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What Are Economies of Scale
Economies of scale refer to the cost reduction companies can achieve in their business operations by becoming more efficient.
In other words, achieving economies of scale can increase your production and lower your production cost.
For example, if it costs a company $1 million to produce 50,000 units, the company can achieve economies of scale by increasing production to 100,000 units for a total cost of $1.5 million.
In this case, the company used to produce each unit at the cost of $20 per unit, whereas by increasing production to 100,000 and becoming more efficient, it produced the same goods for $15 per unit.
Typically, when you can produce more units, you can spread your cost over a larger number of units allowing you to reduce your cost per unit.
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Who Can Achieve Economies of Scale
Any company can achieve economies of scale by becoming more efficient and lowering its production costs or costs to render services.
In most cases though, larger organizations tend to benefit the most from economies of scale as they have the potential to reduce more costs.
You can take advantage of economies of scale when you can scale your business by lowering your production cost.
By cutting costs and maintaining product quality, companies become more competitive in their market.
On the other hand, smaller companies tend to struggle more with economies of scale as they tend to produce less than larger organizations.
By producing less, the company must spread its costs over a smaller number of goods produced.
As a result, it will have to charge more than a larger organization who was able to increase production and spread its costs over a larger number of units produced.
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How Economies of Scale Work
You can achieve economies of scale in several ways to lower your cost per unit.
You can lower your fixed costs per unit by producing more and spreading your costs over a larger output.
You can lower your variable costs per unit by becoming more efficient in your production.
To achieve economies of scale, you should get specialized labor along with the proper technology to help you increase your production.
The more units you can produce, the more you can lower your cost per unit.
Another way you can achieve economies of scale is to take large orders from clients.
If you must mobilize your internal teams, purchase resources, and produce goods, you are better off producing a larger number of units in bulk as opposed to taking small individual orders.
Also, you can take advantage of economies of scale by lowering your cost of capital.
If you can produce more, become more efficient in producing your goods, take bulk orders, and reduce your cost of capital, you are on your way to achieving economies of scale.
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Types of Economies of Scale
There are two main types of economies of scale: internal economies of scale and external economies of scale.
Internal economies of scale are when a company can lower its production costs internally.
For instance, the company can adopt technologies to increase production at lower costs.
The company can purchase its raw material in bulk to benefit from larger supplier discounts.
The company can change its production process to create a more efficient production line.
These are all internal measures a company can take to lower its costs per unit.
External economies of scale are those that are achieved due to external factors that affect the company’s industry.
For example, a company can hire a more skilled workforce to produce more efficiently.
The company can take advantage of government subsidies and tax credits to reduce its cost per unit.
With external economies of scale, the objective is to use external factors to reduce your production costs.
Economies of Scale FAQ
What are economies of scale?
“Economies of scale” refer to the cost advantage a company can achieve by increasing production.
The idea is to increase output in such a way that the cost-per-unit decreases.
For example, if it costs $100,000 to produce 1,000 units (at $100 per unit), you should increase production to 2,000 units at the cost of $150,000.
You are effectively doubling your output, but your cost per unit goes down to $75 per unit.
What are economies of scale examples?
Let’s look at an example of economies of scale to see how it works.
Imagine that it costs a company $25 to produce each unit, where $15 is fixed costs, and $10 is variable costs.
The company can lower its fixed costs by producing more goods and spreading its production costs over larger units.
As for the variable costs, the company can implement technologies and automation to produce goods more efficiently.
If the company can reduce its fixed cost to $12 per unit and variable cost to $8 per unit, then it has reduced its production cost by 20%.
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What are diseconomies of scale?
Diseconomies of scale refer to a situation where a company increases output but its average cost per unit goes up.
For instance, a company may achieve economies of scale in its marketing operations but suffer diseconomies of scale in its management team.
A company should consider the impact of the economies of scale it is looking to achieve holistically as opposed to focusing on one unit without seeing the ramifications on other units.
How do you define economies of scale?
Economies of scale can be defined as the decrease in a company’s cost of production as the company’s production is scaled.
In other words, the more the company increases its output, the more it can lower its production costs.
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How can a company achieve economies of scale?
There are different methods a company can achieve economies of scale.
Fundamentally, there are two types of economies of scale: internal and external economies of scale.
Internal economies of scale are when a company reduces its internal costs and becomes more efficient in reducing costs as it increases its output.
External economies of scale are external factors the company uses to reduce costs, such as applying for subsidies, getting tax credits, and so on.
There are other ways that economies of scale can be achieved, such as through monopoly power, managerial economies of scale, financial economies of scale, and network economies of scale.
Takeaways
So there you have it folks!
What are economies of scale in business?
In a nutshell, economies of scale refer to a company’s cost advantage in scaling its output and reducing its production cost per unit.
The more a company can reduce its cost per unit, the more it can produce more with the same budget.
You can achieve economies of scale in virtually any organization and apply it to any aspect of the business, such as marketing, production plan, a specific department, or the entire organization.
Larger companies tend to be able to better achieve economies of scale as they can increase production and cut excess costs.
Now that you know what economies of scale mean and how it works, good luck with your research!
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