# Part 2: Measuring Current Economies of Scale

MEASURING ECONOMIES OF SCALE IN EACH FUNCTIONAL COST

The Concept of Economies of Scale

Capsule: Costs go down as a company gets bigger because some costs rise more slowly than sales rise. So, bigger companies should have lower costs than smaller companies. This is the implication of the term "Economies of Scale."

Economies of Scale develop when 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 growth of unit volume sold. The explanation lies in the relationship between fixed and variable costs in the Company’s cost structure.

The Concepts of Variable and Fixed Costs

A Company's cost structure includes both variable and fixed costs. Variable costs increase proportionally with the increase in units of product sold. If the number of units of product sold increases by ten percent, the variable costs increase ten percent as well. Fixed costs remain stable over a given level of production. The term "fixed costs" refers to those costs that do not change significantly during the course of a year in which production falls within some expected range. "Fixed costs" are actually misnamed because even "fixed costs" increase as production continues to grow.

Even variable costs may have some fixed element in the Company’s cost structure. We have seen an instance where variable costs decrease as the size of the business grows. A retailer we observed had many stores. At each store there were a few cost items that the retailer assumed to be completely variable. However, the retailer compared these variable costs as a percentage of sales in each of its many stores. The retailer found that even the “variable” costs tended to fall as the number of customer transactions at a store increased.

Examples of Fixed and Variable Costs

We will use a simple example to illustrate fixed and variable costs and Economies of Scale. Assume that a company has a factory that makes cardboard boxes. The factory has the capacity to produce one thousand cardboard boxes in a year. Each cardboard box requires one pound of paper pulp for its raw materials. The Company plans to produce nine hundred boxes in this factory during the year. The overhead for the plant is \$10,000. The plant employs 90 people.

The paper pulp is an example of a variable cost. Each time the Company produces another box, it uses another pound of pulp. If its production were to move from its targeted nine hundred boxes for the year to nine-hundred and fifty boxes, its use of pulp would increase from nine-hundred pounds to nine-hundred and fifty pounds. The units of pulp consumed increase proportionally with the increase in product sold.

Most of the overhead costs of the factory are examples of fixed costs. These overhead costs include the management of the factory, property taxes, maintenance and other costs of keeping the factory open for the year. The Company will pay most of these overhead costs to run the factory no matter what the factory produces during the year.

The fixed costs of our example operation are fixed only for a production range up to the factory’s capacity of one thousand boxes a year. If the Company were to increase its output from nine hundred boxes to nine hundred and fifty boxes, these fixed costs of the factory would not change. Similarly, if the Company were to decrease its production during the year from nine hundred to eight hundred boxes, the fixed overhead costs of running the factory would not change. But these fixed costs would change if the rate of production increased significantly. Should the Company find that it requires eleven hundred boxes rather than nine hundred, it must find another factory.

Using this example, we can express Productivity in a number of ways. The physical Productivity measure is the ratio of physical units of Inputs divided by physical units of Outputs. The Inputs would include People and purchased pulp. The Productivity of the People is 90 people per 900 boxes, or one person per ten boxes. In this case, the Output is measured by boxes since we have no measure of customer orders. The Productivity of the Input, purchased pulp, would be one pound per box.

Economies of Scale

Economies of Scale measure the impact of fixed costs on the Productivity of the Company and its completion. As the units of product the Company sells increase, the units of Input Building Block costs employed by the Company to produce those units increase as well. Since some of these Building Block costs are fixed costs, while others are variable Input Building Block costs do not increase in the same proportion as sales. The analysis of Economies of Scale in our example measures the growth in units of Input Building Block costs that occur with the growth in units of product sold. We measure these Economies of Scale by using our measure of Productivity. With Economies of Scale, the ratio of the number of Inputs per number of Outputs will fall as the number of Outputs increases. It will take fewer Inputs to produce an Output. We return to our example to illustrate this idea.

Recall that the Company uses ninety people to produce its nine hundred boxes. Some of these people are supervisors, Supervise Employees. Others are managers, Think Employees. Still others are direct employees, Do Employees, producing the boxes. Assume the Company increased its production during the year to the level of one thousand boxes. To make that production increase, the Company added five people to its total work force. The Company produced one thousand boxes with ninety-five people.

The increase in production yielded better Productivity and created Economies of Scale. The number of boxes produced increased by about eleven percent, from nine hundred to one thousand. The number of people increased by five and one half percent, from ninety to ninety-five. While the Company needed ten employees to produce each one hundred boxes before it expanded, it needed only nine and a half employees per one hundred boxes produced after the expansion. The Company created Economies of Scale as the Productivity ratio of Inputs to Outputs fell.

This analysis explains companies’ drive for growth in their industries. Our company produced one thousand boxes. It had an Economies of Scale advantage over anyone in its industry producing only five hundred boxes and was, itself, at a disadvantage to any company producing two thousand boxes. In each case, the reason for the superior cost position was the better Productivity that occurs as the fixed costs in the organization are spread over more units of production.

A large company should have Economies of Scale, with better Productivity and lower costs, than a small company. The larger company would use more Inputs but produce more Outputs as well. If Economies of Scale exist, the larger company will have better Productivity, a lower ratio of the number of Inputs to the number of Outputs, than does the small company. But the measurement of Productivity ratios and Economies of Scale from one competitor to another requires data on numbers of Inputs and Outputs which can be difficult to obtain. In many cases, numbers of employees and capital invested in the business is available for publicly traded companies. The Company may complement this data by evaluating the operating margins of each competitor. If Economies of Scale exist in the industry, then operating margins should improve as the size of the competitor increases.

 Concept of Economies of Scale Questions Compare visible Economies of Scale differences among competitors in the industry: How many employees does each company have per physical units of production per million dollars of sales? If available, what units of major purchases does each competitor use per physical units of production or million dollars of sales? What is each company’s Capital intensity (Net Capital Employed divided by sales)? What is the Return on Sales (operating margin) of each company? What is the Return on Net Capital Employed for each competitor in the industry? Which competitors seem to have Economies of Scale advantages in the market?

Economies of Scale may work the same way inside a company as they work inside an industry. This enables the Company to measure the Economies of Scale it is creating. We will see more about this in the next section of StrategyStreet.

 Summary Points Next: Productivity and Time