How do economies of scale work?

The term ‘economies of scale’ is synonymous for efficiency in production of goods and services. It simply means that as the business grows bigger and bigger, the cost of production per unit declines progressively. As the fixed costs remain the same and the lower cost of acquiring raw materials in bulk quantities leads to substantial savings in cost of production, the profits and the margins of the business would be higher than businesses that operate on a smaller scale. 

This can be illustrated by a simple example of a vada pav vendor. Suppose a vendor sells 200 units (vada pavs) per day and the average cost of production of 200 units is Rs 7 per unit. He sells the item at Rs 10 per unit and makes a profit of Rs 3 per unit, that is, Rs 600 (on 200 units) per day. Now, the vendor reduces the price to Rs 8 per unit and, as a result, the demand for his food item shot up to 1,000 units per day. So, now he needs to buy the ingredients such as potatoes, besan, chillies, cooking oil and spices in bulk quantities. Buying in bulk quantities gave him the bargaining power to negotiate for a lower price with the sellers of the ingredients. Therefore, the cost of production of his vada pav declined to Rs 5 per unit. So, despite the lower selling price of Rs 8 per unit, the profit per unit has remained the same (Rs 3 per unit). However, since the sales volume has gone up five-fold (from 200 units per day to 1,000 units), he would be making a profit of Rs 3,000 per day, a 400% increase from the earlier Rs 600 per day. This should explain the concept of economies of scale in its simplest form.

In the case of companies, there are large number fixed and variable costs involved, and economies of scale can be achieved when the fixed costs are spread over larger number of variable costs. The economies can also be achieved by upgradation of technology and retraining and reskilling of employees so as to enable them to do their job better, faster and efficiently, thereby increasing their productivity.

In short, economies of scale can be achieved when the average costs of inputs (variable costs) are reduced, followed by an increase in production. This is because greater the quantity produced, the lower will be the fixed cost, and vice versa. Also, the increase in production resulting from operational efficiencies and business synergies can also lead to economies of scale.