Advantages and disadvantages of economies of scale

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Advantages and disadvantages of economies of scale

This article offers a detailed analysis of the advantages and disadvantages of economies of scale. A business can achieve economies of scale by increasing production and reducing costs. Fixed costs can be spread over more units of production, which reduces the per unit cost for each additional unit produced.

 

What are economies of scale?

According to the Encyclopaedia Britannica (2022) when a business increases output, a decrease in the average cost of producing a product is usually gained. This reduction is commonly known as economies of scale.

 

According to Collins Dictionaries (2022) economies of scale refer to the financial advantages that a business gains when it produces large quantities of items.

 

The concept of economies of scale refers to the cost advantages that businesses can achieve by growing their operations and increasing their output at a single location or production site. Opposite to this idea are diseconomies of scale which happen when average unit costs start increasing, often because of business expansion (BBC, 2022).

 

A business achieves economies of scale when fixed costs are spread over more units of production, which reduces the per unit cost for each additional unit produced. In other words, economies of scale are cost reductions that companies can enjoy as they expand their production activities.

 

For example, when an automotive manufacturer makes 1 car, it incurs high fixed costs, such as the cost of the factory building, machinery, employee salaries etc. However, when the same company makes 20 cars, these fixed costs are averaged out and are lower for each car. It can thus achieve a lower cost for each car and a higher profit margin.

 

It should be mentioned that though companies that achieve economies of scale, have lower costs on average, there is no guarantee that all products will be cheaper. In fact, the opposite may be true for certain products, such as luxury goods.

 

Advantages of economies of scale

With economies of scale, a business can have higher production volumes, which in turn will reduce the costs of production per unit. It can also reduce the overall production costs for each product, which increases profits.

 

One of the key advantages of economies of scale is competitive advantage. For instance, many people may not understand why a smaller company charges more for a similar product offered by a bigger business. The fact is it is possible for larger ones to offer lower prices because they produce more.

 

Demand for certain products may go up suddenly, often during the festive periods. A company that has achieved economies of scale can quickly respond to those demands by increasing production without worrying for incurring significant additional costs.

 

Economies of scale helps an organisation gain the confidence of stakeholders. Particularly, many shareholders will be more confident in investing more money in the company due to its achievement of economies of scale.

 

Disadvantages of economies of scale

By increasing its operations and achieving economies of scale, a company may become complacent potentially resulting in loss of its creative edge and innovative efforts. This can lead to stagnation and a decline in profits.

 

Large companies with economies of scale can put smaller competitors out of business, which means less competition. This is not necessarily a bad thing for those businesses; however, it can lead to higher prices for customers.

 

When a company expands its production, it may decide to sacrifice quality standards. This may result in poor customer service, and lower product quality which could cause customer dissatisfaction.

 

When a company increases its production levels to take advantage of economies of scale, it is at risk of over production. This can lead to a surplus of inventory causing it to sell off the inventory with cheaper prices to make the shelves available for other staff.

 

Examples of economies of scale

Walmart, which has grown to become the world’s largest retailer, benefits from economies of scale by building large warehouses and buying in bulk from suppliers and manufacturers. Likewise, McDonald’s has achieved economies of scale by offering a uniform menu with mass production, lowering average production costs, and negotiating very well with its suppliers.

 

Types of economies of scale

There are two main types of economies of scale e.g. internal economies of scale and external economies of scale. Companies may achieve internal economies of scale by purchasing products in bulk at reduced prices, upgrading machinery and technology, and securing better interest rates form financial service providers. On the other hand, they can achieve external economies of scale when the government decides to improve the infrastructure, and the suppliers improve them efficiency.

 

Summary of the advantages and disadvantages of economies of scale

To conclude, there are many benefits that come up with economies of scale; however, they are not without some demerits. If a company grows too big, it may lose the flexibility that made it successful in the first place. Economies of scale offer lower costs, more production, and the ability to meet customer demand. On the other hand, there may be a loss of flexibility in the business due to large production numbers, and a diminished quality of production.

 

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Last update: 13 July 2022

References:

BBC (2022) Expanding a business, available at: https://www.bbc.co.uk/bitesize/guides/zmjyscw/revision/2 (accessed 12 July 2022)

Collins Dictionaries (2022) Economies of scale, available at: https://www.collinsdictionary.com/dictionary/english/economies-of-scale (accessed 11 July 2022)

Encyclopaedia Britannica (2022) Economies of scale, available at: https://www.britannica.com/technology/production-system (accessed 12 July 2022)

Author: M Rahman

M Rahman writes extensively online with an emphasis on business management, marketing, and tourism. He is a lecturer in Management and Marketing. He holds an MSc in Tourism & Hospitality from the University of Sunderland. Also, graduated from Leeds Metropolitan University with a BA in Business & Management Studies and completed a DTLLS (Diploma in Teaching in the Life-Long Learning Sector) from London South Bank University.