Economies of Scale - on path learning curve

This is the concept that as you produce more, the average cost per unit comes down because fixed costs are spread over more units. Economies of scale occur within a firm (internal) or within an industry (external).

Internal Economies of Scale

These are economies made within a company because of increased volume. As the company produces more and more volume, so the average cost begins to fall.

The reasons for this are usually:

• Technical economies made in the actual production of services or products, for example, large firms can use expensive machinery intensively. At first sight this may be difficult in forwarding but the large companies can afford to invest more in computers and information systems.
• Managerial economies made in the administration of a larger company by splitting up management jobs and employing specialist accountants, salesmen, etc.
• Financial economies made by borrowing money at lower rates of interest than smaller firms. This may also be of limited advantage to forwarders since they tend to have lower borrowing than manufacturing companies.
• Marketing economies made by spreading the high cost of promotion across a large level of output. In the case of this industry as volume increases then there is an opportunity to recover these costs over more locations.
• Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. This certainly applies to airline purchases although shrewd buying can often compensate for having small volumes.
• Research and development economies made when developing new and better products.

External Economies of Scale

These are economies made outside the organisation because of its location and are one of the main reasons why forwarders are located at ports or airports.

The reasons for these occurring are:

• A local skilled labour force is available
• Specialist local back-up companies can supply parts or services
• An area has a good transport network
• An area has an excellent reputation for producing a particular product or providing a particular service. For example, Glasgow/Edinburgh are associated with electronics.

Size is no guarantor of success in any industry and the forwarding industry is still fragmented enough to assume that small operators can operate as efficiently as large companies. Of course, size probably allows larger companies to attract major, global, customers who might overlook smaller domestic forwarders.

Dis-economies of Scale

Internal Dis-economies of Scale

These occur when the company has become too large and inefficient. As the company increases volume, eventually average costs begin to rise because:

• The disadvantages of the division of labour take effect - this is a well-known economic principle
• Management becomes out of touch with the shop floor and some-operations or locations become over-manned
• Decisions are not taken quickly and there is too much form filling
• Lack of communication in a large firm means that management tasks often get done twice
• Poor labour relations may develop in large companies.

External Dis-economies of Scale

These occur when too many firms have located in one area. Unit costs begin to rise because:

• Local labour becomes scarce and firms now have to offer higher wages to attract new workers
• Land and factories become scarce and rents begin to rise
• Local roads become congested and so transport costs begin to rise.

Learning curves

As we all know, another thing that depends on time is learning. A firm''s workers are likely to know a better way to make a product after they have been doing so for some weeks than on their first day on the job. This may enable the firm to reduce its direct labour time (and hence cost) per unit produced.

Experience has shown that this type of learning relates more to the volume of output produced than merely to the lapse of time. Learning reduces labour hours (and hence labour-related costs) per unit, not material costs nor machine costs nor other fixed costs. Hence, it probably has an impact on service industries like freight forwarding.

''The firm with the largest market share, and therefore the largest output per unit of time, should be learning faster than its rivals. If this does result in lower costs, a company which is further along the learning curve can either reduce its selling price, or make a higher margin on each unit sold. Indeed, a company might even

Plan to sell at a loss the first units produced in order to get business at a price which would enable it to make a profit later when it could produce more cheaply.

The explanation for the learning curve is rationalised by the Boston Consulting Group as follows:

Learning

Workers learn. If they learn to do a task better, they can do it in less time. This is equivalent to producing more in the same time. Based on the learning curve, labour costs only should decline 10-15 percent each time accumulated experience doubles

Specialisation

When the scale of activity increases so that numbers of people are involved, then it becomes possible to specialise.

If two people are doing the same thing, it becomes possible to break the task into two parts. One person does all of one half. The other person does all of the other half. Each will therefore do his respective task twice as often for a given total output.

The learning curve predicts that with twice the experience the labour time should be reduced 10-15 percent.

Increase in scale permits such specialisation. Consequently, each worker will approach a total experience at any point in time, which would be twice as much as he could have achieved without specialisation. Doing half as much but twice as often equals the same amount of effort but twice the experience with the task. Consequently, specialisation permits 10-15 percent less time per unit or 10-15 percent more output in a given time.

If the scale doubles simultaneously with total experience, then these two effects should occur simultaneously. Costs decline 10-15 percent because of learning plus 10-15 percent because of specialisation. The sum of 20-30 percent cost decline is alone an approximation of the total learning curve effect. Where growth in output increases at any constant rate, then change in scale and change in total experience can and often do occur in parallel.

Investment

By definition, a profitable investment is one where money spent now results in a future payout that is larger than the original investment. All the return on investment comes in more output for the same total cost, but deferred.

The cost decline in experience curves is a partial function of rate of investment

A significant part of the learning curve cost reduction is the result of return on investment.

Scale

The experience curve effect is the result in part of increased scale. With growth, there is constant addition of capacity. Each added increment of unit capacity becomes a smaller percent of the total capacity unless size of the increment is increased also. Both capacity utilisation and scale effect are affected by growth.

There are limits on scale due to load factors and logistics provided there is a finite total market. However, if the total market grows, then scale can be expected to grow too.

Scale effect applies to all operations, not just process plants. Marketing, accounting and all the overhead functions have scale effects also. Scale effect alone is sufficient to approximate the learning curve-effect where growth is constant and scale grows with volume.

The reasons for the learning curve effect are not particularly important. The important fact is that the learning curve is a universally observable phenomenon. If costs do not go down in a predictable fashion, then, and then only, do the underlying reasons become important. Analysis will usually show the reasons to be inadequate investment, poor assumptions or occasionally just mismanagement.

Summary

The experience curve is the result of the combined effect of learning, specialisation, investment and scale. The effect of each of these is an approximation, and so the experience curve effect itself is an approximation

The combination of these factors should permit a considerably steeper experience cost curve than is actually observed. However, some additional overhead cost is introduced by the need to coordinate and plan these changes.