Economies of scale happen when an enterprise profits for the capacity of its operations. As a business grows, it gains from several efficiencies and synergies. In a nutshell, a higher output leads to lower unit costs (cost advantage). It results in a decrease in average non-fixed costs(variable costs), with an increase in the quantity of output. A firm can implement economies of scale at any stage of its production process.
For example, you have a business where you need to pay staff, rent, or advertisement fees. You cannot pay staff to sit idle, or spend hundreds for rent, for a small number of customers. By applying economies of scale, your costs of production should be less compared to your output. Efficiencies such as financial, technical, or infrastructural factors play a significant contribution to your business as well.
It’s equally important to consider fixed costs as a part of economies of scale. These can take up your business’s expenditure.
Examples of Fixed Costs
Depreciation refers to the bit by bit writing-off of a tangible asset such as plant and equipment. It does not vary as it is incurred with the same value over the life of the asset. For example, you can sell the parts of an inoperable car for $3,000. This price is the car’s depreciation cost or salvage value. If you had bought the car at an initial amount of $15,000, then the total cost of depreciation over its useful life is $12,000.
Amortization often describes the routine decrease in the value of an intangible asset. Intangible assets include Goodwill, Trademarks, and Copyrights. Suppose XYC enterprise spends $20,000 to obtain a patent that expires in 4 years. It should be amortized over the four years before it expires. XYZ enterprise will incur a fixed cost (amortization expense) of $5,000.
- Interest Expense
Borrowing such as loans, bonds, convertible debt, or lines of credit from financial institutions incurs interest expense. These are fixed costs, also known as debt expenses. For example, ABC borrows money from a bank to support its business operation. The initial amount of the loan is $300,000. The annual interest rate is 12%. Its interest rate will be:
Interest expenses= principle* Interest Rate * Period
12/100* $300,000 * 1 = $36,000
Property taxes, rent paid, insurance, salaries, and utility expenses are additional examples of fixed costs.
Economies of Scale Examples
There are two categories of Economies of Scale: Internal and External—the Internal Economies of Scale profits or benefits that occur with the business. By contrast, External Economies occur outside the organization, but within the industry. That makes them more efficient.
Internal Economies of Scale
This model of economies of scale focuses on the long-term growth of the firm. As business increases its range of production, it enjoys economies of scale. Internal economies are those that are unique to each firm. Anything that the firm has control over. Let’s look at a few examples of domestic economies of scale.
Financial Economies of Scale
Large firms have the upper hand of benefiting from reasonable credit rates and availability. Financial institutions offer favorable rates to large firms. The reason being, the risk is notably lower. For example, a new local restaurant is more likely to fail than Mcdonald’s store, which is afforded better rates. Larger firms do not only have access to better prices; they enjoy a more extensive number of financial institutions to borrow from.
Network Economies of Scale
Fundamentally, network economies of scales originate from the fact- the bigger the firm, the more diverse the network. Eventually, the company attracts more new customers. For instance, Facebook’s growing popularity made it top among other social media platforms. Thus, it grew exponentially. Through its diverse network, the amount it could charge for adverts equally grew.
Larger firms enjoy buying in bulk hence at low prices. The higher the purchases, the lower the rates. For example, Walmart can purchase groceries at a lower price than a retail market.
Technical Economies of Scale
As a business grows, it benefits from new production techniques and advanced equipment. For example, a big brand like Kipling has a more sophisticated process of production. It, therefore, has increased efficiencies. However, a self-employed baker is less likely to benefit from a production line of cakes.
External Economies of Scale
External economies of scale refer to the same conditions but within an industry. They occur outside the company. For example, if your government builds a new and better railway network, for a particular service, all the firms in that industry will benefit from the possibility of an enormous influx from customers. It’ll, in turn, decrease production costs. While there are many types of external economies of scale, let’s look at the main ones.
Infrastructure such as schools, roads, railway lines, hospitals will benefit companies in the respective areas. Let us take, for example, clustered banking and financial services in New York. Eventually, the average cost of doing business within that industry becomes lower. Such is an example of positive externalities.
As companies get bigger, they’re able to influence government policies. It may make contributions or threaten close-downs factories. Many jobs can be at risk so that governments may look favorably on their demands.
Occasionally, suppliers may move closer to the firm. For example, Coca Cola has higher operations; its bottle manufacturers operate nearby due to the sheer demand. Therefore, it benefits both the supplier and the firm who profit from cheaper costs.
As we now know, higher production volumes cause the economies of scale. However, they have little to do with variety. The per-unit costs fall as a result of increased production level of products. Eventually, the mass production of products increases the division of labor, specialization, etc.