economy of scale

n., pl., economies of scale.
The decrease in unit cost of a product or service resulting from large-scale operations, as in mass production.

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economic principle that as the volume of production increases, the cost of producing each unit decreases. Therefore, building a large factory will be more efficient than a small factory because the large factory will be able to produce more units at a lower cost per unit than the smaller factory. The introduction of mass production techniques in the early twentieth century, such as the assembly line production of Ford Motor Company’s Model T, put the theory of economies of scale into action.

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Economies of scale refer to economic efficiencies that result from carrying out a process (such as production or sales) on a larger and larger scale. The resulting economic efficiencies are usually measured in terms of the unit costs incurred as the volume of the relevant operation increases. "Scale economies can be present in nearly every function of a business, including manufacturing, purchasing, research and development, marketing, service network, sales force utilization, and distribution," wrote Michael E. Porter, author of Competitive Strategy. "Scale economies may relate to an entirely functional area, as in the case of a sales force, or they may stem from particular operations or activities that are part of a functional area."

Many small business operations are of insufficient size to utilize economies of scale to major strategic advantage, though there are instances in which even smaller businesses can use such economic efficiencies to gain an edge over startup competitors. Indeed, John Pearson and Joel Wisner noted in Industrial Management that "since company productivity is generally defined as a ratio of output to input (for example, revenues divided by costs) management strategies for improving productivity have usually included some form of cost-reduction effort," of which economies of scale is often an essential element. In other words, even the smallest company can make itself healthier by improving its economy of scale. In competitive terms, however, small businesses often find that economies of scale are most visible as a weapon utilized by their larger competitors as a barrier to market entry.

As noted above, the concept of economies of scale has been used in a wide range of business operations, including sales and marketing, Most often, however, discussions of economies of scale have centered around manufacturing, equipment, and facility management areas. Howard J. Weiss and Mark E. Gershon, authors of Production and Operations Management, separated economies of scale into two types—construction and operations. "The construction economy of scale is that construction costs rise less than proportionately to building size," they wrote. The operating economy of scale, meanwhile, is based on the idea that "for any given facility size, there is an optimal operating level that minimizes the cost per unit…. Consider the fact that two plants will require a duplication of resources, whereas one large plant may not. This is the operating economy of scale."

But researchers have also distinguished economies of scale by other criteria. Pearson and Wisner separated economies of scale into "learning" and "volume" segments. "Learning economies of scale include labor and organizational production and planning advancements that accrue with time throughout the company's transformation process," they explained. "A company's learning curve provides an opportunity to identify and forecast supply costs, transformation costs, and finished product costs. Learning curves identify the rate a business has historically reduced the real, value-added, per-unit cost of its products. The ability of a company to continue this cost-reduction trend gives an indication of the adequacy of existing production cost-cutting or value-enhancing procedures and proposals. If a company connot continue to cut product costs or increase value sufficiently over the long run while maintaining satisfactory levels of quality, it stands a good chance of being priced out of the industry by competitors."

Volume economies of scale, meanwhile, are described by Pearson and Wisner as episodes wherein increases in product capacity produce lower unit costs by making additions to plant, equipment, labor force, or other facilities. While these additions to capacity generally produce upturns in fixed costs, these added production expenses are covered by improvements in per unit costs.

Further Reading:

Flint, Perry. "Is Bigger Better?" Air Transport World. March 1998.

Pearson, John N., and Joel D. Wisner. "Using Volume and Economies of Scale to Benefit Long-Term Productivity." Industrial Management. November-December 1993.

Porter, Michael E. Competitive Strategy: Techniques for Analyzing Industries and Competitors. Free Press, 1980.

Potter, Donald V. "Scale Matters." Across the Board. July 2000.

Reynolds, R.L. "Policy Choices and Economies of Scale." Journal of Economic Issues. December 1983.

Weiss, Howard J., and Mark E. Gershon. Production and Operations Management. Allyn and Bacon, 1989.

The benefits of producing on a large scale. As the volume of production increases, the cost per unit article decreases. It is suggested that, after a certain volume of production, this fall in cost will be halted as diseconomies arise, but this will happen only at very high levels of production, if at all. Internal economies of scale arise from within a plant and include indivisibility, specialization, and division of labour. Furthermore, overheads like Research and Development cost less per unit article when production levels are high. Increases in plant size can be important; doubling the capacity of a machine does not necessarily double its cost. In a larger production system, specialist machines can be used to advantage. Buying in bulk reduces costs. These different factors operate with differing force in different industries. See also external economies.

The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods. 

There are two types of economies of scale:

-External economies - the cost per unit depends on the size of the industry, not the firm.
-Internal economies - the cost per unit depends on size of the individual firm.

Investopedia Says:
Economies of scale gives big companies access to a larger market by allowing them to operate with greater geographical reach. For the more traditional (small to medium) companies, however, size does have its limits. After a point, an increase in size (output) actually causes an increase in production costs. This is called "diseconomies of scale".

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