0264 · 4.4.2Economies and diseconomies of scale

Average cost and economies of scale

0:00Sunrise Bakes produces bread for local shops. Expansion could help it buy flour more cheaply and use faster equipment. A larger operation could also become harder to organise, with delayed instructions and wasted ingredients. By the end of this video, you will understand how growth can reduce the cost of each product, and why further expansion can eventually increase it. Output is the quantity a business produces in a given period.

0:22The total cost per unit of output is called average cost. To find it, divide the total cost for a period by the quantity produced during that time. This gives us a useful way to compare operations of different sizes, because we measure the cost of each product. Economies of scale are the factors that lower average costs as a business increases in size. Growth can give a business access to discounts, specialist managers and more efficient equipment.

0:47These advantages reduce the resources or spending needed for each unit. Total spending can increase during expansion while the cost per product falls, because output increases more quickly. The five economies of scale we will examine are purchasing, marketing, financial, managerial and technical. Each describes a different way that a larger business can lower average costs. Some reduce the price paid for resources, while others spread spending across more products.

1:13The important link in every example is between increased size and a lower cost per unit. Purchasing economies are cost advantages from bulk-buying discounts on large orders of materials or goods. Meadow Harvest grows vegetables and purchases packaging from a supplier. As its operations expand, it orders larger quantities of boxes and negotiates a bulk-buying discount, so each box costs less. The supplier gains a substantial order, while the business spends less on packaging per vegetable shipment.

1:40The saving comes from the discount attached to the larger order. Meadow Harvest pays more for its boxes overall, but the packaging cost of each shipment is lower. This reduces average cost when the boxes are used for its shipments. The business needs enough demand for its vegetables to make effective use of the packaging it purchases.

Marketing, financial and production economies

1:57Marketing economies are cost advantages from spreading advertising and distribution spending over more sales. Cedar Threads sells clothing through an online shop. One advertising campaign can reach customers across its expanding sales area. When that campaign supports more sales for the same spending, the advertising cost attached to each item falls. Distribution can provide another marketing economy when a larger business uses its own delivery vehicles efficiently. Cedar Threads can fill a vehicle with customer orders and combine deliveries along suitable routes.

2:27The vehicle’s operating costs are then shared across many items. Greater sales volume makes this arrangement practical and can reduce distribution cost per item. Interest is the payment made for borrowing money. Financial economies are advantages from obtaining loans more easily and at lower interest rates as a business grows. Harbour Stays provides accommodation and has grown from one guesthouse to four sites. It now seeks a loan to expand its premises.

2:50A lender sees a large business with more property, steady revenue and a reliable repayment record, so it judges the lending risk to be lower. The lender therefore offers Harbour Stays the loan more easily, at a lower interest rate than it received as a small business. Borrowing the same amount now involves a smaller interest payment. That saving reduces the finance cost of each night of accommodation provided. Size makes these favourable terms likely, while the lender still checks the business’s financial position and repayment prospects.

3:19Managerial economies are cost advantages from employing specialist managers as a business grows. Willow Parts makes car components and expands its factory. Its larger operations can support a manager who specialises in organising production. Better scheduling reduces delays between tasks and helps the equipment operate for more of the working day. A specialist has the knowledge and time to improve a particular business function. For Willow Parts, fewer production delays increase output from its existing resources.

3:45The manager’s salary is shared across the factory’s substantial production volume. These improvements lower average cost when the savings from better organisation exceed the additional salary expense. Technical economies are cost advantages from using advanced machinery and efficient production methods at a larger scale. Sunrise Bakes can invest in equipment that shapes bread dough automatically. Flow production makes standardised products continuously through a sequence of stages. With sufficient demand, the expanded operation can use this method to produce bread efficiently.

4:15The machinery requires substantial spending, but it can process large quantities using fewer resources per loaf. Its purchase cost is spread across the bread produced over its useful life. High output makes that equipment easier to justify financially. Technical economies therefore connect suitable machinery and production methods with a lower average cost.

Causes of diseconomies of scale

4:34Diseconomies of scale are the factors that raise average costs when a business grows too large. Expansion can make an organisation increasingly difficult to manage. Errors, delays and wasted resources then increase the cost of each product. The point at which these problems become serious depends on the business and how effectively its growth is managed. The four causes are poor communication, lack of commitment or loyalty from employees, weak coordination and lack of control.

