Economies of scale definition
/What are Economies of Scale?
Economies of scale cause unit costs to decline as the number of units produced increases. This effect occurs because the pool of fixed administrative and production costs is spread over a larger number of manufactured units. This concept can be used as the basis for a strategy to be the low-cost provider, where a company keeps its prices low in order to increase its unit sales. As its sales increase, the company continues to expand it production volumes, thereby driving down its per-unit costs even more – which can be used as the basis for an additional price cut, which should produce even more sales. An additional issue that enhances the situation is the possibility that variable costs will also decline; this occurs when volume discounts can be applied to the purchase of very large amounts of raw materials. In addition, as a company gains experience with the production of increasing unit volumes, it becomes more efficient at the production process, which drives down unit costs further.
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Impact of Economies of Scale on Acquisitions
Economies of scale may be the key reason why an acquirer buys another company. The acquirer centralizes all administrative functions, thereby reducing the overall costs of the consolidated business. Doing so reduces the total cost per unit across all subsidiaries, making the business more competitive. However, it is not always possible to strip administrative costs out of a consolidated entity, especially when the subsidiaries operate in different industries.
The Limits of Economies of Scale
The economies of scale concept has an upper limit. A business will find that it must incur additional fixed costs as its sales increase beyond a certain point, due to additional complexities inherent in operating a very large business. For example, a business may find that additional sales require it to distribute goods into distant regions, which increases its transport costs. This means that the cost per unit will begin to increase after a certain point, which is referred to as diseconomies of scale.