Use economies of scale

Average cost a unit falls as volume spreads the fixed costs and bulk buying lowers the variable cost, until overtime, supervision and storage push it back up; price bulk discounts net of holding costs and find the volume a target cost needs.

Paper packet. Every task here also exists on screen, where it is checked automatically; answers written on paper are not assessed by Nydus. When you are back at a device, enter your answers there.

1. What you will learn

You will work out average cost at different volumes, price a bulk order net of storage, compare volumes with overtime, write the average-cost rule, fill in a bakery's sheet at a doubled volume, and find the volume a target cost needs.

2. What you already have

You can split a business's costs into fixed and variable, and compare growth choices on the change in monthly profit. Growth also changes what each unit costs. This lesson follows the cost of one unit as volume rises, first falling, then — past a point — rising again.

3. Words for this lesson

4. The fixed share falls as volume rises

Neighborhood Kitchen's catering line has fixed costs of 2,400 dollars a month — a van lease, a share of the kitchen, insurance — and each tray costs 5 dollars in food and packaging.

The variable cost stays at 5; only the fixed share falls, halving each time the volume doubles. That is why a larger rival can charge less and still make money, and why a small business's first extra customers are so valuable: each one lowers the cost of all the others. Bulk buying adds a second economy: at 400 trays, the packaging supplier's bulk price might take the variable cost from 5 to 4.50. Every figure here rests on stated assumptions about volume, price and cost. It says what follows if those assumptions hold; it is not a prediction, and it is not advice about what any real business should do.

Term	What it means
Average cost	Total cost divided by the units made: the fixed share a unit plus the variable cost a unit.
Economies of scale	The ways a unit gets cheaper as volume rises: fixed costs spread, bulk discounts, better equipment.
Diseconomies of scale	The ways a unit costs more past some volume: overtime, extra managers, storage, mistakes.
Bulk discount	A lower price a unit for buying a larger quantity at once.
Holding cost	What it costs to keep stock until it is used: space, insurance, spoilage and the cash tied up.

Another way: table

Average cost a tray at three volumes.

Trays a month	Fixed share	Variable	Average
100	24	5	29
200	12	5	17
400	6	5	11

Another way: steps

Separate the fixed costs a month from the variable cost a unit.
At each volume, divide the fixed costs by the units and add the variable cost.
Price any bulk discount, less the cost of holding the extra stock.
Add the costs that appear at higher volumes: overtime, storage, supervision.
Find the volume with the lowest average cost the business can actually sell.

5. The method, step by step, and how to check it

Separate fixed and variable. Fixed costs stay the same whatever the volume within a range: rent, a lease, insurance, salaried staff. Variable costs rise with each unit: materials, packaging, card fees, hourly labor on the job.

Work the average at each volume. Divide the fixed costs by the units and add the variable cost a unit. Doubling the volume halves the fixed share; it does nothing to the variable cost.

Add what appears at higher volumes. Past the business's normal capacity, extra units bring new costs: overtime rates, a second shift, a supervisor, more storage, more mistakes. Add them to the units that carry them before dividing.

Compare. The volume with the lowest average cost is the cheapest to run at — but only if the business can sell that many.

Check each figure by sense. The average cost can never fall below the variable cost, however large the volume, and it must fall as volume rises until new costs appear.

6. Bulk buying and what it really saves

Suppliers usually charge less a unit for larger orders, because one large delivery costs them less to handle than many small ones. A 10 percent discount on 2,000 dollars of jars saves 200. But the extra stock has to be kept somewhere until it is used, and the cash is spent months before the jars are sold.

So a bulk discount is priced net: the discount, less the holding cost — the rented space, insurance, any spoilage or breakage, and the cost of the cash tied up (the interest it would have earned, or the line of credit it forces the business to draw). A discount that saves 200 but needs 150 of storage saves 50, and it may still be wrong if the cash was needed for something else. Perishable stock and fashion lines carry the highest holding costs, because what is not sold in time is lost.

7. Where the economies stop

Economies of scale do not go on forever. Past a certain volume a small business meets costs that grow faster than the volume. Staff work overtime at time-and-a-half. The owner can no longer see every job, so someone must be paid to supervise. The premises get crowded and work slows. Mistakes rise as newer staff take on more. These are diseconomies of scale, and they push the average cost back up.

The lowest point — the volume where the fixed costs are well spread but the new costs have not yet set in — is usually close to the business's normal capacity. Growing past it means a step up in fixed costs, such as a second van or a larger kitchen, which starts the average cost curve again from a higher fixed base.

8. Competing with larger rivals

A larger rival often has a lower average cost, because its fixed costs are spread over more units and it buys in bulk. A small business rarely wins by matching its prices. It wins by differentiation — quality, service, a local name, a product the large rival does not make — or by focus on customers the rival serves badly.

Small businesses can still share some economies of scale. Buying cooperatives let independent shops order together at bulk prices; shared kitchens and workshops spread fixed costs over several businesses; online marketplaces offer shipping rates negotiated for millions of sellers. Each lowers the average cost without making the business itself any bigger.

9. Step costs

The fixed share falls with volume only if the fixed costs really are fixed. Many costs that look fixed are fixed only within a range. One van serves up to a certain number of deliveries a day; past that, a second van doubles the vehicle cost in one step. One kitchen serves up to a certain number of covers; past that, a larger kitchen or a second shift is needed. These are step costs: flat for a while, then a jump.

A step cost changes the picture. Neighborhood Kitchen's catering line might have an average cost of 11 dollars a tray at 400 trays, the most one van can deliver. At 450 trays, a second van at 900 dollars a month lifts the fixed costs from 2,400 to 3,300, and the average cost becomes 3,300 ÷ 450 + 5 = 12.33 dollars, higher than at 400. Only when the second van is well used — at 600 or 700 trays — does the average fall below 11 again.

