Therefore TC = TVC + TFC (Sloman, J., & Sutcliffe, M., page 173)
If we take the companies total cost and divide it by each unit of output we have the average cost (AC) of production. This figure is essential when evaluating the sale price for the unit of output. It is also necessary to know the marginal cost, which is the cost of producing one additional unit of output. In order to produce one more unit of output the company will need extra units of variable input, i.e. labour. This marginal cost information will inform managers whether the additional unit of output can be produced at a cost lower or higher than average cost of production. If production is continued with marginal costs higher than the average cost then the average cost will increase causing diseconomies of scale. (Beachill, B., 2004)
There are different types of economies of scale depending on the nature of costs and production method for a specific product. Economies of scale can be divided into internal and external economies which are shown in the diagram below.
Internal economies of scale relate to the reduction in unit cost produced by increasing internal efficiencies of the company. The factors influencing internal economies of scale are: purchasing, technical, financial, managerial economies and advertising. (A level of Achievement Business A Level Resources., 2000)
As a company expands it has the ability to order its raw materials and components in larger quantities thereby maximising its ability to negotiate discounts from its suppliers. Larger companies are more able to invest in the latest technologies which increase efficiency and productivity therefore reducing the cost per unit output. For example, a large production machine may produce a higher output than two smaller machines and only require one operator to achieve this doubling output. As a company expands it will have access to a wider range of capital because it offers more security for borrowing i.e. share issues which can reduce the cost of borrowing for investment in the new technologies. Large multiplant companies are able to spread their overheads by utilising one human resources department or one research and development which service the multiple plants. Larger companies are able to employ specialist managers who are specifically employed as experts in purchasing, production or marketing and are able to develop efficient working practices.
Managers in production and purchasing will concentrate their efforts in efficient production processes and ensuring best procurement of raw materials, ensuring the lowest unit cost possible whilst maintaining a quality product. Managers in marketing ensure that existing and potential customers are aware of and supplied with quality products at a competitive price. Advertising is very expensive for small companies and can add a significant percentage to the final unit cost of the product. As companies expand and their unit sales increase the cost of advertising as a percentage of the final unit cost decreases. As an example if a small business produces 500 chairs a year and the cost of advertising is £1,000 per year then the total advertising cost per unit is £2. Whereas a larger company producing 5,000 chairs a year the unit cost for the same advertising reduces to £0.20 per unit.
Large companies benefit from specialisation and division of labour. In a large company workers can be employed on more simple and repetitive jobs. Workers become highly efficient at their particular job; need less training, less time as lost workers switching from one job to another and the workers require less suspension as they become experts in their single task.
There are also external factors contributing to economies of scale these being factors that the firm are unable to control. As a company expands smaller companies will often set up locally in competition with one another to supply materials to the large company. These competitive suppliers will advantage the big company by reducing the cost and materials. Large companies are able to work with local colleges and training centres to develop the skilled workforce that they need at a very little cost.
Companies need to be aware that they can reach a point beyond which further expansion may lead to diseconomies of scale.
The diagram above plots cost against output, and shows that there is a point on the long run average cost curve, at which further expansion may lead to an increase in unit cost. This lowest point is known as the minimum efficient scale (MES), this is where the internal economies of scale have been fully exploited. (Tutor2u., 2005). This increase in unit cost after the point of MES is known as diseconomies of scale.
Diseconomies of scale occur when the company becomes so large that management become so out of touch with the shop floor, decisions take too long to be approved, and poor labour relations tend to occur in large workforces. These are all known as internal diseconomies of scale. There are also some external diseconomies of scale which occur when companies become large and successful. Local labour becomes scarce and firms have to offer higher wages to maintain their existing workforce and attract new workers. Local land and buildings become more scarce and rents begin to rise and the local transport infrastructure can become congested increasing transport costs.
The output of a company is dependent on the amount of resources available and how they are used. (Sloman, J., & Sutcliffe, M., 2004) By varying the amount of resources maximum efficiency and therefore optimum output can be achieved. Resources can be defined as one of four factors of production. These factors are; land, labour, finance and entrepreneurship. (Rodda, C., 2004) Some inputs can be varied in the short term; some may take longer to change. A short run increase in production is said to be achieved when one factor remains fixed, for example, a company may increase production in the short run by providing more raw materials, offering overtime to existing staff, or employing temporary staff, and using more electricity but they would have to use existing factory space and machinery as these would take much longer to change. Therefore the factory space can be considered a fixed factor in the short term.
The reference to long run in the above chart if the period of time when all factors of production are variable in supply. (Rodda, C., 2004)
The short run is defined as a period of time when at least one of the four factors of production is fixed in supply. (Rodda, C., 2004)
Short run increase in production is not sustainable in the long term as unit output cost will start to rise as reliance is given to increase labour costs i.e. regular overtime. Long run planning should run parallel to a short run programme.
The long run period is not a fixed period of time and is dependent on the time it takes to make all the factors of input variable, for example, if a shipping company required a new ship to carry more passengers it may take years to reach the long run state, where as the purchase of a new production machine may only take a few weeks to reach the long run state. (Sloman, J., & Sutcliffe, M., 2004, page 169).
The diagram below demonstrates that it is possible to plot a long run average cost curve from a number of short run average cost curves. If the companies starting position shows a short run average cost curve (SRAC1) then if the company builds a second factory it may lower its output costs by sharing administration costs, this factories output is represented by SRAC2 on the graph. By plotting successive factor investments the long run graph can be produced demonstrating the efficiency improvements. (Sloman, J., & Sutcliffe, M., 2004)
This essay demonstrates how by varying the input factors associated with production, economies of scale can be achieved. Input factor costs both fixed and variable are explained as is their effect on production costs. By careful evaluation and adjustment of the input factors maximum efficiency can be achieved. It is particularly important as a company expands to monitor short run production costs and to plan to achieve a long run production where all inputs are variable. Particular attention must be paid to marginal cost and to the other issues discussed which relate to increasing output costs due to diseconomies of scale. A full explanation of how short run costs differ from those in the long run has been given.
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