Economy of scale refers to reduction in cost of manufacture and supply of a product which results from the change in cost structure when the total quantity of the product supplied is increased. The phenomenon of economy of scale is applicable to most of the products but not all. Further, it is applicable only within a specific range of production volume. Also, the exact reduction in the production cost varies from product to product and range of production volume.
Economies of scale can be beneficial to a company only under certain condition. It is not necessary that company will always be able to sell more of the products manufactured to avail of economy of scale.
Typically, a company can increase its sale by reducing the price at which it sells its products. Thus, by increasing production, a company is able to reduce its cost per unit, at the same time it must also reduce the price per unit. A company will benefit from economy of scale only when the increase in total cost of production for all the units is less than total increase in volume. We will explain this by an example.
Let us say a company manufactured widgets 1000 per day at cost of $5 per widget and sell them at $8 per widget making a profit of $3000 per day. The company can reduce its cost to $4.80 per widget by doubling its production to 2000 widgets per day. To earn a profit of $3000 on its increased production the company will have to sell widgets at a unit price of $6.3. thus the company will be impacted positively only if it can sell 2000 widgets per day at price of more than $6.3. At a price lower than this its profits will reduce.
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