Business Paper 1 - Economies of Scale (143)

Economies of Scale

the reduction in (average) costs per unit of production that occur as a

business increases its scale of production / as the business grows

Internal Economies of Scale

• purchasing economies of scale – as businesses grow, they increase the

  size of orders of raw materials or components. This may then result in

  discounts resulting in lower average unit costs

• marketing economies of scale – as businesses grow, each pound spent on advertising will have greater benefit for the business. The cost of a

  marketing campaign will be spread over a greater level of output reducing average unit costs.

• financial economies of scale – as businesses grow, they will have access

  to a wider range of finance - as the assets of businesses grow, they are

  able to offer more security when seeking to borrow money which reduces risk to the lender - larger businesses can therefore negotiate more favourable rates of interest reducing average unit costs

• managerial economies of scale – as businesses grow, they are able to

  employ specialist managers who know how to get the best value for each pound spent in the business, improving decision making reducing average unit costs

• technical economies of scale – as businesses grow, they are able to

  purchase the latest equipment and incorporate new methods of

  production. This increases efficiency and productivity, reducing average

  costs of output reducing average unit costs

External Economies of Scale

external economies of scale occur through the growth of the whole industry

(1) outside of the business (1) resulting in lower average unit costs (1).

• supplier economies – a network of suppliers may be attracted to an area

  where a particular industry is growing. The setting up locally of supplier

  businesses, often in competition with one another, reduces buying costs

  reducing average unit costs

• educational economies – local colleges will set up training schemes suited to the largest employers’ needs, giving an available pool of skilled labour - this reduces recruitment and training costs reducing average unit costs

• financial economies – financial services can improve, with banks and

  other financial institutions providing services that may be particularly

  geared towards a particular industry reducing average unit costs

Diseconomies of Scale (+ Internal Diseconomies of Scale)

diseconomies of scale is where the business faces higher costs per unit as the

business grows in size - diseconomies of scale occur due to e.g.

communication and coordination problems

internal diseconomies of scale:

• coordination issues — The larger an organisation becomes, the more difficult it is to coordinate. Inevitably there is good deal of delegation and this empowerment of more and more managers to make their own decision which can result in different departments heading in different directions. To counter this, numerous management meetings have to be held. The time that managers spend in meetings, in an attempt to ensure better coordination within large organisations, can be viewed as a significant overhead cost.

• communication issues — As an organisation grows and levels of hierarchy increase, the efficiency and effectiveness of communication breaks down. This leads to increasing misunderstanding and inefficiency as each level of hierarchy grows further and further apart

  and messages become distorted, resulting in increasing average costs.

• motivation Issues – It is harder to satisfy and motivate workers as they may feel lost, ignored and distanced from the decision makers

Evaluate the impact of economies and diseconomies of scale on a business and its

stakeholders

• Economies of scale have led to significant price drops in some market segments which have

been advantageous to consumers.

• Electronics, clothes and phone services are just three of the sectors that have seen real price

falls over the last 20 years. Therefore, consumers do benefit from the fall in a business's costs

if they are reflected in a reduction in price.

• Shareholders may well benefit if economies of scale have helped businesses prosper as they

have increased in size, resulting in increased share values.

• Some businesses have increased their scale to such an extent that they have become

monopoly suppliers and eliminated their competitors. These were no longer able to compete

as their larger competitors took more and more advantage of the economies of scale available

to them.

• Suppliers are increasingly finding themselves under pressure to provide cheaper goods and

services to businesses who operate on a large scale. This has proven to be the case with large

supermarkets, resulting in many farmers going out of business as the profit margins that they

were operating proved to be unsustainable.

Explain the survival of small firms

How do small firms survive?

• They provide a service that is difficult to scale up. Most plumbers, electricians and roofers are local small businesses. They seem better able to deal with fluctuations in demand, adapting their target market to changing market conditions. In this case it seems that flexibility is the key.

• Target market size—sometimes the potential sales are suited to small businesses, for example dog grooming services or kennels.

• Population density - large businesses need large target markets: if these don't exist then the market is left to small businesses.

• Quality of service and product - often it is this added value aspect of the business that justifies the higher prices charged

• Customer Loyalty

• Niche Markets - sometimes the niche is so small it is isn't worth the big business's time