4.5. Economies of scale, fixed cost absorption and learning

Question 1

Remark about firm’s size

Answer 1

Firm size is not an outcome but rather a strategic decision
e.g.
• Successful chemical, pharma, banking, insurance are sectors characterized by big players
• Successful furniture manufactures or doctor offices on the other hand are often small/medium-sized

Question 2

4 types of corporate strategy

Answer 2

• same business = business growth (profitable if business is specialised)
• different business = diversification ->
• vertical integration/value chain expansion (upstream and downstream)
• new geographic market = international expansion

Question 3

3 modes to achieve corporate strategy

Answer 3

• organic growth
• mergers and acquisitions
• partnerships

Question 4

Define standardisation

Answer 4

Creating large volumes of goods with identical or very similar characteristics for relatively long periods of time leads to a standardization of production processes (creating rules, guidelines etc.)

Question 5

Benefits of standardisation

Answer 5

• reduces consumer uncertainty
• network effects: the value of a good or service is a function of how many people use it (email, social network websites..) - several products only have value when other people use it
• easier to implement quality control
• reduces cost

Question 6

Costs of standardisation

Answer 6

• Limited choice set (not good to target specific segments of demand)
• May discourage product and process innovation
• Demotivation of workers

Question 7

Why does standardisation reduce cost?

Answer 7

a source of:
• Economies of scale
• Economies of fixed-cost absorption 
• Economies of learning
if these 3 exist => larger firms exist

Question 8

Define economies of scale

Answer 8

Reduction of average unit cost due to increased capacity

Question 9

Calculation of average unit cost (AUC)

Answer 9

AUC = Total Costs / Quantity produced

Question 10

Define production capacity

Answer 10

Maximum units of output that a company CAN produce

Question 11

Sources of economies of scale

Answer 11

• Bargaining power: easier to get price discounts from suppliers
• Specialization of labour: resources can be employed in a more specialized way
• Better Asset Use:
  + Indivisibility of certain inputs: Even if production capacity is low, some inputs cannot be bought in sub-units. Hence, the related costs do not increase when capacity increases (or increases less than proportionally)
  + Greater efficiency: Doubling the size of a truck’s power does not cost twice as much
• Geometric properties of containers - storage and transport

Question 12

Downsides of increasing scale

Answer 12

1. Diseconomies of scale
   – Due to technical constraints, managerial complexity, employee demotivation. A large facility becomes difficult to control
2. Quality
   – As the size of a classroom increases, the quality of teaching may decrease (more difficult interactions etc.)
3. Degree of utilization

Question 13

Production utilisation

Answer 13

The number of units that a company DOES produce

Question 14

How to calculate utilisation rate?

Answer 14

production utilisation x 100 /production capacity

Question 15

How does utilisation influence unit cost?

Answer 15

Fixed cost absorption

Question 16

Define fixed cost absorption

Answer 16

reduction of unit cost due to greater spreading of fixed costs

Question 17

Economies of fixed cost absorption

Answer 17

– We realize fixed-cost absorption economies by increasing the rate of utilization (for a given production capacity)
– These economies are higher if fixed costs represent a larger fraction of total costs
– If there are no fixed costs, there is no potential for fixed-cost absorption economies

Question 18

Natural monopoly and its relation to economies of scale and fixed cost absorption

Answer 18

– Indivisibility of inputs (driver of econ of scale) AND large amount of fixed costs (driver of fixed cost absorption)
– Resulting large production capacity
– Necessity to have high utilization
– Only a very small number of firms can be profitable

Question 19

Define excess capacity

Answer 19

• exists when the current levels of demand are less than the full capacity of a business - also known as spare capacity
• when utilization rate is low

Question 20

What happens at excess capacity?

Answer 20

• Pressure to cover high fixed costs by selling more -> Increased price competition -> Decreased profitability
=> The reason why firms with large levels of fixed costs (manufacturing) are more likely to have a lower margin (ROS)

Question 21

Define economies of learning

Answer 21

Reduction of unit cost due to cumulative production

Question 22

Define learning curves

Answer 22

shows the cost reduction (in percentage

terms) that occurs for a doubling of output.

Question 23

Learning curves and experience curves

Answer 23

e.g. a 20% cost reduction for every doubling of output It is called an “80% experience curve”, indicating that unit costs drop to 80% of their original level.

Question 24

Learning curves in different industry

Answer 24

– Aerospace 85% learning curve (little cost drop to original level)
– Shipbuilding 80-85% learning curve
– Involving complex machines 75-85% learning curve
– Repetitive electronics manufacturing 90-95% learning curve

Question 25

Sources of learning economies

Answer 25

• Enhanced human skills
– People to learn to improve their work habits and perform assigned tasks more quickly and better.
• Simplification of products and processes
– When people gain experience they find ways to simplify
• Better selection of materials
– Understanding which production resources are most appropriate for carrying out a given activity
• Higher programmability of activities
– Events become more predictable and response-time to non-standard circumstances is quicker
• Higher coordination
– With experience, individuals get to know one another and learn to work in teams and coordinate different processes

Question 26

Example of economies of scale and learning: Dr. Shetty, Narayana Hospital

Answer 26

35 Heart surgeries a day:
• asset use
• specialization of nurses, doctors,
• learning (sad but true, we are all guinea pigs!) 1000 beds
• bargaining power on all medical supplies
In addition to “no frills” service for the poor, cross-subsidized by “yes frills” services by the rich

Question 27

Why are sucessful firms in some industries larger in size than in other industries?

Answer 27

• Economies of scale (be aware of diseconomies)
• Fixed cost absorption economies (especially important in industries with large fixed costs)
• Learning (e.g. higher in industries with higher complexity)

Question 28

Differences between economies of scale and learning

Answer 28

• learning: a company can do something at a less expensive unit cost after time, where economies of scale are lower costs the more you do.
• If something is simple, but takes a lot of capital to be done, economies of scale will take place
• one involves increasing capacity and one is just cumulative, capacity did not increase
• it does not depend on producing more quantity or a wider portfolio, but from becoming a true specialist in a certain field, by producing a greater cumulative amount of the same product