Definition of economies of scale: The observation that the unit cost of production tends to decrease when higher the quantities are produced.
What are economies of scale?
Economies of scale are the cost advantages achieved when a business increases its output. These are a microeconomic concept which you’ll come across in the best economics books.
The reason why economies of scale exist, is because there are two types of cost to produce a good or service:
Variable costs include raw materials, labour for assembly, and packaging. These are incurred for each item, and therefore increase in line with the quantity produced.
Overheads are only indirect linked to each unit produced, such as the cost of running a factory and the administration of running the general ledger, payroll and other accounting functions of a business.
These don’t tend to increase in line with production – a business doesn’t need to hire additional payroll clerks as a result of increasing production by 5%.
These means that the higher the quantity produced, the lower the overhead costs per unit. This means that total cost (variable cost + overhead) begins to fall.
A real example of economies of scale
Imagine a pizzeria produces 100 pizzas a day. The cost of ingredients, the wood for the pizza oven, and the chef’s time comes to £1.20 per pizza. These are the variable costs and will incurred for each pizza made.
The pizzeria has fixed overhead costs of £450 per day. This includes the rent, business rates, the wage of the customer-facing staff member and a manager.
What’s the cost of just one pizza per day?
The answer would be 1 x £1.20 = £1.20 variable costs, plus £450 of overheads. Thus the total cost of producing just a single pizza is actually £451.20. That’s a pricey pizza.
What about 100 pizzas per day?
The answer would be 100 x £1.20 = £120 variable costs, plus £450 of overheads. That’s £570 for 100 pizzas, or £5.70 each. If the Pizzeria sells their pizzas for £6 or more per pizza, they’re in profit!
What about 500 pizzas per day?
This would give 500 x £1.20 = £600 + £450 overheads. That’s £1,050 for 500 pizzas. That works out as just over £2 per pizza. With these
So in summary:
- The first pizza costs £451.20
- 100 pizzas cost £5.70 each
- 500 pizzas cost £2 each.
And that’s with the raw ingredients and labour being bought at the same cost in all scenarios.
Economies of scale come primarily from the overhead costs being shared across more units of output.
What other drivers cause economies of scale?
We’ve explained how sharing a fixed overhead cost across a higher production level will result in a lower total cost per product. But this isn’t the only reason why it becomes cheaper to manufacture or offer a service at scale. Here are some other reasons:
Businesses can negotiate lower costs for variable costs by purchasing in bulk and enjoying a discount. If an order is sufficiently large, the business could negotiate a better price with the supplier.
Workers become more efficient at tasks when performing them in large batches, as this video shows. This means that less time is spent on each unit, reducing the variable cost further.
Delivery becomes more efficient – a high output factory can ensure that it will consistently fill vans or trucks which carry its goods to the customer. This ensures that the delivery cost per unit is as low as it can be.
High volume can reduce wastage – a small town patisserie might need to throw away 40% of their products at the end of a day, due to the inconsistency of demand across its varied range. With higher footfall, the pattern of orders will be more consistent day-by-day and the patisserie can better plan to meet rather than exceed demand.
How is the phrase economies of scale used in a sentence?
“Large capital expenditure is required to achieve economies of scale in the manufacturing process.”
How does the definition of economies of scale relate to investing?
Investors also benefit from economies of scale, as you will find that it is more efficient to run a larger investment portfolio than a small one.
If you compare stockbrokers and financial advisers, you will notice that some fees are flat or fixed. This means they act like an overhead, and therefore become disproportionate when investing little money.
This is why in my guide How to invest £1,000 I suggest that investors reduce their investing costs by picking variable fee structures rather than fixed fee structures. This will help ensure that a small sum isn’t eroded by high fees.