Economies of scale

Introduction:
 One objective of operation managers is to achieve productive efficiency
o This occurs when the average cost per unit of output is at its
lowest.
 The scale of a business has a major impact on the average costs of
production
o Scale in business means size.
o There is a range of output over which average costs fall as output
rises. Over this range larger businesses have competitive
advantage over small businesses in terms of cost.
o Thus business enjoys economies of scale by being large sized up to
an extent
 So economies of scale is a reduction in a firm’s unit costs of
production that result from an increase in the scale of
operations

Factors that influence the scale of operation of a business:

 Owner’s objectives
 Capital available
 Size of the market (small market thus do not need large scale production)
 Number of competitors (more competition lower market share smaller
businesses)
 Scope for scale economies.

Internal economies of scale:

 Cost benefits those arise within the firm. They occur for a number of
reasons
o Purchasing economies of scale
 Large firms will get discount when buying raw materials
and components when buying in bulk
 Also administration costs do not rise in proportion to the
size of the order.
o Marketing economies of scale:
 The marketing costs will increase with size of a business,
but not at the same rate.
 E.g. cost to the sales force of selling 30 product lines
is not double that of selling 15 lines.
 The marketing costs can be spread over a higher level of
sales for a big firm and this reduces the average cost.
o Technical economies of scale:
 Large firms can justify the cost of flow production lines.
Flow production lines produces at mass amount and thus
offer lower unit costs than other production methods.
 Also the most innovative and efficient technologies can be
afforded by big firms and probably by small firms as well.
However, large firms can only justify the cost because they
 produce a huge number of products on which the fixed cost
is being divided. On the other hand small firms will see an
increase in cost because they do not produce enough to
justify the high fixed cost.

o Managerial economies of scale:

 Large firms can afford and employ specialist managers
unlike small firms, which usually have one general
manager.
 Due to the specialists employed for every department in the
organisation efficiency may improve and average cost will
fall.
o Financial economies of scale
 Large firms can sell huge amount of shares and thus
administrative costs of raising the finance lowers
 Also they can get lower interest rates from the lenders due
their size and reputation
 Also large firms have a variety of source from which they
can arrange finance easily.
o Risk bearing economies of scale
 As a firm grows it may well diversify to reduce risk
 Large businesses can also reduce risk by carrying out
research and development
 The development of new products can help firms
gain a competitive advantage over smaller firms.

External economies of scale:

 It is reduction in cost which a business enjoys as the industry grows.
Likely to arise if the industry is concentrated in a particular region
o Labour
 Labour force might build up surrounding the industry, if an
industry is concentrated at a particular region
 Training costs might fall as local schools and colleges may
offer training courses, which are aimed at the needs of the
local industry.
o Ancillary and commercial services
 An established industry, particularly if it is growing tends to
attract smaller firms to serve its needs
 Specialist banking, insurance, marketing, waste disposal,
maintenance, cleaning, components and distribution
services are some examples
o Cooperation
 Firms in the same industry are more likely to cooperate if
they concentrate in the same region
 They might join forces to fund a research and development
centre for the industry.
 Also an industry journal may be published, so that
information can be shared
o Disintegration
  Disintegration occurs when production is broken up so that
more specialisation can take place
 When an industry is concentrated in an area firms might
specialise in the production of one component and then
transport it to a main assembly car plant.

Diseconomies of scale:
 If a business expands the scale of its operations beyond the minimum
efficient scale, diseconomies of scale may result
 This is where average costs rise as output rise
 There are variety of sources of diseconomies of scale
o Internal economies of scale
 Problems arising mostly from managing large businesses
 Communication becomes more complicated
 Coordination and control is more demanding due its
sheer large size
 Motivation may suffer due to alienation leading to
poor management and workforce relations
 Technical diseconomies also arise
o In some cases two small plants is better than
one large plant, if the large plant breakdown
production halts altogether
o External diseconomies of scale:
 These may occur from overcrowding in industrial areas
 The price of land, labour, services and materials might rise
as firms compete for a limited amount
 Congestion might lead to inefficiency, as travelling workers
and deliveries are delayed.

Ways to avoid diseconomies:

 Management by objectives
o Avoids coordination problem by setting clear goals and targets
from each department
 Decentralization
o This gives divisions a considerable degree of autonomy and
independence
o Thus business is operated as more like small business units with
closer control
 Reduce diversification to reduce coordination and communication
problem.

Conclusion:
 The decision to expand the scale of operation is a crucial one
 There likely to be considerable costs involved
o Purchasing land
o Buildings
o Equipment
o Employing more staff
 The capital invested in this will always have alternative uses
 Thus any decision to increase the scale of operation should be well
judged.
 Also producing more should not be confused with increasing scale of
operation. More can be produced by better utilization of existing
resources capacity, where as, increasing scale of operation means using
more of all resources.