How economies of scale lower costs

One of the earliest ways in which it was possible to achieve cost leadership was to create economies of scale.  This meant firms needed to become big and have large production volumes. This is because, in general, as the volume of production goes up, the average unit cost goes down – for the following reasons:

  • physical laws: the volume or capacity of an vessel or container increases at a greater rate than the materials needed to make it.  A container 1 metre square on all sides is made from 6 square metres of materials, with volume of 1 cubic metre.  When the sides are 2 metres, it is made from 24 metres of material, but its volume is 8 cubic metres.  So whilst the materials used have increased four fold, the capacity achieved has increased eight fold.  This applies not just to containers but also to buildings. aircraft, pipelines and etc.
  • specialised machines: firms with a high level of production, and hence revenues, are able to purchase and use efficiently specialized manufacturing tools.  Small scale operators cannot afford such capital investment, nor exploit the full capability/capacity of such machinery.
  • cost of plant and equipment: A high volume of production may allow a firm to build larger manufacturing operations. Large-volume firms will be able to build lower per unit cost manufacturing operations and will have lower average costs of production.
  • employee specialization: High volumes of production are also associated with high levels of employee specialization.
  • overhead costs: A firm with high volumes of production can spread its overheads costs (such accounting, control, and R&D) over more units.
  • use of waste stream: if the operation has a waste stream, large scale operators may be able to make economical use of this in some way, not feasible for small scale operators.  For instance large petrochemical works have a numbers of sub processes that exploit waste streams to make oil based products.

However, this takes a limited industrial view of strategy. As we shall se in the next blog there are other ways of being a low cost operator.

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