Economies Of Scale

Economies of scale: the break point analysis By J.M. P_U_E_R_T_A_S, Lecturer The break point analysis shows one reason why organizations can get ECONOMIES OF SCALE, where the average unit cost falls as the number of units sold increases. We know that

TOTAL COST= FIXED COST +VARIABLE COST × N (WHERE N IS THE NUMBER OF UNITS PRODUCED)

Now we can find the average cost per unit by dividing the total cost y the number of units, N. Then Average Total cost per unit= Total Cost/n or (is the same) Average Total Cost per unit= Fixed Cost divided by n units plus variable cost As n increases, the average cost per unit will fall because the proportion of fixed cost to be recovered by each unit sold is reduced, as shown in the following figure

WORKED EXAMPLE: A restaurant serves 200 meals a day at an average price of 20 euros. The variable cost of each meal is 10 euros and there are fixed costs of running the restaurant of 1750 euros a day. a) What profit is made by the restaurant? b) What is the average total cost of a meal? c) By how much would the average cost of a meal fall if the number served rose to 250 euros a day?

The distribution of fixed costs to more units is only one reason for economies of scale. In many situations there are economies of scale even when the fixed costs are ignored. Then cost reductions occur because people become more familiar with the operations and take less time, machine operators become more practised, problems are sorted out, or disruptions are eliminated. Economies of scale are often suggested as a reason for making facilities as large as possible. This is certainly the reason why, say, oil tankers have become increasingly large. But in many circumstances there are also diseconomies of scale. Here the advantage of reduced fixed cost per unit is more than offset by increased bureaucracy, difficulties of communication, more complex management hierarchies, increased costs of supervision, and perceived reduction in the importance of individuals. These effects usually lead to economies of scale up to an optimal size and then diseconomies of scale as shown in the following figure

(Material based on “Quantitative Methods for business” by Donald Waters. Second Edition. Draws based on Miquel’s creativity and inspiration ;-)))