What are Economies of Scale?

Economies of Scale is the manufacturing phenomenon that explains why the more you produce the lower your costs per unit.

 

This mainly happens because, the more you produce the more optimized the manufacturing processes tend to be.

Mainly, due to:

  • Facilities have less downtime.
  • Fixed costs are spread over more units.
  • Raw material becomes cheaper precisely due to Economies of Scale.

 

Economies of Scale can be explained with 2 simple metrics:

  • Cost per Unit.
  • Units Produced.

Cost per Unit and Units Produced

Cost per Unit: Costs divided by units produced.

  • How much cost you to produce one unit of product.

 

Units Produced: The number of products manufactured.

  • Generally limited by facilities.

 

Although you think that it is intuitive that, the more you produce, the lower the cost per unit, it was not until 1776, with Adam Smith’s “The Wealth of Nationsthat someone realized how important this phenomenon is.

 

Let’s see how Economies of Scale work with a simple example that you will understand:

Economies of Scale example

 

Imagine that you want to make your own car.

  • Why not?

 

How much time and effort would it take to design it, build the engine, weld everything, etc.? From scratch.

  • And remember: It must work perfectly and be a safe vehicle.
    • It can’t disintegrate at 120 km/h.

 

Let’s assume that it would take you 20 years.

20 years would imply:

  • 20 x $50,000 annual salary = $1,000,000 in workforce.
  • Materials, tool rental… Let’s assume another $1,000,000.
    • Remember: you are doing everything from scratch.

 

Grosso modo, you would have: A handmade car costs 2 million dollars.

 

Now, imagine that Ford (from the picture) starts a new 100% automatic manufacturing plant that costs 1 billion dollars.

  • To keep things simple, we will omit salaries, energy costs, etc.

 

If they only manufactured one car; your same car, that car would cost 1 billion dollars.

  • What a “magnificent” investment that would be.

 

But… If they produced 1 million cars, the price per unit would be 1,000 dollars.

We know that you are not Ford Motor Company.

  • You don’t have a billion dollars to invest.

 

Now before we talk about how you can take advantage of this principle, we have to mention a classic classification of Economies of Scale.

Types of Economies of Scale: Internal and External

Some economists classify Economies of Scale in 2 different categories:

 

Internal Economies of Scale:

  • The traditional meaning: By Producing more, you reduce Cost per unit.
    • Either by the installation of new machinery, process improvement, etc.
  • It depends only on your Manufacturing process.

 

External Economies of Scale:

  • When external factors multiply the productivity.
    • Promoted by you (generally, a big influential company) or by the Market itself.

 

Example of External Economies of Scale

 

Imagine that you start a Food delivery company (like Uber eats).

 

Among many factors, your earnings would depend on:

  • How quickly your employees can get food to customers.
  • The number of restaurants there are in a city.

 

Where do you think you could expect to have more profits:

  • In a small town with mostly unpaved streets…
  • … Or in a big city with a good urban infrastructure?

 

Exactly: Those are External Economies of Scale.

  • If you were a large company, you could convince a regional government to invest in urban infrastructure.
  • If you were a small company, you couldn’t do anything.

Now comes the question:

  • Can you use Economies of Scale as a small Business?

 

How does this concept apply to Small or Medium-sized companies?

  • Why is it useful?

The importance of Economies of Scale

Although Small Businesses cannot create Economies of Scale as much as large corporations, they take advantage of them every day.

 

How?

  • By buying in Bulk and Retail.

 

 

Economies of Scale allow bartenders to make a profit when you pay $3 for a Coke.

  • They buy 1,000 at $1 each, and sell them to you for $3.

 

Behind every Small business or Company, you will find Economies of Scale.

 

The usual process is:

  • Buy cheaply in bulk, process if necessary, and sell in smaller, more expensive quantities.

 

Now, let’s see some examples:

Economies of Scale examples

Since you surely can think of dozens of large companies examples, we have chosen some more “everyday” examples that will make you understand what Economies of Scale are and how they are present in our daily lives.

 

Let’s begin:

Christmas Business - Economies of Scale example

 

Imagine that you want to make some money in Christmas.

 

After thinking carefully about it, you have decided to start your Christmas Business:

  • You’ll sell Christmas baskets.
    • Baskets with wine, food, sweets, etc.

 

You will use Economies of Scale to make a profit.

 

How?

  • You’ll chose popular items everybody loves.
    • Chocolate.
    • Red Wine.
    • Cheese.
    • etc.
  • Then, you’ll buy them in bulk.

Finally, you’ll prepare the baskets with some decorations.

 

You probably won’t get rich with this Business.

But, if you sell 20 baskets at $100 to your family and friends and earn $20 with each basket

  • You’ll make $400.

 

Maybe, next year, you can promote your baskets to Companies.

  • For employees and managers.

Carpenter - Economies of Scale example

 

Now, let’s imagine that you are a Carpenter.

  • You make a living making wooden furniture.

 

Your tables are sold between $300 and $2,000.

  • If you think this is expensive, check the price of the artisan tables.

 

How is it possible that IKEA sells tables at $50?

 

Well, first of all, IKEA don’t generally use wood.

  • Their cheapest tables are made of chipboard.

 

However, IKEA has suppliers that produce thousands of Tables every week.

These suppliers buy materials at very low prices and also have very low transportation costs.

 

The entire IKEA supply chain benefits from Economies of Scale.

  • From transportation to manufacturing costs.

 

That is one of the keys to their extremely low prices.

  • Besides… You are the one who would put that table together.

Making a Soup - Economies of Scale example

 

In case you still have doubts about how Economies of Scale work, this last example will put an end to your doubts.

 

Imagine that you are preparing a Soup for 10 people.

 

Suddenly, your brother calls you and tells you that your cousins will join the meal:

  • There will be 5 more people.

 

You have to prepare Soup for 15 people.

  • That is 50% more “customers”.

 

Do you think you would have to work 50% more?

  • Of course not.

 

In the worst case, if you were extremely nice, you would buy 50% more food.

  • But, your time, effort, materials employed, tools… Would be the same.

 

If you like to cook, then you already know: It takes almost the same time, effort and money to cook for 2 people as for 3.

  • And 3 is a 50% more than 2.

Summarizing

Economies of Scale is the manufacturing phenomenon that explains why the more you produce the lower your costs per unit.

  • This mainly happens because, the more you produce the more optimized the manufacturing processes tend to be.

 

There are mainly 2 types of Economies of Scale:

  • Internal Economies of Scale: It depends only on your Manufacturing process.
  • External Economies of Scale: When external factors multiply the productivity.

 

Behind every Small business or Company there are Economies of Scale.

The usual process is:

  • Buy cheaply in bulk, process if necessary, and sell in smaller, more expensive quantities.

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