Using an appropriate example, explain how economies of scale can positively impact on business profitability.
Economy of scale refers to reduction in cost of manufacture and supply of a product which results from the change in cost structure when the total quantity of the product supplied is increased. The phenomenon of economy of scale is applicable to most of the products but not all. Further, it is applicable only within a specific range of production volume. Also, the exact reduction in the production cost varies from product to product and range of production volume.
Economies of scale can be beneficial to a company only under certain condition. It is not necessary that company will always be able to sell more of the products manufactured to avail of economy of scale.
Typically, a company can increase its sale by reducing the price at which it sells its products. Thus, by increasing production, a company is able to reduce its cost per unit, at the same time it must also reduce the price per unit. A company will benefit from economy of scale only when the increase in total cost of production for all the units is less than total increase in volume. We will explain this by an example.
Let us say a company manufactured widgets 1000 per day at cost of $5 per widget and sell them at $8 per widget making a profit of $3000 per day. The company can reduce its cost to $4.80 per widget by doubling its production to 2000 widgets per day. To earn a profit of $3000 on its increased production the company will have to sell widgets at a unit price of $6.3. thus the company will be impacted positively only if it can sell 2000 widgets per day at price of more than $6.3. At a price lower than this its profits will reduce.
When a company has invested a large amount in the form of capital assets, a large amount of fixed cost per unit of production is likely apart from the direct or variable cost per unit of production.However , the capital investment being the same, the fixed cost per unit of production can be telescopically reduced per unit of production which may contribute for the profit also. The direct cost per unit of production being the consumption base is always goes along with the scale of business.
Example : A bus owner invests 20 lakh rupees in bus and employs 3 people. He operates 600 kilometers and gets a revenue of Rs20000 . He has a fixed cost (due to interest on capital, rent and salary and tac,1000+8000+2000)=Rs 11000 per day and direct cost of Rs11 due to fuel , tyre and wear and tear. So, its costs him 600*11= Rs 6600 as direct cost required to operate 600 kms. He increases the scale of his operations as he understands that he has better traffic potential which brings better revenue per kilometer than what he gets. So he operates some additional operation covering 700 kilometers day with the same rate of revenue per kilometer or at least not less. So, now his revenue is 700*(20000/600)=Rs23333 per day and cost =fixed cost 11000+ direct cost700*11= Rs18700. His fixed cost/ kilometer has come down by 11000/600-11000/700 =18.33-15.71 = Rs2.62 reduction due to the spread over of fixed cost per unit and this has an advantages in his profitability also.