Economies of Scale Companies that can deliver their goods or services at a low cost, typically from economies of scale, have a distinct competitive advantage because they can undercut their rivals on price. Likewise, companies with low costs can price their products at the same level as competitors, but make a higher profit while doing so. This type of moat creates a significant barrier to entry, since a prohibitively large amount of capital is often required to achieve a size needed to be competitive in a market.
Economies of Scale - Wal-Mart Wal-Mart WMT is perhaps the most salient example of a company benefiting from economies of scale, and for good reason. As a dominant player in retailing, the companys size provides it with enormous efficiencies that it uses to keep costs low. For example, its size allows Wal-Mart to do its own purchasing more efficiently since it has roughly 5,000 large stores worldwide. This gives the company tremendous bargaining power with its suppliers. Not only does it get its products cheaper, but its size allows it more inexpensive distribution. In addition, it has an enormous amount of information concerning consumer likes and dislikes, and it can spread its best practices across its entire store base.
Economies of Scale - Wal-Mart• To see economies of scale in action, lets assume that Wal-Mart can acquire a DVD from a supplier for $5, while it costs one of Wal-Marts smaller competitors $6. It also costs Wal-Mart $4 to distribute the DVD and pay for the overhead costs of the stores, while it costs the smaller competitor $5 to do the same. Wal-Mart can then sell the DVD for $5.50, and still make a $0.50 profit. The smaller competitor cant charge that little, because at a cost of $11 per DVD, it would be losing money.
Economies of Scale - Dimensions Internal economies of scale• Technical economies of scale• Specialization of workforce• Learning by doing• Hire specialists External economies of scale• External economies of scale occur outside of a firm but with in an industry. Thus, when an industrys scope of operations expand due to for example the creation of a better transportation network, resulting in a decrease in cost for a company working within that industry, R&D activities in universities, external economies of scale have been achieved.
Technical economies of scale Occur when a business invests in new technology and is able to increase production. As a result, production costs per unit will fall.
Specialization of workforce• Division of labor is the specialization of cooperative labor in specific, tasks and like roles. Historically an increasingly complex division of labor is closely associated with the growth of total output and trade, the rise of capitalism, and of the complexity of industrialization processes.
Economies of Scale - business forecasting• Imagine we work for a company in a buoyant sector. our sales are increasing, and we could sell more of our product if we made more units. However, our nervous about the risks of hiring more people – and we had also need to hire a production manager to run a larger team. Plus, we assume we had still make the same profit on each item sold. we dont think the increase in volume would offset the cost of extra staff, so we decide to keep producing the same quantity. Our competitors, however, have had a lesson in economics. They know that growth and increased production could bring their costs down, and therefore increase profit per unit. What do they know that we dont know? Its called economies of scale
Economies of Scale - business forecasting• Without Economies of Scale suppose that we manufacture widgets. This is our current cost structure for each unit –4 knobs @ $ 0.50 each = $ 2.002 rods @ $ 1.50 each = $ 3.005 bolts @ $ 0.25 each = $ 1.255 spinners @$ 1.00 each = $ 5.0030 minutes labor@$12.00per hour= $ 6.00Total $17.25
Economies of Scale - business forecasting If we produce 300 widgets per month, our manufacturing cost of goods sold (COGS) is $17.25 x 300 = $5,175. Each widget sells for $25, leaving you with a gross profit of $2,325 per month, which is a 31% gross profit margin. With the higher demand for your widgets, we could increase production to 600 units per month. To increase production, however, well need to hire a production manager to keep operations running smoothly. well need a bigger truck to ship our units. we might even have to hire a full-time maintenance manager instead of using a part-time contractor. When we add it up, it seems as though well simply decrease our net income:
Economies of Scale - business forecasting300 Units 600 UnitsRevenue $7,500 (300 units @ $15,000 (600 units @: $25) $25)COGS: $5,175 (300 units @ $10,350 (600 units @ $17.25 $17.25)Gross $2,325profit:Maintena $1,000 (contractor) $1,500 (maintenancnce: e manager)Shipping: $300 (1 trip/week) $600 (2trips/week) $2,000 (production manager)Net $1,025 (13.7% of $550 (3.7% ofincome: sales) sales)
Economies of Scale - business forecasting What do we do? The market wont allow a price increase. we might lose some customers because we cant meet demand. But, looking at the figures, it doesnt seem to make sense to work more and earn less
Economies of Scale - business forecasting Adding Economies of Scale• If we increase the size of our raw material orders, our suppliers will give you a discounted price – so the actual cost to produce each unit will go down.• The shipping company would decrease our per-trip rate from $300 to $250, because bigger orders, and more orders, mean more business for them.• Hiring production and maintenance managers would increase efficiency, so we could actually produce 675 units, instead of 600 units, with the same labor costs (a 12.5% increase).
Economies of Scale - business forecasting Lets look at the new per-unit cost structure with an output level of 675 units:4 knobs @ $ 0.45 each = $ 1.802 rods @ $ 1.40 each = $ 2.805 bolts @ $ 0.20 each = $ 1.005 spinners @ $ 0.80 each = $ 4.0027 minutes labor@$12.00per hour= $ 5.40Total $15.00
Economies of Scale - business forecasting Variable costs alone have brought down our per-unit cost. Now, look at our income figures again – 675 units Revenue: $16,875 (675 units @ $25) COGS: $10,125 (675 units @ $15) Gross profit: $6,750 Maintenance: $1,500 (maintenance manager) Shipping $500 (2 trips/week) $2,000 (production manager) Net income: $2,750 $2,750 (16.3% of sales)
Economies of Scale - business forecasting Although our total cost (COGS plus maintenance and shipping) is higher, our average cost per unit has decreased – therefore your profit margin has increased. 300 units 675 units Total cost: $6,475.00 $14,125.00 Cost per unit: $21.58 $20.92 Gross profit 13.7% 16.3% margin:
Economies of Scale - business forecasting economies of scale is on the cost per unit, or average cost (AC) – not the total cost. If we take advantage of economies of scale, our unit cost will typically decrease as the number of units increases – so well probably earn more.