In the beginning of this Unit we mentioned that, ceteris paribus, firms are willing to produce more as prices augment. We also stated that the objective of any business activity in a free market is profit maximization.
In maximizing profits the business will, in practice, be covering:
- Cost of raw materials, new stocks, consumables etc. required by a trading business.
- Overheads such as rent, rates, light, heat, carriage, post, insurance, telephone expenses etc. incurred in running a business.
- Wages and salaries, National Insurance charges, pension funds, commissions etc. incurred on manpower.
- Capital expenditure subject to payback periods on premises, plant and machinery.
- Interest on money borrowed such as mortgages and/or loans, as well as interest on dividend.
- An income for the entrepreneur. This may be drawing for the sole trader, earnings for a partnership or dividend for ordinary shareholders.
What remains is, hopefully, a profit.
Costs are generally divided into explicit costs and implicit costs. All of the above may be termed as explicit costs. Implicit costs indicate the costs foregone in opting for one line of business and not another. For example, an entrepreneur may be “losing” interest on money used to purchase capital goods. ‘Rent foregone’ on premises used as a business premises is another type of implicit cost. So are ‘Profits foregone’ on other commodities/services that an entrepreneur opts not to supply in preference of the chosen commodity and/or service.
The Advantages & Disadvantages of Achieving Economies of Scale
Once a business starts to expand, it is said to be developing economies of scale (scale in the sense of size). A business would, therefore, be enjoying savings due to its size.
Economies of scale may be manifested in the following examples:
- Certain key or management positions would have to be recruited by a business irrespective of its size, and the relative salaries paid. Such managers are proportionately less costly for the larger business.
- Certain machinery can be operated by one person or shared by more than one employee. The sharing makes the capital investment more cost effective for the larger business.
Economies of scale create advantages for the business organisation:
- Simplification: Mass production. Compare, for example, the quality of services and commodities (including delivery and pricing) in respect of traditional furniture sets and mass produced units, such as kitchens, bedrooms etc.
- Standardization: Computer parts and accessories, for example, are standard and adaptable to a variety of models or brands.
- Specialization: Processes are broken down into units. Some units may even be sub-contracted out by the company, such as car locks in the automobile industry or electronic components in household appliances.
Other advantages of growth are that:
- The company will afford to spend more on research and development.
- The company will afford to invest in new products.
- The company may afford higher costs or under-cutting in increasing market share or awareness.
The consequences and potential risks of growth are:
- Output is increased enormously. As output increases, demand also increases. At one time, for example, a household used to have one shampoo for the family. Now we have one or more shampoos for each member of the family. Consider also the demand for water at a time when a town was served by one pump in the town square with the present time when each house is connected to the public water supply as well as maybe having its own well. If demand decreases, for whatever reason, at a point where the company has achieved high economies of scale, its investment may be such that it makes it costly to exit from the market.
- The security of companies is increased as they expand. However, as mentioned above, exit from markets may be more costly.
- It was traditionally believed that employment security is greater. This is not necessarily the case nowadays. Corporate growth has resulted in mergers and acquisitions primarily to maintain or expand market share. In as far as personnel are concerned, these types of corporate growth generally bring with them a rationalisation of processes. Redundancy is one of the recurring features of corporate rationalisation or restructuring.
- Sales and marketing may move beyond national confines.
Economies of Scale may also have increased costs or disadvantages, such as:
- High output requires storage and distribution. Higher storage and distribution costs are incurred.
- Marketing has to become more flexible and versatile. At one time, the householder used to visit the local grocer and purchase a particular brand of a commodity that the grocer supplied. Nowadays, several brands of the same commodity “compete” for the householders’ attention on the same shelf in a supermarket.
- Repetitive work is created by specialization. Nowadays, industrial cases regarding repetitive strain injury (RSI) are causing employers and their insurers a reasonable packet in compensation and injury/sick leave.
- In conclusion of this section, achieving economies of scale is part of the natural process of growth in the long run for a company. The less competitive the environment, the greater the economies of scale that can be achieved. However, growth does not only create benefits (such as lower unit cost, or market expansion/diversification), but also presents a number of risks inherent with growth.