As a business grows in size and produces more units of output, then it will aim to experience falling average costs of production (i.e. on average, each unit of output costs less to produce). This is known as benefiting from economies of scale. In other words, the business is becoming more efficient in its use of its inputs to produce a given level of output.
Economies of scale can be divided into internal and external economies:
- Internal economies of scale simply benefit a single business as it grows (i.e. its average cost of production starts to fall).
- External economies of scale, however, benefit all the businesses in a particular industry (i.e. the average cost of production will fall for all the businesses in a particular industry).
Internal economies of scale
Internal economies of scale fall into four main categories:
- Technical. This refers to the fact that the use of automated equipment and machinery to produce output is far more cost-effective than using labour, since the machinery can be used 24 hours a day, with no breaks and with a constant level of output per hour.
- Purchasing. Larger businesses are more likely to be able to bulk-buy their supplies and their raw materials, and therefore secure their supplies at a far lower cost per unit than a smaller business.
- Financial. Banks and other financial institutions are more likely to offer a lower rate of interest on a loan repayment to a larger business than to a smaller business, since the larger business represents less of a risk because it is more financially secure.
- Managerial. Larger businesses are more likely to be able to afford to employ managers who are specialists in a particular field. These managers can therefore devote all their time to specialising in one particular field (resulting in higher levels of efficiency and hopefully falling average costs). Smaller businesses will often employ managers who have to perform a variety of tasks and therefore cannot specialise in a single area of the business.
External economies of scale
External economies of scale fall into three main categories:
- Labour. A large pool of available labour in a particular area of the country which has been trained at a local college, or even at a rival business, will possess specialised skills which will be useful to the whole industry, rather than simply to just one business.
- Joint ventures. Two or more businesses may decide to join forces (perhaps for R&D) in order to spread the costs and the risks of developing a new product or manufacturing process.
- Support services. A wide range of commercial and support services often cluster together in a certain area near a number of rival businesses (e.g. waste disposal, cleaning, component suppliers, distribution, etc). Clearly this benefits all the businesses in the area, rather than just one of them.
However, it is also possible that as a business grows in size and produces more units of output, then it will actually experience rising average costs of production (i.e. on average, each unit of output costs more to produce).
It is also possible that as a business grows in size and produces more units of output, then it will actually experience rising average costs of production (i.e. on average, each unit of output costs more to produce). This is known as experiencing diseconomies of scale. In other words, the business is becoming less efficient in its use of its inputs to produce a given level of output.
Diseconomies of scale can also be divided into internal and external economies:
- Internal diseconomies of scale simply affect a single business as it grows (i.e. its average cost of production starts to rise).
- External diseconomies of scale, however, affect all the businesses in a particular industry (i.e. the average cost of production will rise for all the businesses in a particular industry).
Internal diseconomies of scale
Internal diseconomies of scale fall into three main categories:
- Communication. This refers to the fact that as a business grows in size, the channels of communication lengthen and are more prone to delay and distortion. This can result in inefficiency in terms of the time taken to perform a task and, therefore, this can lead to higher costs.
- Co-ordination. As a business grows in terms of the number of employees, the number of departments and the number of different plants, then the overall co-ordination of all these can become very difficult. More and more meetings will be required and this all costs both time and money.
- Motivation. As the number of workers increases in a business, each worker will be seen to be making only a very small contribution to the finished product. This can result in falling levels of job satisfaction and motivation, which in turn can result in falling levels of productivity and, therefore, higher costs.
External diseconomies of scale
External diseconomies of scale often result from the overcrowding of businesses in a particular area and the resulting congestion, the late arrivals of supplies and raw materials, the late deliveries of finished goods to customers or warehouses, and the late arrival of employees to work. All these factors will affect all the businesses in a particular area and therefore push up their costs of production and distribution.
This is often referred to as 'Network Analysis' and it is a way of showing how a lengthy and complex project (e.g. a building project) can be completed in the shortest possible time.
The project is broken down into a number of separate activities, and each activity is then placed in the correct sequence, so to minimise the duration of the project.
It shows which of the activities are 'critical' - this means that if these activities are delayed, then the project will not be able to be completed on time. Management effort and resources can then be concentrated on ensuring that these 'critical' activities are completed on schedule. Other activities (which are not critical) have a degree of flexibility in the amount of time taken to complete them. This ensures that the waste of time and resources are minimised, and the profitability of the project is maximised.
A critical path diagram shows:
- the order in which each activity must be undertaken
- the duration of each activity
- the earliest date at which later activities can commence
Each diagram is composed of 'Activities' and 'Nodes':
- An activity is that part of the project which requires time and resources - it is represented by an arrow, running from left to right.
