Economies of Scale(s)

Oh, hello there! Welcome to Timos’s Silver Scale Shop!

We are a specialty boutique that crafts silver balance scales for judges, and…umm…people who like to balance things the good old-fashioned way!

While being a boutique manufacturer has been great, it’s not nearly as lucrative as it sounds (and it doesn’t sound all that lucrative). That’s why I’ve been saving up to bring this puppy to the big leagues. My goal is to get my scales in the hands of every judge, baker, mailman, and “pharmaceutical company” in the world!

My first problem? It costs a large amount to manufacture my scales, due to the small amount that I end up manufacturing each day. Being that I’m working with metal, I have to melt the silver and pour it into the mold, which takes a bunch of expensive machinery, making my basic cost of operating, regardless of output, a huge portion of the operation (AKA high fixed costs).

My plan? Take advantage of economies of scale. Economies of scale (EOS) is the advantage of lowering your cost per unit of output (in my case scales) as you increase output. So basically that means my cost per scale will lower as I make more scales–simple, right? That’s because there are certain fixed costs, like rent, machinery and tools, salaries, etc., associated with doing business that can be spread-out among more items, making profit per item higher.

Currently, I produce about 20 scales per week, but my machines cost me $7,500 each week to run. While that doesn’t sound too bad, I sell my scales for only $450 each–leaving me with only a few bucks in my pocket each month. But, if I can create and move more scales each week, I’ll lower the cost per scale to the point where I’m making a killing!

Now, when looking at economies of scale, there are two different types: internal economies of scale, and external economies of scale. Internal economies of scale come about in several different forms: production, managerial, network, financial, and monosopy power. Since I’m still trying to figure out the perfect approach, let’s dive into each for a little bit:

Production Economies of Scale: If I were to pursue EOS by way of production, then I would buy the absolute best machinery and turn the production dial “up to 11.” By doubling the number of scales made per week, I cut the per unit cost in half.

Managerial Economies of Scale: Consider this: I hire the world’s foremost scale salesperson, Lady Liberty. Lady Liberty could sell scales to the international space station. With her on my team, I will absolutely beat all sales records and dominate the competition. The more she sells scales by the seashore, the more I produce, so my cost per unit falls accordingly.

Network Economies of Scale: Network EOS comes about most easily in eCommerce businesses, or businesses that have web portals to buy their products. It is a lowering of the cost per unit by not needing to pay very much for each new customer. Since the site is already built and whatnot, the cost of bringing in new business is of negligible difference.

Financial Economies of Scale: Without getting too far into Weighted Average Cost of Capital (WACC), a company has financial economies of scale when their WACC is lower due to sheer size. That is to say, as a large enough company, you are able to raise money (either by debt or equity) faster and cheaper than smaller companies.

Imagine I’m a behemoth of a scale company after instituting one or more of the other strategies. I decide to take Timos’s Silver Scale Shop public on the New York Stock Exchange and raise some equity capital. I raise $100 million on the exchange, then turnaround and issue another $50 million in debt in order to build another factory. No one would dare take a tiny boutique shop public, but a large corporation is ripe for the selling. Furthermore, as a large company, I probably have a pretty great credit rating, allowing me to issue that debt with a yield of 5% (since I’m AAA rated), as opposed to 8%, if I were rated at BB-.

Monopsony Power: This is when, after becoming a super-behemoth, a company is able to lower cost per unit simply by throwing their weight around at suppliers. Think Walmart. They are enormous, likely buying more televisions and paper towels than you will ever see in your life. Because of this, Walmart knows they can squeeze suppliers until they lower their prices, making Walmart’s margins even wider.

While internal EOSs are controllable by the business, external EOSs are, essentially, a product of those all rolled-up into one. When a company becomes large enough, they hold a degree of weight in decisions outside of the normal line of business. Let’s say that scale sales really take off and I want to build a giant store for people to come and buy my wares–a super-scale shop, if you will. The issue is that I would need to build a new freeway in the area in order to support the traffic to my building (because, obviously, people would flock to buy my scales). Well, as a super-scale-power in the world, I could influence the local government to build such a freeway due to the huge economic impact that my store will bring.

All of this sounds great, right? I should just keep building and building until the entire world has tossed aside modern digital scales and replaced them with my timeless silver scales!

Well that would be great, but at some point the company becomes “too big for its britches” and runs into some issues. This is what is called diseconomies of scale (DOS). This occurs when a business becomes too large and cannot maintain its operations as well as it might have before, leading in an increase in cost per unit as output increases. For example, we expand our scale-selling operation to China but need to set up a Chinese division to handle intricacies of the market. As much fun as that sounds, it leads to an added layer of bureaucracy, where information and decisions have to be passed through several layers of the company before anything can get done, making us slower and less efficient than when we were a small, agile business (in my basement).

diseconomies of scale
Source: Investopedia

The second component is in quality controls, with a distinct focus on labor. After expanding our flagship factory from 12,000 square feet to 25,000 square feet, it becomes a bit difficult to supervise and motivate all of our employees. We try everything: breaking them up into teams, gamify-ing certain work goals, and spending a ton on after-work outings, but nothing sticks! Our employees are about as motivated as cats are keen on taking baths. Since the company is so large, it is nearly impossible to create the same type of close-knit atmosphere that was once present, leaving employees feeling distant and disengaged (not to mention all of the costs associated with a huge factory), thus lowering our productivity and, you guessed it, raising our cost per unit.

But, I’m just a boy with a dream–and a lot of scales. Who knows if I’ll ever be able to really achieve economies of scale, but hopefully I never hit the tipping point of losing money on every additional scale I make.

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