Economies of scale

What are economies of scale?

Economies of scale are the cost advantages that a large company has over a smaller business because of its size. Those advantages may exist due to increasing efficiency, like how advances in a company’s production technology make it quicker and cheaper to produce its products.

Deeper definition

Economies of scale have the advantage that the cost per unit of output generally decreases with increasing scale as fixed costs are distributed over more units of output. As businesses become more proficient at producing their product or service, it becomes cheaper for them to produce as well: the first unit it produces costs a massive amount of capital, but the second one benefits from the costs already invested in the first.

That’s because companies with a lot of revenue have the ability to reinvest more of that revenue into their production process. Sometimes that means bulk-purchasing more material at a lower cost, spending more to get more volume, out of which the company can produce more of the product. That company may also allocate more money for research and development or product testing, allowing it to innovate, or for upgrading and installing improved technology that may make its operations faster and more efficient.

Eventually, the more of something the company makes, or the more times it’s able to perform a service, the cheaper it becomes to do it again.

 

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Economies of scale example

The introduction of an assembly line is a classic example of economies of scale at work. Before they became the norm, it was a considerable expense to incorporate one that not every business could afford. Now no manufacturing business can afford not to.

With the assembly line, it might take an entrepreneur millions of dollars to produce a single car, from building the factory and installing the assembly line, to advertising the business, to hiring workers. All things being equal, with those expenses out of the way, the second car will cost just a fraction of the first one, even though it’ll sell for the same price. Multiply that by hundreds or cars sold and eventually the investment has paid for itself.

Other Investing Terms

Prudent investor rule

Prudent investor rule is a term every investor should understand. Bankrate explains it.

Fiduciary rule

The fiduciary rule describes what a financial advisor can do with your money.

Repurchase agreement (repo loan)

A repurchase agreement is a short-term loan to raise quick cash. Bankrate explains.

Derivative

Derivative

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