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#30 What Happens In Economies of Scale (EOS)?

Updated: Jan 5, 2022

Alright! EOS is refers to an increase in production efficiency where the number of goods produced increases. Typically, this is a phenomenon where the company that achieves economies of scale lowers the average cost per unit by increasing production (output), which spreads the fixed cost over the number of goods produced. Economies of scale exist when it is cheaper to produce two products together (joint production) than to produce them separately. The phrase “bigger is better” is found in economic history that traces the history of economies of scale. The coordination of economies of scale significant with the era when demand for products in the market began to increase and mass production became a trend for most economic processes.

Do ever wonder why EOS is everyone’s tea? This is because EOS can formulate and implement business competition strategies and EOS is also widely used by large companies rather than small companies. Even so, consumers do not understand that products from small companies are more expensive than those sold by large companies. Why there is a difference between those two companies? This is because the price per unit depends on how much production costs the company incurs. Large companies can produce more and spread their production prices over a large number of products. We also often see the same price on one product because many companies produce the same item in the industry.

What are the reasons that explain economies of scale?

Economies of scale can lower the price of production per unit of goods. First, the specialization of labor and technology is increasingly integrated with production thus boosting overall production volumes. Second, lower expenditure expenses can come from the large quantities purchase raw materials from suppliers, profitable long-term employment contracts, or lower capital costs. Third, the spread of the costs of some internal functions on a larger number of finished goods units to help lower prices. The internal company functions for example accounting, IT, and marketing.

Internal Economies vs External Economies

There are two types of economies of scale. First, let’s start with internal economies where is borne within the company. While the external ones are based on external factors. Internal economies of scale occur when a company reduces costs internally, which results in a reduction in company size or decisions from management. Therefore, large companies can achieve internal economies of scale, by lowering costs and increasing production levels, where they can buy large quantities of raw materials, have patents or special technologies, and of course because they have stronger capital to do so.

External economies, on the other hand, are factors that occur when an industry is heavily concentrated in a particular area or factors that can affect the entire industry. This is mean that none of the company can control the costs on its own. This occurs when there is highly professional skilled labor, government subsidies, a joint venture from another company, or anything that can cut down the cost from joining much company.

Examples Economies of Scale

From Soft drinks to Food products

Let's assume say Company X manufactures Soft drinks. The management company decides to initiate the following action.

  • Increase the number of units of soft drinks (bottles/packs) produced so that the average cost of producing one unit decreases. It can be concluded here that they have achieved this through economies of scale. This makes product X more affordable and competitive in the market.

  • What will happen if the company decides to make manufacturing and marketing of potato wafers and other packaged food products? That is by adding additional products in a similar product to the product line will allow company X to spread a certain fixed cost to a large number of units. Thus, the company can reach more customers with its advertising budget, its sales force can be used to sell both products, and new products can be stored and shipped from the company's existing infrastructure. Furthermore, company X was then able to market itself as a “food products” company and not just a “Softdrinks” company.

In the example, X has increased the variety of items produced rather than increasing the number of Soft drinks produced. As a result, the company's advertising, selling, and distribution costs may generally remain the same, but the number of products sold will increase. Thus, because the firm manages to reduce the total cost per unit produced, X can be more profitable.

Specialization - Computer production

Another economy of scale is in the production of complex items such as computers. The production process involves various complex stages. So to produce a computer, you have to split the process and workers who specialize involve in producing certain parts. e.g. an employee can be very expert in design; others in testing etc. Specialization requires less employee training and a more efficient production process. However, if you have several different production processes, it is most effective to produce large outputs.

Do you wonder what is actually economies of scope? Economies of scope differs from economies of scale though their principles are similar where larger companies that profit from lower average costs. However, economic scope occurs when large companies use existing resources to diversify into related markets. For example, when a company produces soft drinks, the company can use its marketing and distribution network to start producing healthy drinks.

Last but not least, economic of scale is important as it can help businesses to be more competitive in their industry. Therefore, companies will strive their best to create economies of scale whenever possible, just as investors will strive to identify economies of scale when choosing investments. One well known example of economies of scale is the network effect.

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