Closely tied to the question of how much capacity should be provided to meet forecasted demand are issues relating to the size of the increments of capacity to be added at any point in time. An operating facility’s size or, more precisely its scale usually affects the costs of acquiring and operating it. Although it is generally, recognized that it seldom costs twice as much to build and operate a facility (or increment of capacity) that is double the size of another, those costs depend on the specific technology and circumstances.
A facility’s total capital and operating costs generally increase at a slower rate than its capacity or output volume. This concept, called economies of scale, often is used – sometimes without careful analysis – as a justification for adding products or services to an existing facility or building a new facility that is bigger than currently needed. Although the concept is based on plentiful evidence of actual cost behaviour, so many different phenomena are encompassed by the term that confusion often arises as to what it really means in a specific situation. Moreover, different forms of scale economies (and diseconomies) affect not only capacity decisions, but many of the other types of decisions addressed here.
Economies of scale can arise for a variety of reasons and derive from many different components of total costs. Therefore, unless the logical connection between the scale economies observed in a given situation and the circumstances and actions that apparently caused them is carefully identified inaccurate forecasts of future costs can result. The easiest, most logical way to sort out the various causal factors that underlie such economies is according to time period.
In the very short term, many of the costs of operating a facility are relatively independent of its actual output volume. Hence, they are called period costs or unfortunately fixed costs. We say unfortunately because the term fixed cost often is misconstrued to an even greater extent than is economies of scale. All costs are variable over the long run, and are fixed only to the extent that decisions to change them require time to implement. In situations where many of the costs associated with an operation are difficult to change quickly (e.g. the wages of salaried personnel, the costs of depreciation, taxes, and insurance for plant and equipment, interest costs on borrowed capital, and in many settings, even the cost of direct labour), increasing the output will not cause total costs to increase proportionally. In such situations the major increase in total cost will come from the variable or direct operating costs, such as those associated with operator time, material and energy usage, and wear dependent equipment costs. Therefore, the cost per unit of output will decrease as total output increases:
Fixed costs + variable costs / total units produced
=fixed costs /total units + variable cost/ unit
This is sometimes referred to as spreading the overhead costs and is characterized as a short term effect because over time most fixed costs can be changed: salaried personnel can be added or reduced, investment in inventories or equipment can be increased or decreased and whole areas of a facility can be added or shut down. Also, as facilities reach their capacity limits, new capacities must be added. Since increments usually are added in chunks, the operation can shift rather quickly from operating at full capacity to being underutilized. As a result, this type of scale economy is usually transitory. In order to achieve economies that are more lasting, changes must be made in the way the existing process is managed.
Over a longer time period the firm can exploit increased operating rates to reduce costs in several related ways. In the case of repetitive operations, for example, one can increase the size of the batches being processed, thereby reducing the number of changeovers required to satisfy a given volume of sales. The average cost per unit would then be given by:
Average cost/unit = changeover cost/ total units + processing cost/unit
The extent of the economies achievable through this kind of action depends on how much it costs to make a changeover which is affected by other factors:
The actual cost of changing over to a different product (e.g. preparing operators, as well as resetting fixtures, dies, computer programs, ad instruction modules and perhaps adjusting and cleaning internal parts).
Run-in and run-out costs (the cost of higher than normal errors or defects and reduced labour efficiency at the beginning and end of a new batch)
The cost of lost output (when people and equipment are operating near full capacity, the time lost during changeovers may result in lost sales or lead to overtime and other costs to compensate for this lost production)