The way economies of scale work

December 29, 2014

You have probably heard about economies of scale, but may not be sure how they work.†In this article, we will discuss when economies of scale take place.

1. When economies of scale occur

Letís assume you are an accounting manager or controller in a manufacturing company.† Your company produces a number of products and your business has a significant portion of fixed overhead in relation to the overall cost structure.† The overhead for a year is $10,000,000 and it is assigned to products at a rate of $5 per unit. (This is simplification, of course, because in most instances overhead would not be applied at the same rate per unit of different products, but for the purpose of our discussion we will assume so).† In the current year, your company expects to manufacture 200,000 units.† This still leaves some unused manufacturing capacity.

What will happen if your company obtains several large new clients and your manufacturing capacity will be utilized better?† In here, we will assume that the fixed overhead remains the same.† In the table below, you will see what happens if the output increases:

Overhead Cost

Manufactured Units

Overhead Cost per Unit

$1,000,000

200,000

$5.00

$1,000,000

250,000

$4.00

$1,000,000

300,000

$3.33

As you can see, with the increase in the number of manufactured units, the overhead cost per unit decreases.† Effectively, the company can sell products and generate a higher gross margin or reduce the selling price when the number of manufactured units increases.† This happens because the fixed overhead cost is constant while the number of units to which itís applied increases.

This is an example of economies of scale based on overhead costs.† Economies of scale are considered when two companies merge.† For example, a private equity group buys several large competitors in an industry and merges them.† Because overhead of the two companies can be reduced to that of a single company (or approximately of a single company), economies of scale come into place in such mergers.

It is important to note, however, that the assumption of constant fixed overhead is just that Ė an assumption.† In real life, overhead only stays constant up to a certain capacity and then, after the critical point is reached, the overhead increases.† For example, one assembly line supervisor (who represents an overhead cost) can supervise manufacturing processes up to a certain capacity level; when that capacity increases (e.g., it doubles), the one supervisor may not be sufficient and another supervisor may need to be hired.† In essence, fixed overhead costs may have a nature of step-variable costs and this should be considered in economies of scale.

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