Economy of Scale

Economies of scale refer to the reduction of average production costs over the long term as a result of boosted output. As production increases, either within a firm or within an industry, a comparatively lower level of investment is required for each individual unit. The utility of the production process is thereby rendered more efficient as its application is spread over a wider range. The competitive attractiveness of building economies of scale lies in the fact that they allow firms to pass their cost savings on to customers, thereby lowering prices and undercutting competitors without damaging profit margins.

Scale economies also tend to heighten barriers to market entry, as smaller competitors find it increasingly difficult to cut costs to the levels possible for larger firms (made possible by their economies of scale). In this way, larger firms see economies of scale as an attractive business strategy, since it keeps new competitors from sapping their customer bases and profit margins. On the other hand, progressively cheaper technologies can pull against the advantages of economies of scale by lowering the barriers to entry and leveling the investment required to compete in a given industry

Line extension and economy of scale support each other. Economy of scale allows the company to make their investment in R&D and production of new and innovative products. Lets take the example of Procter and gamble which is one of the leading company of the world, having more than 130 product line.

Procter & Gamble competes through differentiation, and spends heavily on research and development to create products that are differentiated from that of competitors, and spends heavily on advertising to signal the value of the company’s brands. Due to their relationship with many retailers and investment in learning about consumer behavior,

P&G has a good sense of what consumers want in a product, and can effectively focus research and development to create new products, and improve existing products to better meet consumer needs. P&G is decentralized, with global business units focused on individual countries. This cuts overhead, and more importantly, lets the business unit optimize operations for a particular country. The combination of global scale and local focus enhances the company’s competitive advantage

Economies of scale allow P&G to spend much more than rivals on R&D and advertising. For example, P & G spends over twice as much on research and development than its nearest competitor. P&G’s largest competitors by trailing 4 quarters revenue are Unilever ($60B), Kimberly Clark ($19B), and Johnson & Johnson’s consumer segment ($16B).

Only Unilever has the scale to come close to what P&G can spend on advertising. Procter & Gamble’s advertising and R&D is spread over 44 brands that account for 90% of the company’s profits. There are many opportunities to leverage proprietary technology among multiple categories. P&G’s research and development is enhanced by a global relationship with nearly two million researchers in technology areas connected with P&G businesses. Moreover, these new products can be quickly brought to market Using P&G’s existing brands and distribution system. P&G’s relative level of innovation is apparent from the results of the 2008 industrial research institute’s pace setter study that measures the top new products measured by sales. In 2008, P&G had 10 out of 25 of the top new products in the non-food category. In comparison, Unilever, J&J, Kimberly Clark, Colgate, L’Oreal, and Energizer collectively had 7.