Economies of scale refers to the fact that the average unit cost of a product can be reduced by increasing the rate of manufacturing output of the product.
Examples of economies of scale include the following:
- Spreading of Fixed Costs: The unit cost of a product includes an allocation for fixed costs. By increasing the output rate of the product, the fixed costs are allocated across a larger number of units and the unit cost of each product falls.
- Reduced Purchase Costs: As the output rate increases, the quantity discounts obtained from suppliers for the purchase of higher volumes of raw materials also increases, and the unit cost of the product therefore decreases.
- Capital Costs: The capital cost of facilities and equipment used to manufacture the product reduces as the required output increases. For example, the cost of installing a large capacity machine is not significantly more than installing a smaller machine.
While economies of scale can be an advantage, increasing the production output rate can also lead to diseconomies of scale, this occurs when the average unit cost of a product starts to increase as the business gets larger. Diseconomies of scale result from such factors as increased bureaucracy, reduced flexibility, and a loss in focus of the business as it grows.
For further information see the Wikipedia Economies of Scale definition.
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