Economies of scale are cost savings the are derived from efficiencies by a firm. As production increases, and assets are utilized more and more in the production process, costs to produce products are lower on a per-unit basis. This allows for cost-savings. Higher output levels from bigger firms will allow for better economies of scale as costs of production are spread out of a larger quantity of production. A firm needs to achieve an optimal level of production to achieve economies of scale. At an optimal production level, output on the highest cost-effective basis is achieved. Economies of scale would mean the lowest cost of production and, therefore highest margin levels.
The importance of understanding Economies of Scale is stressed in the Stock Market For Beginners – How To Invest in Stocks video series, my FREE YouTube video series on this subject.
Understanding Economies Of Scale
The amount of production usually determines the economies of scale that could be achieved by a firm for the product or service. For instance, rent for a facility will be a fixed cost for the firm regardless of output. Each month, regardless of production level, rent for a building will need to be paid.
In the case of rent, if the rent were to be $10,000.00 per month, and the amount produced by a firm is 10,000 units, then the representation of rent for each unit of production is $1.00. Given that, with a fixed amount of rent, if the firm were to increase to 100,000 units on a monthly basis this would optimize economies of scale and drive rent, relative to units produced, downward to $0.10 per unit; a greater level of economies of scale have been achieved.
Please note: rent is but one factor that would be considered in the cost to produce a product.
Understanding Scale & Economies of Scale
Understanding this may also help someone understand pricing of products. For example, a smaller firm may have a certain size facility and pay a per-square foot price for rent. And a bigger firm may have an amount of square footage for a facility, but, the cost per square foot may not be linear.
Consider this: If Firm A had a square footage of 10,000 sq. feet and Firm B had 100,000 square feet. Firm A may pay $1.00 per square foot whereas Firm B with a far larger facility may pay a percentage of that on a per foot basis despite them paying more overall. Perhaps Firm B pays $0.80 per foot for a total $80,000.00 monthly versus the $10,000 monthly paid by Firm A. With production levels consistent with facility size, on a relative basis, Firm B pays less with a higher production level. Firm B has achieved a higher level of economies of scale.
Small Firms versus Big Firms & Economies Of Scale
Understanding how economies of scale works may help a consumer understand why smaller firms might charge a higher price for the same product produced relative to a bigger firm with a higher output level. Given the example above, with lower costs on a per-unit basis, this enables a Firm B to charge less to consumers because the firm has achieved a higher rate of economies of scale on a per unit basis.
Limitations to Economies of Scale
There are limitations to economies of scale when a firm scales up. A firm cannot endlessly increase production in a single facility without maximizing the facility’s capacity. At that point, a firm would need to expand into a new facility. There would be a new cost born from this.
A working Example of Economies of Scale
Given the example above, one firm that I am looking at which has the potential to achieve a better, more optimized economies of scale is Village Farms VFF Stock. Village Farms is in the process of scaling up its business more and more. For now, based upon cost of goods, gross margins are approximately 20% of revenues. However, as more and more of the production facilities are utilized, and cost savings are achieved. economies of scale will drive the gross margin rate higher. This will result in a higher rate of profitability on a per-unit basis as higher and higher levels of economies of scale are achieved.
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