Updated July 27, 2023
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Introduction to EconomiesĀ of Scale Example
Economies of scale are said to be achieved when more units of a service or good can be produced on a bigger or a larger scale, that too with (on average) fewer or lesser input costs. This will happen when the organization grows larger and thus its production units tend to increase which shall give the company a chance to reduce its costs.
This advantage comes into the picture due to the inverse relationship between the companyās production of units and the per-unit fixed cost.
Examples of Economies of scale (With Excel Template)
Letās take an example to understand the calculation of the Economies of Scale in a better manner.
Economies of Scale – Example #1
Avenue supermarket and Walmart are two of the biggest retail markets and they sell their products with the lowest price in the market and still they manage to make profits with thinner margins. The local shop vendors are worried about the same and wanted to know why it is so that despite selling at a lower price it is still able to make a profit and also are able to expand. Letās analyze the reason for the same by using the concept of economies of scale.
Solution:
Both Avenue supermarket and Walmart adopt EDLP and EDLC policies which stand for Everyday Low Price and Everyday Low Cost. Hence, they change their prices on a daily basis depending upon what their vendor is charging. The key thing in this policy is that they procure the goods in bulk and they have an advantage with major discounts and further there are no middlemen which operate for them and they have their own independent procure department which keeps on looking into the cheapest price for a particular product. Purchasing at a lower average cost which is achieved through buying in bulk is one of the sources of economies of scale which can be termed as āpurchasingā.
Economies of Scale – Example #2
Kashmira Shah an employee of Crompton limited and also head of the production department. Crompton limited has seen a bad year in terms of finance and its profits have been declining. Management has asked Kashmira to find a solution to reduce the production cost and hence increase profit.
Kashmira analyzed the market and Cromptonās competitors and found out that their technology is outdated, and the goods produced are also not up to the mark. She learned about new technology which is costly but if installed will drastically improve the quality of the product and will also increase the speed of producing goods and can help in reducing the cost.
Further, the new machinery will have a longer life as well. After Kashmiraās recommendation, the company installed the machinery and now their profits have started inclining even though marginally. On analyzing the reasons for the same, it was discovered that the gross margin of the company has increased significantly, and management was happy about the same.
You required to discuss the economies of scale for the above example.
Solution:
The key to economies of scale is in the reduction of cost by growing larger, increase in sales, reduction in cost. In this example, it seems the key pain for the company was the quality of the goods and the cost of making the same. Early the company was back push through competition due to the use of outdated technology.
Now the company has adopted new machinery which even though required huge investment as it was stated that its costly and the result can be seen where the gross margin of the company has increased which could be attributed to two reasons, one of them could be sales increases significantly and second could be increased in quality of goods and lesser scrap production which in turn would reduce the variable cost of producing the product.
Thus, it appears that the company has achieved economies of scale by implementing new technology and hence reducing cost.
Economies of Scale – Example #3
Vipul Thakur is the current chairman of the Peopleās bank. Vipul Thakur has an engineering background and is an expert in implementing the automation process throughout his journey in this bank. He has help banks go ahead of the competition by automating many manual processes which boost up their customer morale and also employee morale.
He also implemented many net bank services that were not offered by other banks. However, since his appointment as chairman of the bank, nothing much has been productive by him after rising from the post of managing director of the technical know-how department. The shareholders are concern about whether Vipul is able to take the bank to the next level as he is not from a financial background.
After few years, he was not re-elected as a post of chairman by the board, and instead a new person was hired externally as chairman to the board who had done a Ph.D. in finance and he gave impressive vision to the bank by implementing the bankās first cryptocurrency called as āPeoā.
This was given thumbs up by the market and shareholders were impressed as it became the first bank to implement the same. The deposit increase in the bank due to brand value and the bank was able to offer loans 2 times than it offered during Vipulās tenure.
You are required to discuss whether this can be construed to economies of scale?
Solution:
Economies of scale can be achieved at any stage of the companyās lifecycle. Even a matured firm can implement the same by exploring new opportunities which it’s unrelated to their previous process. Here, Vipul was a successful employee and climbed the chain of success ladder through his amazing engineering skills, but he couldnāt do much when he was hired as the chairman as that required more of out looking the market and getting ahead of competitors by taking decisions which would benefit the firm in long term.
Since the management was changed and when a new person was hired he gave a new vision to the bank which was required and also implemented the first bankās cryptocurrency which made the bankās brand name more valuable and shareholders and customers became more loyal which boost up their deposit and it can also be seen that due to this the bank could sanctioned loans 2 times more than Vishalās tenure which clearly shows an increase in the loan would increase their earnings and the cost of interest paid on deposit would be spread across these loans which would technically reduce the cost of funds. This can be attributed to economies of scale through managerial enhancement which was done by hiring a better-skilled person for the job.
Economies of Scale – Example #4
Below is the summary of XYZ over the years for goods manufactured and the cost of producing the same. You are required to ascertain whether XYZ is experiencing economies of scale?
Solution:
To determine whether XYZ is experiencing economies of scale, we will first find out the average cost for the firm over these years which can be computed by dividing the cost by goods produced.
- Average Cost = Cost / Goods Produced
- Average Cost = 1,450,000 /50,000
- Average Cost = 29.0
As can be seen from the above table that cost has declined from 29 to 26 per ahead which signals the company is experiencing economies of scale.
Conclusion
- Economies of scale are mostly cost advantages firms experience when costs can be spread over a bigger amount of goods and when the production becomes efficient.
- Ā A business’s size can be related if it can take advantage of economies of scaleālarger firms can have higher production levels and more savings in cost.
- Economies of scale can be both external and internal. External factors will affect the entire industry and on another hand, internal economies can be caused by factors within the firm.
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