What is Economies of Scale?

Companies use economies of scale to reduce the operational costs and increase the volume of production. This concept was first implemented in the 1840s by various companies across Europe. It is currently used among large and small companies all over the world. Most financial managers value it because it has been historically associated with increasing levels of private wealth.

How It Works

Companies are said to have achieved economies of scale when they manufacture more goods on a larger scale with minimal input costs. This typically means that the company is in a better position to reduce its costs as the production volume increases.

Take, for example, a company that spends $500,000 to manufacture 100,000 items per month at the cost of $5 for each item. The $500,000 includes $250,000 for fixed costs and $250,000 for variable costs. Suppose the company decides to increase its production volume to 200,000 items over the next one month; its variable costs will increase twofold. In this case, the cost of the variables will move from $250,000 to $500,000 while the fixed costs will not change. The total cost incurred to produce 200,000 items will rise from $500,000 to $750,000. As a result, the cost per item will fall from $5 to $3.75. The reduced cost per unit is due to the expanded volume of production.

How Companies Can Increase Production Volume and Keep Costs at Minimum

The division of labor and specializations are the two main ways to increase production volume and reduce costs. These techniques enable the employees to major on specific tasks and improve their skills with time. The tasks are then performed faster and better, leading to efficiency and reduced costs of production.

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Increasing the number of raw materials ordered can also be effective. This is because increasing the size of raw materials ordered will prompt the suppliers to offer discounted prices, making the cost of production per unit to go down. An increase in the number of raw materials ordered and the production volume will also make the shipping company to reduce its rates per trip. This happens because of bigger and more orders, which means more business for the shipping company.

Companies can also increase their production volume and reduce costs by hiring production and maintenance managers. Hiring these individuals increases efficiency among employees. For instance, they can guide them to produce 900 units instead of 800 with the same labor costs.

Benefits of Achieving Economy of Scale

A company that achieves an economy of scale can effectively attain the flexibility to reduce its prices. Reducing prices leads to more customers and increased sales volumes. The company also has the flexibility to use a constant price tag on its products and still get great profits.

A company that achieves an economy of scale operates more efficiently than others. More efficiency means better ability to invest in the latest technology and new equipment. This leads to increased output, less down times and quality products. A good economy of scale can also enable the company to donate more products to non-profit organizations. This leads to greater sense of social responsibility.

Companies should always strive to ensure their rate of production does not increase the overall costs. This can only be done if the business puts into place various initiatives to achieve economies of scale.