Economy of Scale

Economy of scale means that an organization is structured in such a way that as production volumes rise, per unit costs fall. In effect, this is a fancy of way to say “bigger is better”.

It is based on the idea that a product has two basic components to its cost, fixed and variable. Fixed costs stay constant as production fluctuates, and variable costs shift as production changes. The cost of a building, for example, stays constant regardless of whether zero units or a million units are produced inside of it. The spending on widgets that go into the Widgetron 2000, conversely, goes up and down with the ebb and flow of production.

(NOTE: Fixed costs are relevant only for specific production windows. Once capacity is exceeded, the infrastructure will need to grow.)

This means that companies with a lot of overhead need to produce more to cover their costs. One of the problems of that overhead is that it often reduces flexibility. A company that does not scale will lose far less money during slow times than a company that relies on a large, expensive infrastructure that scales well.

Consider the example of a lemonade stand. Fixed costs of the stand are likely relatively low. Rising and falling sales just means more overtime for the neighbors’ kids and a few more bags of sugar. There is little scaling, as the unit costs are independent of the production quantities.

But what if little Jimmy ran a bottling operation out of the garage? Let’s imagine that he invested in sophisticated equipment, maintenance contracts, and pays rent to his parents. He has a lot of costs to cover even if he doesn’t sell a single bottle of golden delight. But, at high volumes, he spreads his costs over thousands of bottles, meaning the costs above and beyond ingredients become minimal for each bottle. The bottling facility exhibits economy of scale.

In many ways, Lean principles are at odds with a cost structure that has a high percentage of fixed costs. Lean promotes right-sized machines and product-oriented work cells. Neither of these scales very much. You’ll need to add more equipment if production goes up substantially, so there is not a significant dip in cost per unit at high volumes.

But that’s not to say that Lean organizations can’t be capital intensive. It just means that you have to have a good understanding of the customer and know you can sell enough product to justify the cash outlay. Look at Toyota, one of the most renowned of Lean companies. They have massive infrastructures in their facilities. The unit costs drop substantially as they roll more cars off of their assembly lines.

But many companies miss the point on big, expensive machines. They buy them, and want to keep them churning out parts to keep the costs down. Unfortunately, if there is no immediate use for the part, there is an immense cost to the overproduction.

Lean companies do, however, have a related benefit that comes from size. While not truly an economy of scale, large companies have greater resources and can develop capabilities, systems, and infrastructure that support Lean efforts. A big organization can dedicate space to a continuous improvement / kaizen room and workshop stocked with tools and materials. They can create a cadre of internal talent that can teach others and share best practices. They can hire automation experts and tooling experts who can quickly build hanedashi devices (autoejectors) and production fixtures. The costs of those capabilities are allocated across a larger organization, so become feasible.

Words of Warning About Economies of Scale

• The logic behind creating economies of scale are sound but are often misapplied. All businesses do not benefit from having a capital-intensive cost structure.
• Increasing production to reduce costs only counts if there is a buyer for the product.
• Economies of scale come from fixed cost structures that tend to be inflexible. Be sure of the long-term demand before betting on scaling.
• Don’t look at local costs when investing in big equipment. Look at how the whole system will be affected. Several smaller, slower machines are often better than one large one.
• Don’t confuse indirect costs with fixed costs. An HR team, for example, will likely grow as production grows due to the larger staff.
• Don’t neglect variable cost savings just because fixed costs are high. As volumes go up, the impact of Lean rises. This is where Toyota really sees the benefit of Lean (though they do follow the equipment investment warning above.)

Think of people as fixed expenses, not as variable ones. Traditionally, labor is looked at as a variable cost, as people can be hired and fired to match demand. But there is a long-term demoralizing effect whenever there is a layoff.

More importantly, strong Lean organizations invest heavily in developing more than just production skills in their teams. They create an army of problem solvers. Every person who leaves the company takes some of that investment with them, and eventually, when production rises again, the new person has to start from square one.

Some industries, though, are highly seasonal or have some other reason for demand spikes. If you do have a highly variable demand, make sure that people know the job is temporary if there is a chance they will lose it when demand drops. They won’t like it, but they won’t be surprised. But the permanent staff will feel safe and satisfied, making them much more supportive of cost saving efforts.