Economies of Scale

Posted by PITHOCRATES - December 31st, 2012

Economics 101

Employers are very Reluctant to hire Additional Employees because Labor Costs are their Greatest Costs

When it comes to running a business there is nothing more costly than people.  Employee salaries and wages.  Payroll taxes.  And benefits.  People need a large paycheck to live on and will go to the employer that offers the highest pay.  Government has imposed costly taxes and regulatory costs.  And to further entice good workers employers have to sweeten the deal with some fringe benefits like health insurance, paid vacation time, holiday pay, paid sick days and retirement plans.  It adds up.  Something like this:

As you can see the amount of pay employees are familiar with (the working pay above) is far less than the total cost to the employer.  The employee doesn’t see the 63.1% markup on their working pay that their employer has to pay in addition to paying the employee.  As a business hires more employees these costs add up.  A small factory with 15 workers on the factory floor can cost the employer $1.6 million.  Which is why labor costs are the greatest costs of most businesses.  And why employers are very reluctant to add additional employees.

The more Productive you are the Lower your Unit Cost and the Lower the Selling Price in a Store

Besides labor costs a business like a factory will have material costs, too.  These are variable costs.  They’re variable because they vary with varying levels of production.  The more production there is the more variable costs there are.  In addition to variable costs businesses have fixed costs.  Often simply called overhead.

Factories make things.  Like things you can pick up off a store’s shelf.  Things with low prices on their price tags.  But when it can cost a small manufacturer $1.6 million JUST for its labor costs how can they sell things with such low prices?  By making a lot of those things to sell.  As much as they possibly can with their variable and fixed costs.  What we call economies of scale.  And the more they can make for their given costs the lower the unit cost is for each thing you can buy off a shelf at a store.   As you can see here:

Assuming a factory can produce anywhere from 1,250,000 to 2,750,000 units with a given labor force operating the same production equipment in a factory you can see how the unit cost falls the more they produce.  Which is why there is so much talk about productivity.  The more productive you are (the more you can produce for a given cost) the lower your unit cost.  And the lower the selling price in a store.  Increasing productivity could mean moving an assembly line a little faster.  Or replacing some people with machines.  Things that workers don’t like.  But things consumers love.  For they like low prices when they go shopping.

Employers are very Reluctant to Hire New Employees and Prefer Increasing Productivity with Automation

If you crunch these numbers for the labor costs of 16 and 17 workers you can see how unit costs rise as an employee or two is added to the production floor.  At an annual production of 2,000,000 units the unit cost increases $0.05 (4.6%) going from 15 to 16 workers.  Adding two workers increases the unit cost $0.11 (10.1%).  Doesn’t seem like a lot.  But we notice when something we once bought for $0.99 now costs $1.04.  And we don’t like it.  But business owners like it even less.  Here’s why.

Business may be booming.  Those on the factory floor may be working a lot of overtime to produce at a rate of 2,000,000 units per year.  And are growing unhappy with all of that overtime.  They keep demanding that the owner hire another person.  The owner does.  Increasing unit costs by $0.05.  But the owner hopes the booming economy will continue.  And that they can even increase the production rate.  For if they can sell an additional 250,000 units the unit cost can actually fall $0.07 to $1.02.  Making the addition of a new worker on the factory floor not increase costs.  As the increase in production will make costs fall greater than that increase in labor costs.

But it doesn’t always work like that.  Economic booms don’t always last.  When too many factories increase production to meet booming demand they bring too much supply to market.  Causing prices to fall.  And forcing factories to cut back on production rates.  So instead of increasing the production rate they may find themselves cutting back.  Perhaps going from 2,000,000 to 1,750,000.  A fall of 250,000 units.  Increasing the unit cost $0.21 (19.3%).  Which could very well raise the unit cost above the prevailing market price.  Requiring layoffs.  To get the unit cost back down to $1.09.  Allowing them to sell at the prevailing market price.  And at a production rate of 1,750,000 units that may require letting go more than just one worker.  Maybe even more than two.  Which is why employers are very reluctant to hire new employees.  And prefer increasing productivity with automation.  For it is far easier to make machines increase or decrease production rates than it is to hire and lay off people.  Making it easier and less costly to reach great economies of scale.  Which makes low prices.  And happy consumers.


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