So the question for a growing business is not only whether its costs fall with volume, but where the next step is and whether the volume beyond it will fill the new capacity. A growth plan that crosses a step with only a little extra volume can raise the average cost, not lower it.

The same idea explains why a business often grows in jumps. It fills its present capacity, working its fixed costs harder and its average cost down, until the next step is needed; then it takes the step and spends months filling the new capacity. Each step is a small version of the decision about a second location: a fixed cost taken on in the expectation of the volume to spread it over.

10. What to do with a lower cost

Lower costs a unit are worth most when they can be turned into something customers value or into profit the business keeps. There are three common uses.

The first is keeping the price and keeping the saving: the margin a unit grows, and so does the profit. This suits a business whose customers are not choosing on price.

The second is passing some of the saving on in a lower price, to win more customers from rivals. That works when customers compare prices closely and the lower price brings enough extra volume to lower the average cost further. It is the strategy of the cost leader, and it is dangerous for a small business, because a larger rival with even lower costs can always cut further.

The third is spending the saving on quality or service: a better ingredient, a faster delivery, a longer guarantee. This keeps the business differentiated while its costs fall, and it is often the best use for a small business, because it strengthens the thing its customers came for.

11. In the world: a coffee roaster's second roaster

A small coffee roaster in Portland, Oregon, sold about 1,500 pounds of coffee a month to cafés and online customers. Its fixed costs — rent, the roaster's loan, insurance and the owner's salary — were about 9,000 dollars a month, and each pound cost about 6 dollars in green beans and bags. Average cost: 9,000 ÷ 1,500 + 6 = 12 dollars a pound.

Wholesale demand was growing, and the owner looked at 3,000 pounds a month. The same roaster could handle it on longer days, halving the fixed share to 3 dollars. The green-bean importer offered a lower price for full-pallet orders, taking the beans from 6 to 5.40 a pound. But the longer days meant paying a part-time roaster about 1,800 dollars a month, and the pallets needed a storage unit at 300.

The owner worked it through: (9,000 + 1,800 + 300) ÷ 3,000 + 5.40 = 9.10 dollars a pound, nearly 3 dollars below the cost at 1,500. At a wholesale price of 11 dollars a pound, the lower cost turned a thin margin into a healthy one. The owner signed three new café accounts, bought the green beans by the pallet, and kept a review point: if volume fell below 2,400 pounds for two months, drop the part-time roaster's hours.

12. In the world: buying cooperatives

Independent hardware stores, grocers and pharmacies in the United States often belong to buying cooperatives, which negotiate bulk prices for thousands of members. The cooperative gives a small store some of the purchasing economies of a national chain while it stays independent.

13. Where this goes wrong

Bigger is always cheaper a unit. Only until overtime, supervision and crowding set in.

A bulk discount is pure saving. Take off the cost of holding the stock and the cash it ties up.

Doubling volume halves the cost a unit. It halves the fixed share only; the variable cost stays.

A small business must match a large rival's price. It usually competes on something else.

Economies of scale need more units sold. They count only if the extra units can be sold.

14. Maya's mugs at two volumes

15. Monica's bulk jar order

16. Northside Repairs with overtime

17. Your turn: Bright Home Cleaning

18. Guided practice

Maya's studio has fixed costs of $4000$ dollars a month — rent, the kiln's lease, insurance — and each mug costs $2$ dollars in clay, glaze and firing. Complete the sentence.

At $800$ mugs a month, each mug carries _f dollars of fixed costs, so her average cost is _a dollars a mug.

19. Guided practice

Complete the worked solution: Monica's supplier offers a $6$ percent discount on an order of $1000$ jars at $6$ dollars each, instead of buying them a few at a time. Storing the extra jars would cost her $300$ dollars in rented space. Find what the bulk order saves.

20. Guided practice

Neighborhood Kitchen's catering line has fixed costs of $4800$ dollars a month, and each tray costs $2$ dollars in food and packaging. Fill in the average cost a tray at 100, 200 and 400 trays a month.

21. Practice

Northside Repairs has fixed costs of $4800$ dollars a month, and each repair costs $6$ dollars in parts. It can do 200 repairs a month in normal hours, or 400 if the mechanics work overtime, which adds $8$ dollars to every repair above 200. Which volume gives the lower average cost a repair?

22. Practice

A business has fixed costs of $f$ dollars a month and a variable cost of $v$ dollars a unit. Write its average cost a unit, $a$, when it makes $q$ units a month.

23. Somewhere new

A bakery in Chicago has fixed costs of $18000$ dollars a month, and each loaf costs $3$ dollars in ingredients. It bakes 3,000 loaves a month and is thinking of doubling to 6,000; at the larger volume its flour supplier's bulk price would take $1$ tenths of a dollar off each loaf's ingredients. Fill in the working sheet.

24. Lesson test

Lesson test: one question per skill, one attempt each, no hints. Your answers are checked when you submit.

25. Test question

Bright Home Cleaning has fixed costs of $2800$ dollars a month, and each clean costs $3$ dollars in supplies and travel. To match a larger rival's prices it needs an average cost of $7$ dollars a clean. How many cleans a month must it do?

26. What you can do now

You can follow the cost of a unit as volume rises and falls. Tell someone why a bulk discount is not pure saving. Next: testing a second product.

	Average cost a tray, dollars
100 trays
200 trays
400 trays

	Amount
Average cost a loaf now
Fixed share a loaf at 6,000
Ingredients a loaf at 6,000
Average cost a loaf at 6,000