Economies of scale: why does the cost per unit fall when more is produced, and when does it stop?
When more bread is baked, the rent and equipment cost per loaf decreases. But beyond a certain point a new tandoor, and a new cost, is needed. A calculation using a bakery as an example.
Akmal aka, the baker in the neighbourhood, knows two kinds of days well. In the wedding season he bakes 400 loaves a day and ends the month with full pockets. In winter he bakes 70 loaves a day and, even though the price is the same, barely breaks even. The reason is simple: rent, the tandoor and the apprentice's wages do not change with the number of loaves.
Economists call this economies of scale: as the volume of production increases, the average cost per unit of output decreases.
Why does each unit get cheaper?
There are two types of costs: - Fixed costs do not depend on volume. In Akmal aka's workshop these are rent, depreciation of the tandoor and the apprentice's wages - Variable costs are added for each unit. For Akmal aka these are flour, salt, yeast and gas
Average cost per unit = fixed costs / volume + variable cost per unit.
In Akmal aka's workshop (amounts are hypothetical), fixed costs are 12 000 000 soum a month, and the variable cost of one loaf is 2 000 soum. One tandoor produces at most 12 000 loaves a month.
| Monthly volume | Fixed cost per loaf | Variable | Average cost per loaf |
|---|---|---|---|
| 2 000 | 12 000 000 / 2 000 = 6 000 | 2 000 | 8 000 |
| 6 000 | 12 000 000 / 6 000 = 2 000 | 2 000 | 4 000 |
| 12 000 | 12 000 000 / 12 000 = 1 000 | 2 000 | 3 000 |
When volume increased 6 times, the cost of one loaf fell from 8 000 to 3 000 soum. No savings were made: the same fixed cost was simply divided among more loaves.
When does the effect stop?
If more than 12 000 loaves are needed, a second tandoor and a second baker are required. Suppose fixed costs rise to 22 000 000 soum a month.
| Monthly volume | Fixed costs | Fixed cost per loaf | Average cost per loaf |
|---|---|---|---|
| 12 000 | 12 000 000 | 1 000 | 3 000 |
| 14 000 | 22 000 000 | 1 571.43 | 3 571.43 |
| 24 000 | 22 000 000 | 916.67 | 2 916.67 |
You see: at 14 000 loaves the cost rose again. Until the new tandoor is fully loaded, it does not pay for itself. At 24 000 loaves, however, the cost fell even below the best result with one tandoor.
When volume is large, another advantage appears: if flour is bought in bulk, the supplier sells it cheaper. If the variable cost falls from 2 000 to 1 800 soum, the average cost at 24 000 loaves becomes 916.67 + 1 800 = 2 716.67 soum.
But there is no endless growth either. If the bread starts being distributed to distant districts, a delivery cost of, say, 300 soum is added to each loaf; and the more employees there are, the harder control becomes. Economists call this diseconomies of scale: in an excessively large enterprise, the average cost starts to rise again.
Where does this show up in the accounts?
Workshop rent and tandoor depreciation are recorded in production overheads (2510) (NAS No. 21, paragraph 128), and at the end of the month they are allocated to the cost of products. That is why, in a month with low volume, the costing shows a high cost per loaf, and in a month with high volume a low one, even though the price of flour has not changed.
Practical conclusions
- Before expanding, calculate the average cost at the new volume: when will the new equipment be fully loaded?
- Check that there is demand for the additional volume. Unsold bread is not cheap, it is a total loss
- In businesses with high fixed costs (workshops, bakeries, printing houses), holding volume may be more important than raising prices
- Also calculate the break-even point: economies of scale start working after it
Test yourself
5 questions on this topic: pick an option or reveal the answer.
In a hypothetical market the producers' supply curve is P = 10 + 0.5Q (P in thousand soums, Q in units). If the market price is 30 thousand soums, what is the producer surplus (the area of the triangle between the supply curve and the price line)?
In economic theory, by what rule does a firm choose its output level to maximize profit?
The equation of exchange of the quantity theory of money is M × V = P × Q. In a hypothetical economy the money supply M = 200 bln units, the velocity of money V = 5, and real output Q = 500 bln units. What is the price level P?
In economic theory each factor of production brings income to its owner. What is the income received by the owner of the land (natural resource) factor called?
In hypothetical country A, one working day can produce 12 metres of fabric or 6 kg of tea; in country B, 4 metres of fabric or 4 kg of tea. Which country has the comparative advantage in which good?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- NAS No. 21 "Chart of Accounts", paragraph 128 (subparagraphs "b" and "e") · depreciation of production fixed assets and rent payments for production buildings are reflected in production overheads (2510)
- Example, amounts and calculations · compiled by the author, hypothetical