What are Economies of Scale?

Economies of scale

 

What Are Economies Of Scale?

The theory of economies of scale was proposed by Adam Smith. The theory posits that if economies of scale can be obtained, a country can attain economic growth.

Economies of scale are when a company enjoys a reduction in its average cost of production because of an increase in production or output. This simply means that an inverse relationship exists between cost and output. The higher the units of production, the lesser the average cost incurred in production. 

Economies of scale demonstrate the cost-cutting and competitive advantages that larger companies have over smaller organisations. The greater the company’s size, the greater the cost savings. This is because profits are re-invested in the manufacturing process by companies having a lot of revenue. They can also afford to acquire raw materials in bulk, saving money in the process. Some companies also put aside funding for R&D, which allows them to innovate and improve their product offerings.

Key Takeaways 

  • Economies of scale refer to the cost savings that organisations enjoy as a result of efficient production processes that enable them to produce more for less. It helps businesses become more price competitive and generate more revenue.
  • Internal economies of scale happen within the organisation and includes technical, marketing, managerial, financial, and network economies of scale. External economies of scale are when a company gains an advantage because of events and developments in its own industry or the larger external environment.
  • Diseconomies of scale occur when a corporation or business has reached its maximum point of efficiency. Instead of continuing to reduce costs while increasing output, a company will see an increase in costs as output rises.

There are two types of economies of scale. Internal and external. Internal economies of scale are within the control of an organisation’s management. While external economies are influenced by external factors such as government policies, geographical limitations and industry-related factors. 

Internal Economies of Scale

There are five types of internal economies of scale that typically exist as an organisations expands.

Technical

Technical economies of scale is the cost reductions that a company achieves as a result of increased usage of large-scale mechanical processes and technology.

It gives larger companies more advantages than smaller businesses because they have the capacity to improve and optimise the manufacturing process.

As output grows, they invest in more efficient equipment and optimise processes based on past performance. 

Managerial

When you recruit professional managers or people with competence, you can obtain managerial economies of scale. As a company expands in size, it becomes possible to afford to acquire highly trained people. As a result, various functional units are created that are overseen by these experts, resulting in increased efficiency. In comparison to a small business owner who performs everything in the business without specialist skills, an experienced sales executive or manager recruited in a large organisation will be able to help an organisation generate greater revenues.

Marketing 

When a company can spread its advertising and marketing budget across a larger output, it achieves marketing economies of scale. The unit per cost of advertising and marketing is reduced since these costs are spread over output. Furthermore, larger companies can get better advertising deals and reach a wider audience than small enterprises, resulting in increased brand awareness and influence over brand perception.

Financial 

In contrast to a small business, a large organisation has easy access to low-cost capital. This is due to the fact that large organisations are thought to be more creditworthy. They have assets that can be used as collateral to get a loan. To put it another way, they have better credit ratings than smaller businesses. It is believed that their risk of default is low because of the amount of money they generate in sales and revenue. Again, larger organisations can raise capital by launching an initial public offering (IPO) or issuing bonds on the stock market. They tend to have larger economies of scale since they have better access to more capital.

Network 

Online and eCommerce businesses are examples of businesses that have network economies of scale. This is because a digital business can increase its customer base with little or no additional cost incurred in infrastructure. As a result, businesses in this domain enjoy increasing profitability as they add new customers. 

External Economies of Scale

As previously stated, they are the benefits that an organisation receives as a result of events or variables that occur outside of its control. Industry developments, as well as national economic trends, could be among the contributors.  

External Economies of Scale

  • A rising GDP can lead to increased consumer demand, resulting in economies of scale.
  • When there is an overall growth in the industry that helps organisations gain access to suppliers at a cheaper rate. 
  • Lower cost of doing business instigated by reduced taxes or tax incentives.

Diseconomies of scale

Advantages accrue to an organisation when it expands or grows in size. However, too much growth gives rise to what is called diseconomies of scale.

For example, one of the problems of very large organisations is decreased efficiency. There will be too many people doing the same thing as a result of specialisation of jobs.

Not only that, bureaucracy becomes the order of the day when there are many levels of management. It’s possible that a lack of communication will occur, particularly if the organisation expands internationally. The acquisition of new businesses or mergers may lead to a conflict of corporate cultures. If such organisations don’t learn to deal with cultural differences or if not addressed in time, progress will be slowed. Other sources of diseconomies of scale include a lack of control, having numerous branches, and too many products. Rather than reduced average costs, inefficiencies will lead to increased production costs. At this point, it is said a company’s maximum point of efficiency has been reached. 

In conclusion, companies should aim for a balance between the effects of economies and diseconomies of scale whenever developing strategic plans to expand, so that the average cost of all decisions taken is lower, resulting in improved overall efficiency.

 

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