Write a 500 word summary of the advantages and disadvantages of economies of scale how these advantages and disadvantages relate to management decisions
Economies of scale can be generally described as a cost advantage that a producer gains due to an increase in the volume of production. In this assignment I will discuss the advantages and disadvantages of economies of scale and how it relates to management decisions.
When discussing economies of scale there are two types: internal and external. Internal economies of scales occur within an organization and external economies of scale occur between organizations. When a business is experiencing internal economies of scale there are lower average costs per unit because the fixed cost has been distributed over a larger quantity of output, production can be spread out and fewer resources required for each unit produced. External economies of scale occur when it is cheaper for separate companies to produce a joint product than it would be for them to produce a separate product because of sharing resources and other factors.
One advantage is that with economies of scale comes higher productivity and therefore greater output. If a company has high fixed costs, it may make sense to produce as much as possible in order to spread those costs over a larger quantity of output. For example, a company operating on small scale with high fixed costs and is only able to produce one product at a time (e.g., 1000 units), with total variable cost per year of $100,000, if the company increased production and was able to produce 2 units at a time (2000 units) its total variable cost per year would be $50,000.
Another advantage with economies of scale is that it can improve a business’ bargaining power which can lead to lower costs and more revenue. For example, several businesses may decide to form a joint venture and produce one product instead of each business having its own individual production facility. This can lead to lower costs for the businesses involved and therefore more revenue.
One disadvantage with economies of scale is that some organizations may not be able to take advantage of such savings because they are unable to increase output. For example, ABC Co. has 100 employees and produces 100 units of output per year (fixed costs are $1,000). If the company were to increase production it would need to hire more resources in order to produce 200 units. Assuming that each unit requires one employee then this company is not able to take advantage of economies of scale because it has reached its production limit.
Another disadvantage is that economies of scale only occur when the volume level increases – if the volume decreases it could lead to diseconomies of scale. This can be due to rising costs per unit caused by lower efficiency and therefore higher average cost, or having difficulties in managing a larger business might become more difficult which can lead to lower profits.
Overall it is evident that economies of scale have both advantages and disadvantages, the aim of this paper was to highlight these and discuss how they can be useful in management decisions.