What are ‘Economies of Scale’
Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger factory will produce power hand tools at a lower unit price, and a larger medical system will reduce cost per medical procedure.
BREAKING DOWN ‘Economies of Scale’
Economies of scale give rise to lower per-unit costs for several reasons. First, specialization of labor and more integrated technology boost production volumes. Second, lower per-unit costs can come from bulk orders from suppliers, larger advertising buys or lower cost of capital. Third, spreading internal function costs across more units produced and sold helps to reduce costs. “Internal functions” include accounting, information technology, and marketing. The first two reasons are also considered operational efficiencies and synergies. The second two reasons are cited as benefits of mergers and acquisitions.
EXAMPLES OF ECONOMIES OF SCALE
In a hospital, it is still a 20-minute visit with a doctor, but all the business overhead costs of hospital system are spread across more doctor visits and the person assisting the doctor is no longer a degreed nurse, but a technician or nursing aide.
“Job shops” are those that produce products in groups such as shirts with your company logo. A significant element of the cost is the “set-up.” In job shops, larger production runs lower unit cost because the set-up costs of designing the logo and creating the silk-screen pattern are spread across more shirts.
In an assembly factory, per-unit costs are reduced by more seamless technology with robots.
A restaurant kitchen is often used to illustrate how economies of scale are limited: more cooks in a small space get into each other’s way. In economics charts, this has been illustrated with some flavor of a U-shaped curve, in which average cost per unit falls and then rises. Costs rising as production volume grows is termed “diseconomies of scale.”
LIMITS TO ECONOMIES OF SCALE
Management technique and technology have been focusing on limits to economies of scale for decades. Today:
Set-up costs are lower due to more flexible technology and equipment is priced more closely to match production capacity, enabling smaller producers such as steel “mini mills” and craft brewers to compete more easily.
Outsourcing of functional services make costs more similar across businesses of various sizes. These functional services include accounting, human resources, marketing, treasury, legal, and information technology.
Micro-manufacturing, hyper-local manufacturing, and additive manufacturing (3D printing) can lower both set-up and production costs. Global trade and logistics have contributed to lower costs, regardless of the size of an individual plant.
In aggregate, the average cost of tradable goods has been falling in industrial countries since about 1995.