Increasing your profit margins
High costs hit profits, and one vital way of reducing costs is to develop economies of scale where the cost of producing individual units falls as the volume of production increases.
Overview
Given that fixed costs need to be divided between the total number of units produced, the more units produced the lower unit costs become. Economies of scale can be achieved when your suppliers are able to offer lower prices for large orders, or because your own means of production reaches a large enough scale for goods to be produced more cheaply – perhaps through more efficient equipment or where fixed costs are divided over many more units.
The graph below shows the average cost per unit falling as production levels increase:
Output
The benefits
Economies of scale:
• improve efficiency
• boost profitability
• may lead to price reductions
• enable resources to be used efficiently
• optimize output
• emphasize a focus on costs
• enable us to question current methods and look for improvements.
Why it matters
Achieving economies of scale is not simply about increasing profit margins. It is also about passing these savings on to customers by offering competitive prices, and benefiting shareholders and people who invest and risk their capital by building the value of the business.
Economies of scale are all about crunching the numbers and looking for ways to reduce those numbers even further. It may involve making substantial investments in new equipment. Again, it is a simple case of doing the sums: calculating all the costs, investment: price and expected sales and then seeing what comes out. The goal is to reduce average unit costs while being mindful of other considerations, such as the need to maintain an acceptable standard of quality and brand values.
The importance of managers taking economies of scale into account is clearly seen in the publishing industry. A short print run of a book is very expensive. The high fixed costs of the set-up are divided between a small number of books. These costs can be recouped only by charging a high price per book, which then has the disadvantage of being uncompetitively priced. When those high initial costs are spread over a larger print run, average cost per unit falls dramatically.
Admittedly, however, economies of scale are not always the only consideration – risk is also an important factor. Not only is there no point in achieving economies of scale if the product doesn’t sell, it has simply exposed you to greater risk or limited your strategic options by tying money up. Nonetheless, economies of scale enable companies to be more competitive and to increase their profit margins.