StrategyStreet / Tools / Glossary of Terms / Economies of Scale

Economies of Scale

The phenomenon where unit costs decline as the number of units sold increases. This phenomenon occurs because part of the cost structure grows at a fraction of the rate of growth of unit volume sold (abbreviation: EOS).

Example 1:

Shaw's immense size enables it to buy raw materials, which make up as much as 60% of the carpet, for 15-30% less than many rivals. (Year 1996-SIC 2273)

Explanation: Shaw achieves a rate advantage on purchase costs because of its size and relative purchasing power compared to its competition. This advantage is an example of Economies of Scale.

Example 2:

In 1992, General Electric initiates a 24-hour dealer delivery program in which it committed to deliver products to retailers within 24 hours after an order had been placed. Maytag, a $3 billion company, cannot hope to duplicate this Convenience innovation at anywhere near the unit cost incurred by General Electric, a $60 billion conglomerate. Though both firms command approximately the same market share in the home laundry industry (in 1991 Maytag has a 17% share and GE a 16% share), General Electric has a much larger total appliance market share than Maytag.

Explanation: GE is a much larger company in the home appliance business than is Maytag. It is able to promise deliveries that Maytag cannot match because of its extensive size compared to Maytag. Maytag simply could not match GE's cost of this program because GE is able to spread its fixed delivery cost Inputs and ICDs over so many more appliance deliveries and sales dollars. The significant size advantage GE maintains over Maytag enables the Company to have a better Input/Output ratio than does Maytag.

Example 3:

Beginning in the early 90s, Cisco outsourced manufacturing responsibilities to partner firms. The Company then developed a quality control system using digital procedures. These procedures for quality control were virtually infallible. Cisco gave these quality systems to its partners. (Year 2004 - SIC 3576)

Explanation: Cisco spent money to develop quality control procedures and then spread the cost of those procedures over many units of production by licensing the procedures to its manufacturing partners. The Company improved its Productivity and created Economies of Scale by spreading the cost of the quality control procedure ICDs over more products and customer orders. As the largest competitor in the market, Cisco had more Output over which to spread its fixed cost ICDs.

Example 4:

In designing its low-end micro-film machine, Kodak added an assembler to the production design group to ensure that the new machine would be easy to assemble. (Year 1989 - SIC 3861)

Explanation: Kodak saved time in redesign, an ICD, by designing the product for manufacturing in an early stage. This reduced the total number of unique ICDs. Kodak had an Economy of Scale advantage here since it was the largest producer of microfilm machines. It could add an FTE to a design team at a lower cost per unit of Output than could any other producer.

Example 5:

As D.R. Horton has expanded nationally, it has consolidated suppliers. “We just entered into a relationship with a provider of faucets that will reduce our overall cost per house by $100.” (Year 1997 - SIC 1531)

Explanation: The elimination of suppliers did two things for D.R. Horton’s Productivity. First, it reduced the cost of its Inputs, purchased faucets, by reducing its rate of costs to improve its Efficiency. Second, it reduced the number of ICDs by reducing the number of suppliers for which it had to maintain relationships, increasing its Effectiveness. The Company created better Economies of Scale as it grew.

Example 6:

Many industry leaders are expanding aggressively, building multiplexes where they can run a number of films and achieve better Productivity. Over time, the number of screens in the average multiplex grew. (Year 1998 - SIC 7832)

Explanation: This move improves the Productivity of the companies in two ways. First, it increases Efficiency of its Input, People, by reducing the unutilized time of employees between movie starting times. Second, it increased Effectiveness by spreading the Input, Capital, ICDs over more movie patrons. The theater multiplexes increased in numbers of screens as each increase in multiplex size produced an Economies of Scale advantage over smaller multiplexes.