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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LESSONS LEARNED #20: “It is never a consumer that complains about ‘predatory’ pricing.” -Old Pithy

Posted by PITHOCRATES - July 1st, 2010

ECONOMIES OF SCALE and vertical integration can do two things very well.  Make industrialists rich.  And make the things they sell cheap. 

The more you make, the less each thing you make costs.  Businesses have fixed costs.  Big one time investments in plant and equipment.  Businesses have to recover these costs.  Each thing they sell has a portion of these fixed costs added to its price.  The more they sell, the less they need to add to each unit sold.  This is economies of scale.  Think of bulk goods.  Warehouse clubs.  Places where you can buy large quantities of things at lower unit prices.  You may buy an ‘economy pack’ of 3 bottles of shampoo shrink-wrapped together.  The purchase price of a 3-pack will be greater than the price of a single bottle of shampoo at your convenient corner drug store.  But the unit cost of each of the bottles in the 3-pack will be less.  You save more over time by buying 3 bottles at a time.  Spending more, then, means spending less.  In time.

Few of us buy raw materials.  Few have a need for crude oil.  Iron ore.  Coal.  Limestone.  Manganese.  But they make the stuff we buy.  A lot of things have to happen before those raw materials make it to us in those things we buy.  It has to be mined or drilled/pumped.  Transported.  Processed.  Stored.  Transported again.  Processed again.  Stored again.  Transported again.  There are many different stages between extracting raw materials from the earth and incorporating them into a final product we consumers buy.  At every stage there are costs.  And inefficiencies.  Which add to costs.  By reducing these costs along the way, the component materials used at the final manufacturing stage cost less.  This reduces the selling price of the final product.  This is what vertical integration does.  It puts everything from the extraction of raw materials to the incorporation of those processed materials into the final product for sale under control of the final user.  It brings in a high level of quality, cost containment and reduction of inefficiencies into the entire process resulting in a high quality, mass produced, inexpensive product.

Not everyone can do these things.  You have to live and breathe the industry you’re in.  You have to understand it intimately.  An industrialist at the top of his game can do this.  A politician can’t.  States trying to take control of their economy have failed.  Every time they’ve tried.  Why?  Politicians are ‘intellectuals’.  They’ve never run a business.  They only thought about it.  And, somehow, that gives them the moral authority to tamper in something they are simply unqualified to do.  And when they meddle, they destroy.  Purposely.  Or through unintended consequences.  In the process, though, they enrich themselves.  And their cronies.

ANDREW CARNEGIE WAS a brilliant entrepreneur.  After working for a railroad, he saw the future.  Railroads.  And he would build its rails.  And its bridges.  With his Keystone Bridge Company.  Which used steel and iron.  So he built his Union Mills.  Which needed pig iron.  So he built his Lucy blast furnace.  Which consumed raw material (iron, coke, limestone).  So he secured his own sources of raw materials. 

His Lucy blast furnace set world records, nearly doubling the weekly output of his steel competitors.  No one made more steel than Carnegie.  For less.  In about 20 years, he brought the price down for steel rails from $160/ton to $17/ton.  And got rich in the process.

Economies of scale.  Vertical integration.  And innovation.  Carnegie hired the best people he could find and used the latest technology.  Always improving.  Always cutting costs.  Always making steel more plentiful.  And cheaper.  His steel built a nation.  Dominated the industry.  And destroyed the competition.  Of course, that drew the attention of the government.  And they tried to break up the steel giant because it was unfair to the competition.  Who couldn’t sell steel as cheap as he could.

JOHN D. ROCKEFELLER was a brilliant entrepreneur.  After trying the oil drilling business, he saw the future.  The refining business.  For America lit the night with kerosene.  And he would provide that kerosene.  At prices that a poor man could afford.  And he did.  And he saved the whales in the process (his cheap kerosene put the whale oil business out of business).

