By increasing production, we can take advantage of economies of scale and lower our average cost per unit, even if our total costs increase. This allows us to earn a higher profit margin and net income, making it worthwhile to increase production to meet demand.

1. 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.

2. 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 company's 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.

3. Economies of Scale - Wal-Mart
• To see economies of scale in action,
 let's assume that Wal-Mart can acquire a DVD from a supplier for
$5, while it costs one of Wal-Mart's 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 can't charge that little, because
at a cost of $11 per DVD, it would be losing money.

4. 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 industry's 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.

5. 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.

6. 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.

7. 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 don't 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 don't know? It's called economies of
scale

8. 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 = $ 2.00
2 rods @ $ 1.50 each = $ 3.00
5 bolts @ $ 0.25 each = $ 1.25
5 spinners @$ 1.00 each = $ 5.00
30 minutes labor@$12.00per hour= $ 6.00
Total $17.25

9. 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,
we'll need to hire a production manager to keep operations running
smoothly. we'll 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 we'll
simply decrease our net income:

10. Economies of Scale - business
forecasting
300 Units 600 Units
Revenue $7,500 (300 units @ $15,000 (600 units @
: $25) $25)
COGS: $5,175 (300 units @ $10,350 (600 units @
$17.25 $17.25)
Gross $2,325
profit:
Maintena $1,000 (contractor) $1,500 (maintenanc
nce: e manager)
Shipping: $300 (1 trip/week) $600 (2trips/week)
$2,000 (production
manager)
Net $1,025 (13.7% of $550 (3.7% of
income: sales) sales)

11. Economies of Scale - business
forecasting
 What do we do? The market won't allow a price increase. we might
lose some customers because we can't meet demand. But, looking
at the figures, it doesn't seem to make sense to work more and
earn less

12. 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).

13. Economies of Scale - business
forecasting
 Let's look at the new per-unit cost structure with an output level of
675 units:
4 knobs @ $ 0.45 each = $ 1.80
2 rods @ $ 1.40 each = $ 2.80
5 bolts @ $ 0.20 each = $ 1.00
5 spinners @ $ 0.80 each = $ 4.00
27 minutes labor@$12.00per hour= $ 5.40
Total $15.00

14. 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)

15. 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:

16. 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 we'll probably earn
more.