Economies of scale and capacity utilisation (economies of capacity)

This note is primarily directed to students. It is the second in a series on strategic cost analysis. Economies of scale is defined as a company's cost per unit being lower when the it produces at a larger volume. This note explains the difference between economies of scale and a related concept called capacity utilisation. Capacity utilisation refers to how much of the existing capacity is used for production.

Example: Airlines industry. In microeconomics, costs are either treated as fixed or variable. Variable costs typically consists of raw materials,other direct inputs and labour involved in turning the raw materials into finished products. Fixed costs typically consists of capital investment in production machinery, research, and labour not directly involved in production. When fixed costs form a large portion of total costs, we normally assume that economies of scale are important in the industry. However, in many modern industries it is impossible to treat costs as either fixed or variable. The airline industry can serve as an illustration: 

• Costs occurring due to increase in number of passengers: Handling charges for luggage, a small portion of fuel charges (for extra weight), landing charges charged per customer, travel agent charges. This is estimated to be a very small portion of total cost, 5-15%.
• Costs occurring due to increase in number of planes: Depreciation or rental of aircraft, landing charges, route charges, most of the fuel charges (plane is heavier than the passengers), labour cost of staff directly involved in flying. This is a major portion of total cost, 70-80%.
• Other costs: Image advertising, management and head-office salaries, investment in computer systems, severance payments (if any). This is a relatively modest portion of total cost, 15-20%.

The airline industry sells air tickets, but only 5-15% of total costs are truly variable based on the quantity of tickets sold. 70-80% of the cost occur when an airline decides to buy a new plane and traffic a route between two cities. The cost is fixed with respect to customers, so it cannot be treated as a variable cost. However, since the airline can easily sell or lease out a plane, the cost component cannot be considered a fixed cost either. In fact, we have three different types of costs in this particular case: (1) variable costs with respect to tickets sold, (2) variable costs with respect to number of planes and (3) fixed costs. (Students of managerial accounting, in particular activity-based costing, will be familiar with this perspective. It is possible to create more than three cost categories, but that will not necessary for this illustration.)

Since the fixed cost component is only 15-20% of total cost, it is not correct to conclude that economies of scale are important in the airline industry. The remaining 80-85% of total cost is not subject to economies of scale. Instead capacity utilisation (or we might call it economies of capacity) is important cost driver. Since in the short term (i.e. less than one year), an airline cannot easily get rid of planes, it has become an important managerial task to increase the load factor (i.e. capacity utilisation). Another way of characterising the industry is to note that the average total cost per ticket is not much influenced by whether the airline has 10, 50, or 100 planes. However, the average total cost per ticket is much influenced by whether the airline has a load factor of 50%, 70% or 90%.

Additional examples. Figure below provides  further examples. Industries like management consulting and clothing manufacturing are examples of industries in which there are very small economies of scale. Since most costs are variable with respect to customers, there is no major issue of economies of capacity. Industries like semiconductor manufacturing and oil refining are examples of the the opposite; large economies of scale. When economies of scale are large, economies of capacity will always be important, especially when customer demand is highly variable. The airline and supermarket industries are examples of the middle situation; low economies of scale, but with substantial economies of capacity. The upper right hand corner of the matrix is empty; meaning that economies of capacity are always important when economies of scale are large.

Figure 1. Source: Qualitative assessment by writer without access to specific data.

        

Implications for industry analysis. The distinction described above has some general consequences for industry analysis:

• Threat of new entrants. Economies of scale makes it more difficult to get into the industry. In developed economies, capital investment is generally a weak barrier to entry (unless the required investment reaches ~$500M), but nevertheless a barrier. However, situations with small economies of scale, but large economies of capacity are more deceptive. It is for instance possible to lease a plane for $1M per year. Such a low investment will make the threat of new entrants high.
• Rivalry. Industries in which economies of capacity is important will experience more rivalry (but not necessarily high rivalry). If the companies could improve economies of capacity, their marginal profit would increase substantially. Such potential will lead to more price competition (especially if price levels are not publicly displayed). If customer demand varies greatly depending on the business cycle, the effect will be stronger. Air travel is for instance more cyclical than energy consumption.