Definition | A company where per unit costs decline as volume increases |
Benefit | Reduced costs |
Barrier | Prohibitive costs of share gains |
Economies of scale are a fundamental concept in business, offering companies a powerful way to increase profitability and create long-lasting competitive advantages. Understanding how they work, their different forms, and how companies can harness them is very useful to understand. This might give you an edge as an investor.
In this article, we’ll delve into the concept of economies of scale, explore real-world examples, and explain how they impact company performance. We’ll also examine different types of economies of scale and their strategic implications.
Understanding economies of scale
Economies of scale occur when a company reduces its average costs per unit by increasing its total production output. This cost advantage is achieved as fixed costs (such as rent, utilities, and salaries) are spread over a larger number of goods produced, making each unit cheaper to produce.
Imagine a factory producing 1000 units of a product, let's say soccer balls. If the factory’s monthly fixed cost is $10.000, each unit (ball) bears $10 of that cost. However, if the factory doubles its output to 2000 units, each ball's fixed cost drops to $5. If this increases to, say 10.000 units, each ball's fixed costs drop to just $1. This shows how powerful economies of scale can be.