what exactly are economies of scale? how do they come about, and what do they do exactly?
In: Economics
Say that you’re going to make a 3 inch deck screw. You make it on a lathe and with a metal chisel to cut the slots for the screw driver. It takes you a couple of hours to get it done. This is now a pretty expensive screw. Next you make a machine that cuts the threads and stamps the head. But it only does one screw at a time. And so it can make 60 an hour. Even taking into account the cost of the machine, these are cheaper screws.
Now suppose you make a really serious version of this machine. It can make the screw in 10 seconds and it has 20 stations. So it can make 120 screws per minute. Again, taking into account the cost of the machine spread over millions of screws, these are much cheaper screws.
This is economy of scale.
Economies of scale are like the “buying in bulk” of the business world. Sometimes it’s raw materials, where it works the same way as it does for you and I — buy a lot at once and get a discount.
It can also be things like taking advantage of things like hauling one pallet across the country costs $1000, but a truckload is only $12000 for 15 pallets. Or a similar thing for building a factory versus subcontracting.
Economies of scale is the idea that the per unit cost of creating a good or service goes down when you create more of it at a time.
There’s a few ways that this happens. One is through simply distributing the same fixed costs over a larger number of units. For example, imagine you design a new type of phone case. Regardless of how many units of the case you sell, your design costs are gonna be about the same. So if you sell more cases, then the design costs get spread over a larger number of units, and each unit is cheaper that way.
Another way is to invest in upfront efficiency upgrades that only make sense with large-scale initial investments. For example, you could purchase a $1 million phone case manufacturing robot that reduces the per unit cost by 10 cents each. Therefore, if you sell 10 million phone cases, you break even on your upgrade (assuming you keep the price the same). If you sell 100 million phone cases, you can make a giant profit while also lowering the cost of your case by 8 cents, benefitting both you and your customers.
Finally, you can use your larger size to convince the entire industry to move to newer, more efficient standards. Maybe there’s a component of your phone case that’s being made by an older process, and if you get your component supplier to switch to a newer process then you can drive down unit costs industry-wide. However, the supplier doesn’t want to switch processes because it might break compatibility with most of their customers. If you simply expand large enough to become ‘most of their customers’ then you can convince them that it’s worth switching to the newer, more efficient process.
Making a thing costs more than just the bill of materials, you also need to consider the upfront cost for the tooling to make the thing.
Let’s say a thing making machine cost $1,000,000, and it takes $5 of materials to make a thing.
The total cost of a thing making machine and 1000 things is $1,005,000.
cost per thing would be $1005
The total cost of a thing making machine and 1,000,000 things would be $6,000,000.
cost per thing would be $6
If you want to make a ham and cheese sandwich you need to open your pantry for 2 slices of bread bread, your fridge to get a slice of ham, and then in it your cheese drawer for a slice of cheese. Set all the stuff down, put it together and make a sandwich.
If you want to make 5 ham and cheese sandwiches for your whole family, you just grab more when you go to the fridge and pantry. You still need to assemble the sandwiches, but you place 5 pieces of bread down at once, put on the 5 slices of cheese at once, of ham at once, and the topper.
This sorta illustrates two of the pieces that make economies of scale work (there are many!), we have purchased things in bulk and our supply chain isn’t that much more complicated for 5 than for 1. And we have formed a rudimentary assembly line, that is its usually faster to do the same thing over and over again than it is to switch tasks.
Imagine if you wanted to sell apples.
You go out and you get your stand together, and bring your one apple. You sell it, and take the time to do the exchange with one customer. You get 1$ for the apple, but it took you a ton of effort just to sell one apple.
The next day, you go out and you do the same thing, except this time you sell 1000 apples. You still only had to set up once, but some customers bought 200, some bought 5, but you made $1000 and the effort you had to take selling them in some parts of the setup was the same as the first one. In turn, it cost you a LOT less to sell the additional apples than the one you sold the other day.
An economy of scale is the idea that as you do more business, a lot of the costs become cheaper the more you do so you can make more profit.
Imagine that you start a lemonade stand today in a busy commercial area. You pay the city $100 in rent to be at that location with really good traffic.
That $100 is a fixed cost; regardless of how many lemonades you sell, you pay the same amount of money to the city.
Now assume you sell lemonades for $2 and the ingredients for the lemonade cost you $1. You’re making a $1 profit on every lemonade, right?
Wrong. If you sell 10 lemonades that month, you lose $90; $10 gross profit – $100 rent.
If you sell 100 lemonades, you break even.
If you sell 1000, you make a healthy $900 profit.
That’s how economies of scale work.
Now you have to assume these economies of scale work across the entire supply chain. In a bigger company, there are more types of costs and more types of savings too. And your suppliers have the same opportunities to scale.
Manufacturing a large quantity of items is usually cheaper per item due to fixed costs being more spread out, bulk purchasing power for the materials, and using automated assembly systems.
Imagine making one donut. It would take you 30 minutes. Now make a dozen donuts – it’ll take 40 minutes. That’s a lot less time per donut.
I worked for a company that made tape drives. They signed an agreement to make tens of thousands of them and sell them at cost to a large company. Why? Because the bulk purchasing power and assembly lines they set up cut the costs of their own products by half. That’s economies of scale.
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