as only incumbents tend to be able to afford to offer products at lower prices, whereas smaller providers typically must increase prices to produce more revenue. Another benefit of economies of scale is that higher volume orders from suppliers can lead to more negotiating leverage and thus more discounts, resulting in lower inventory costs and longer days payable outstanding (DPO). To summarize, the advantages of economies of scale are:
Diseconomies of ScaleThe limitation to the economies of scale is termed “diseconomies of scale,” which is when a company reaches a certain size where its operating efficiency actually begins to decline. The source of diseconomies of scale can stem from:
Beyond an optimal production quantity, the cost per unit changes direction and the curve begins to curve upward (i.e. creating a “U” shape on the cost per unit vs production quantity graph). The shape of the curve indicates how any units produced past that optimal point increases production costs per unit, as opposed to decreasing them. Economies of Scale ExampleLet’s say, for instance, there is a company that sold 200 product units at a total cost of production of $5,000. Given, those two assumptions, we can back out the average cost per unit of $25.
In the next fiscal year period, the company manages to sell 1,000 product units at a total cost of $8,000.
Despite the production output doubling from 200 to 400 units, the total costs incurred increased from $5,000 to $8,000 – an increase of 1.6x. This is due to the associated increase in variable costs as production volume increased. Hence, the average cost per unit is now $20, representing a 20% reduction from $25 in the prior year. Internal vs External Economies of ScaleThere are two main types of economies of scale:
Apple Example – Economies of ScaleOne real-life example of a company benefiting from economies of scale is Apple, particularly in the context of working with its suppliers. Since Apple sells millions of iPhones each quarter, Apple can commit to component orders at significant volumes, with favorable negotiating leverage that results in volume-based supplier discounts. There are also many Apple products that share the same components (e.g. processing chips, display screens), enabling Apple to place even larger (and even better-priced) orders. Step-by-Step Online Course Everything You Need To Master Financial ModelingEnroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks. Enroll Today What are the main benefits of economies of scale?Economies of scale are cost reductions experienced by businesses when their level of output grows. Cost reduction opens up more opportunities for businesses to lower their pricing structure in order to obtain more sales. This is the primary benefit of economies of scale.
Does economies of scale lead to market failure?In addition, increasing economies of scale may push all producers out of a market if none can charge enough to cover costs. In that case, production ceases even if it benefits society. Hence, markets fail under increasing economies of scale.
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