Like Carnegie, cutting costs and production efficiencies consumed him.  He built his own kilns and used his own timber for fuel.  He made his own barrels from his own timber.  He used his own horse-drawn carts, boats, rail cars and pipelines.  He bought up competitors.  He grew to dominate the industry.  By far the biggest shipper, he got better shipping rates than his competitors.  And he constantly innovated.  When others were dumping the gasoline byproduct from refining kerosene into the river (no internal combustion engine yet), he was using it for fuel.  He hired the best talent available to find a use for every byproduct from the refining process, giving us everything from industrial lubricants to petroleum jelly (i.e., Vaseline).

His company, Standard Oil, was close to being a monopoly.  When they controlled 90% of the market kerosene was never cheaper.  He brought the price down from $0.26/gallon to $0.08/gallon.  And that was an outrage.  We can’t allow any one company to control 90% of the market.  Sure, consumers were doing well, but the higher-cost competitors could not stay in business selling at those low prices.  So the government broke up Standard Oil via antitrust legislation (the Sherman Act).  To protect the country from monopolistic practices.  And cheap kerosene, apparently.

BILL GATES WAS a brilliant entrepreneur in building Microsoft.  The personal computer (PC) was new.  You couldn’t do much with it in the early days unless you were pretty computer savvy.  But programs were available that made them great business tools (word processing and spreadsheet programs). 

IBM created the PC.  And they licensed it so others could make IBM-like machines.  IBM clones.  The PC industry chewed each other up.  But Gates did well.  Because all of these machines used his operating system (Microsoft’s Disk Operating System – DOS).  Apple developed the Macintosh (with a mouse and Graphical User Interface – GUI) but it was expensive.  Anyone who used one in college wanted to buy one.  Until they saw the price.  So they bought an IBM clone instead.  And when Gates came out with Windows, they were just as easy to use as the Macs.

Because of the higher volume of the IBM platform sold, Microsoft flourished.  Software was bundled.  New machines came preloaded with Windows.  And Internet Explorer.  And Windows Media Player.  You got a lot of bang for the buck going with a Windows-based PC.  And Windows dominated the market.  Consumers weren’t complaining.  Much.  Sure, there were things they did bitch about (glitches, drivers, viruses, etc.), but it sure wasn’t price.

Of course, Microsoft’s competitors were hurting.  They couldn’t sell their products if Microsoft was giving away a similar product free.  Because they were hurting their competitors, the government tried to break up the company with the Sherman Act. 

THE NORTHERN SECURITIES SUIT of 1902 found a holding company guilty of not yet committing a crime.  Teddy Roosevelt’s administration filed a Sherman antitrust suit against Northern Securities.  This was a holding company for Northern Pacific, Great Northern, and Chicago, Burlington, and Quincy Railroads.  What’s a holding company?  It replaced a trust.   Which large corporations created in response to government’s attacks on large corporations.

Small competitors feared large corporations.  They could not compete against their economies of scale and vertical integration.  The little guys couldn’t sell things as cheap as the big corporations could.  So the government intervened to protect the little guy.  So they could sell at higher prices.

But businesses grow.  All big corporations started out as little guys.  And the growing process doesn’t stop.  So the big corporations had to find other ways to grow.  They formed trusts.  Then the trust-busters busted up the trusts.  The next form was the holding company. 

The trust-busters said that the big corporations, trusts and holding companies were all trying to become monopolies.  And once they eliminated all competitors, they would raise their prices and gouge the consumers.  Northern Securities never did.  But they could.  So they were guilty.  Because they might commit a crime.  One day.

ALL BUSINESS OWNERS aren’t morally ethical and honest.  But the market is, albeit cruel.  Economies of scales will always put the little guy out of business.  Sad, yes, for the little guy.  But for every little guy put out of business, millions of consumers save money.  They can buy things for less.  Which means they have more money to buy more things.  New things.  Different things.  From new little guys who now have a chance with this new surplus of purchasing power.

But when politicians get involved, consumers lose.  When they help a competitor, they help them by keeping prices high.  To keep competition ‘fair’.  For the politically connected.

Consumers never complain about low prices.  Only competitors do.  Or their employees.  Those working on whaling ships didn’t like to see the low price of Rockefeller’s kerosene.  But the new refining industry (and its auxiliaries) created far more jobs than were lost on the whaling ships.  We call it progress.  And with it comes a better life for the many.  Even if it is at the expense of the few.

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