- A node is the start or finish of an activity, and it is represented by a circle. Each diagram must start and end on a single node and no activity lines must cross each-other.
Diagram 1 illustrates what a node looks like and diagram 2 illustrates a simple network :
The Earliest Start Time (E.S.T) is calculated from left to right on the diagram, by adding the duration of the previous activity to its own E.S.T.
The Latest Finish Time (L.F.T) is calculated from the right to the left after the E.S.Ts have been calculated. Work backwards through the diagram, starting with the E.S.T in the final node, and deduct the duration of each activity to arrive at the L.F.T in each node.
- Activity A is the start of a project (duration 3 days)
- Activity B can start when activity A is completed (duration 5 days)
- Activity C can start when activity A is completed (duration 7 days)
- Activity D follows all the other activities (duration 2 days)
The critical path is ACD, since if any of these activities are delayed then the project will not be able to be completed in 12 days.
The critical path is represented by double arrows.
The only activity with any spare time (called 'float time') is activity B, which takes 5 days to complete, but has 7 days in which to be completed (i.e. between day 3 and day 10). Therefore it has 2 days 'float time'.
It is clear to see from diagram 2 that if more than one arrow feeds into a node (as in node 3), then the EST at this node is determined by the longest preceding activity (in this case activity C).
The LFTs are calculated by working backwards from right to left. In node 4, the LFT will also be 12 days, because the earliest completion time for the project is day 12, so the management would want the LFT to also be 12. (The first and the last nodes will ALWAYS have the same EST and LFT). The LFT at node 3 is simply 12 days minus the 2 days that it takes for activity D to be completed.
This gives an LFT at node 3 of 10 days. The LFT at node 2 will be 10 days minus the duration of activity C of 7 days (since this is longer than activity B). This gives an LFT at node 2 of 3 days. The LFT at node 1 is simply 3 days minus the duration of activity A (i.e. 3 days - 3 days = 0)
Diagram 3 illustrates a more complicated network:
Consider the following table and use it to draw up a fully labeled network showing ESTs, LFTs and the critical path.
|Activity||Order/ dependency||Duration (days)|
|B||must follow A||4|
|C||must follow A||6|
|D||must follow B||4|
|E||must follow C||2|
|F||must follow C||8|
|G||must follow F||2|
|H||must follow F||1|
* Critical path is ACFG
* Therefore, activities B,D,E and H all have 'float time' available, (8 days, 8 days, 8 days, and 1 day respectively)
The minimum time in which the project in diagram 3 can be completed is 20 days. Any delay to activities A, C, F, or G (i.e. the critical activities) will cause the duration of the project to be more than 20 days.
The activities which have some float time available (i.e. activities B, D, E, and H) can be completed when appropriate, and any resources which are not being used at these locations can be transferred to the critical activities to ensure that these are completed on time.
Critical Path Analysis is a very useful management tool when a large and complex project is being undertaken, since it can help to reduce the total time and the resources that are needed to complete a difficult project, as well as identifying the potential areas which may cause problems.
However, it does need to be followed strictly and rigidly if it is to be a success and it does not allow for any changes in the external environment having a detrimental effect on the length of the project (e.g. poor weather conditions for a building project, or a high level of absenteeism amongst the employees).
This term refers to the ability of a business to compete effectively with foreign competitors in a particular industry, based on factors such as price, design, quality, and lead times.
The competitiveness of a UK business with overseas rivals will often be affected by the exchange rate of the pound (£) against foreign currency, since a strong pound may result in a fall in demand from both foreign and domestic customers and a corresponding increase in imports entering the UK.
Over recent years, the price of the product has been less of a consideration for many customers as the main reason for purchasing one brand over another. Instead, other factors such as the quality, reliability and after-sales service offered (e.g. warranties, guarantees, etc) have become important selling-points for products.
Companies and brands such as BMW and Technics have achieved high sales levels and profits through selling well designed, well built, high quality products, which are more expensive than many other rival products on offer. Selling these products at high prices enables the business to establish an upmarket, quality image, as well as producing high value-added products which contribute greatly towards the overall profitability of the business.
The UK is seen to have a distinct international competitive advantage in several industries, including fast moving consumer goods (f.m.c.g's), insurance and banking, and pharmaceuticals. In order to retain this competitive advantage over other foreign rivals then there are a number of criteria which must be met:
- Develop strong marketing and branding (i.e. find out what the customer wants and develop a strong corporate image to help sell the products).
- Become more capital intensive in the production of the products.
- Look for long-term growth and profitability, instead of short-term gains.
- Develop a strong reputation for customer service and after-sales service (helping the customer as much as possible is likely to keep them loyal to you).
- Don't assume that a low-priced product will outsell its higher-priced rivals (price no longer provides the competitive edge that it once did).