In business today, some companies enjoy the Economies of Scale while others do not. The difference between the companies that enjoy economies of scale and those that do not is based on the volume of output. Companies that are involved in large scale production are more likely to enjoy economies of scale compared to those that specialize in small scale production. Having understood the basic principle of the economies of scale, it becomes easier to define it.
Economies of Scale is defined as the cost advantage caused by the volume of large scale production. It is the reduction of cost-per-unit as a result of large scale production. There are two categories of Economies of Scale, external and internal. Internal Economies of Scale include Technical, Financial, Commercial, Managerial and Risk Bearing among other factors. Major sources of internal Economies of Scale are discussed below.
1. Technical Economies of Scale
With the current development in the technological realm, technical prowess is improving on a daily basis. In any organization, it is a general goal to minimize the cost of production in every possible way. This has led to the development of machines and equipment that have reduced the number of workers required for a certain chain of production. This includes a section of production such as packaging, packing, and other technical aspects. Companies dealing with heavy machinery are also experiencing this growth to their advantage.
The use of machines in the chain of production has two major advantages that influence the price-per-unit. First, it reduces the cost of production by reducing the number of workers paid to do the job. Secondly, most machines can handle jobs done by ten men ago. This ultimately promotes large scale production which reduces the cost incurred on them.
2. Financial Economies of Scale
Every financial institution is very protective of its financial resources and to ensure that their money is safe, due diligence is done. Before a loan is given to a company, the financial institutions will ensure that the borrower is able to pay the loan at the agreed interest rate and on the stipulated time. With this in mind, it is apparent that big companies are more likely to access loans compared to smaller ones.
Companies that are large scale producers have more bargaining power to access loans from financial institutions. In addition to access of loans, they also get better and lower interest rates. On the other hand, small companies have limited access to loans and financial help and even when they get a loan it is normally charged at a very high interest rate. Therefore, large scale companies enjoy financial economies of scale more than the small scale companies.
3. Commercial Economies of Scale
The commercial economies of scale are also known as the Marketing Economies of Scale. Selling in bulk has numerous advantages. When a company sells its products in bulk, the cost of its average cost of selling reduces significantly. Big companies are capable of delivery good in bulk at a go hence reducing the coat of numerous trips. In addition, due to the reduced cost of production as result of large scale production, the company can easily get clients due to the reduced price-per-unit. The advantage for large companies is not only realized through selling. Since such companies are bulk producers, it means they also purchase their inputs in bulk.
Therefore, they also enjoy the advantage of purchasing their raw material at a cheaper price compared to smaller companies. The low prices of input enable large companies to sell their products at a lower price. Low prices create demand and with high a demand for product marketing is not necessary. Marketing increases the cost of selling but if it is not necessary to spend on marketing due to the high demand of a particular product, the cost of selling per-unit reduces.
4. Managerial Economies of Scale
The performance of any organization is dependent on the quality of the decisions made by management. The managerial economies of scale are achieved when qualified and competent managers are hired. Large companies will always have the best managers because they can afford them. Highly trained and qualified managers are very costly to hire and small companies are not financial capable of hiring such individuals.
Large companies on the hand can hire the best managers in the market at any cost. This gives the big organizations an upper hand in terms of decision making giving them an advantage of having the best brains. For a company to grow, the management needs to keep reviewing new methods that can enhance its production and reduce its operating cost. Only qualified and experienced managers can have such skills and only the big companies can afford their salaries.
5. Risk-bearing Economies of Scale
Lastly, Risk Bearing is a techniques used by organization to cushion themselves from the impacts of unprecedented risk. This involves diversifying a firm’s production in order to reduce the average risk of making losses. Practically, all the lines of o production cannot generate losses simultaneously. The risk-bearing techniques enables the firm to bear losses generated by one line of production through the profits generated by the other lines of production.
Nonetheless, the diversifying process is a complex and costly endeavor that only big companies are capable of doing it. Small companies are forced to maintain one line of production hence bearing the effect of losses when they occur. Large companies, on the other hand, are cushioned by their other line of production when one of them generates loses.