4:59Each creates a different difficulty within an expanding organisation. To understand a diseconomy, trace the problem through to its effect on costs or output. That final connection shows why the business’s average cost increases. Poor communication involves messages being delayed, misunderstood or distorted. As Sunrise Bakes expands, instructions pass through more management levels before reaching production employees. A change to a customer’s order arrives too late, so the wrong quantity is produced.

5:26The business wastes ingredients and pays for additional production, which raises its cost per correctly completed order. A lack of commitment or loyalty from employees arises when they feel little attachment to the business or its success. Once Sunrise Bakes has hundreds of employees, an oven operator may feel unimportant and distant from senior managers. They can become less willing to put effort into their tasks. If output falls while wage costs remain unchanged, the labour cost attached to each unit increases.

5:53Weak coordination means departments or sites fail to organise their activities effectively together. Sunrise Bakes opens another production site, but purchasing and production use different schedules. Ingredients arrive after they are needed, so equipment stands idle while employees wait. Paid working time produces fewer loaves, so average cost rises. Lack of control occurs when managers cannot supervise activities effectively across an expanded business. With many sites to oversee, managers may overlook careless use of ingredients or unnecessary spending.

6:23Those problems continue because they are detected slowly. Greater waste increases total spending without a matching increase in output, so the cost per loaf rises.

Average cost calculations and curve

6:32Sunrise Bakes compares three possible operating sizes over the same period. Assume it produces the same type of loaf at each size, and every figure includes all production costs. At the small size, total cost is twelve thousand dollars for two thousand loaves. Twelve thousand divided by two thousand gives an average cost of six dollars per loaf. The medium operation costs twenty thousand dollars and produces five thousand loaves.

6:55Twenty thousand divided by five thousand gives four dollars per loaf. Total spending has increased, but output has grown sufficiently to reduce the cost of each loaf. Purchasing discounts and more efficient machinery could explain this saving. At the large size, total cost reaches thirty-five thousand dollars for seven thousand loaves. Dividing thirty-five thousand by seven thousand, the cost per loaf comes to five dollars. Average cost has risen from four to five dollars as the operation expands further.

7:21Communication problems or weak coordination could explain why this additional growth becomes more costly per product. A simple average cost diagram shows this relationship visually. The vertical axis measures average cost per unit in dollars, while the horizontal axis shows output per period. The falling section represents economies of scale as the business expands. Average cost is lowest at the bottom of the curve, which marks the most efficient size.

7:46Beyond that point, the curve rises because diseconomies outweigh the benefits of further growth. Some purchasing discounts may still exist, but organisational difficulties create greater costs overall. The curve is a simplified illustration of the relationship. A particular business’s most efficient size depends on its technology, activities and management. When interpreting growth, focus on average cost and identify the reason for its change. A higher total cost can accompany a lower cost per unit, as our medium operation demonstrated.

8:16Explain a technical economy through machinery and its effect on resources per product. For managerial economies, connect specialist expertise to savings from improved organisation.

Exam application and recap

8:25In Paper One Short Answer and Data Response and Paper Two Case Study, questions can connect these concepts to information about a business. Kestrel Care makes hospital supplies, and expansion allows it to buy packaging in bulk. Delivery instructions also pass through more management levels. An exam-style question asks you to explain one economy and one diseconomy of scale it could experience. Explain means set out purposes or reasons, say why and how, supported with relevant evidence.

8:51Begin with the relevant factor, use the business information, and trace its effect on average cost. Each sentence should add a clear step to that reasoning, and both factors must use the details of Kestrel Care. Kestrel Care could gain purchasing economies because its larger packaging orders allow it to negotiate bulk-buying discounts. Cheaper packaging lowers the cost of each supply item, so average cost falls. Poor communication could arise because delivery instructions pass through more management levels and reach employees late.

9:19Incorrect deliveries would create additional transport costs, so average cost would rise. Economies of scale are the factors that lower average costs as a business increases in size. Purchasing, marketing, financial, managerial and technical advantages each provide a route to lower cost per unit. Growth creates these opportunities through larger orders, shared spending, favourable borrowing, specialist expertise and suitable equipment. The outcome depends on using those advantages effectively. Remember that diseconomies of scale are the factors that raise average costs when a business grows too large.

9:50Poor communication, lack of commitment or loyalty from employees, weak coordination and lack of control create delays or waste. The most efficient size balances the cost benefits of expansion against these organisational problems. Always connect the change in size to what happens inside the business, then finish with average cost.