Relationship between efficiency and economies of scale

relationship between efficiency and economies of scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger factory will produce. Cost efficiency, economies of scale and economies of scope in the British retail banking . scale and the constant composition of outputs in relation to costs. Exploring the relationship between efficiency and profitability .. large firm to exploit economies of scale and scope, and to achieve a better market penetration .

Other common sources of economies of scale are purchasing bulk buying of materials through long-term contractsmanagerial increasing the specialization of managersfinancial obtaining lower- interest charges when borrowing from banks and having access to a greater range of financial instrumentsmarketing spreading the cost of advertising over a greater range of output in media marketsand technological taking advantage of returns to scale in the production function.

relationship between efficiency and economies of scale

Economies of scale is a practical concept that may explain real-world phenomena such as patterns of international trade or the number of firms in a market. The exploitation of economies of scale helps explain why companies grow large in some industries.

Economies of scale - Wikipedia

It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country—for example, it would not be efficient for Liechtenstein to have its own carmaker if they only sold to their local market. A lone carmaker may be profitable, but even more so if they exported cars to global markets in addition to selling to the local market.

Economies of scale also play a role in a " natural monopoly ". There is a distinction between two types of economies of scale: An industry that exhibits an internal economy of scale is one where the costs of production fall when the number of firms in the industry drops, but the remaining firms increase their production to match previous levels.

Conversely, an industry exhibits an external economy of scale when costs drop due to the introduction of more firms, thus allowing for more efficient use of specialized services and machinery. The management thinker and translator of the Toyota Production System for service, Professor John Seddonargues that attempting to create economies by increasing scale is powered by myth in the service sector. In trying to manage and reduce unit costs, firms often raise total costs by creating failure demand.

Seddon claims that arguments for an economy of scale are a mix of a the plausibly obvious and b a little hard data, brought together to produce two broad assertions, for which there is little hard factual evidence. This law has a direct effect on the capital cost of such things as buildings, factories, pipelines, ships and airplanes. Drag loss of vehicles like aircraft or ships generally increases less than proportional with increasing cargo volume, although the physical details can be quite complicated.

relationship between efficiency and economies of scale

Therefore, making them larger usually results in less fuel consumption per ton of cargo at a given speed. Heat losses from industrial processes vary per unit of volume for pipes, tanks and other vessels in a relationship somewhat similar to the square-cube law. A crude estimate is that if the capital cost for a given sized piece of equipment is known, changing the size will change the capital cost by the 0.

Also, the efficiency increases with size. Many aircraft models were significantly lengthened or "stretched" to increase payload. This is because labor requirements of automated processes tend to be based on the complexity of the operation rather than production rate, and many manufacturing facilities have nearly the same basic number of processing steps and pieces of equipment, regardless of production capacity.

Economical use of byproducts[ edit ] Karl Marx noted that large scale manufacturing allowed economical use of products that would otherwise be waste. In the pulp and paper industry it is economical to burn bark and fine wood particles to produce process steam and to recover the spent pulping chemicals for conversion back to a usable form.

This method is capable of making valid and consistent inferences about the performance of a two-stage production system, as well as the main sources of inefficiencies within a company. Findings — A poor performance over the study period is observed in the sample companies.

The low performance is mainly due to the low profitability. The results do not confirm the existence of a positive strong correlation between efficiency and profitability.

Economies of Scale - Definition, Types, Effects of Economies of Scale

The companies that have the capability of producing their products with the best practices are not always capable of generating the maximum profits. Practical implications — The need for the improvement of performance has two aspects: According to the study findings, the long-term survival of firms in our sample seems to require adopting mainly profitability-enhancing strategies.

Keywords Efficiency, Profitability, Performance decomposition model, Plant efficiency, Process efficiency, Profit Paper type Research paper Introduction Economic profits are usually the measure of financial success for a company. From this point of view, meat products production in Greece seems to be a profitable activity with positive future prospects.

The specific sector has additional benefits like increasing demand 4 percent per annum overICAP Hellas Given the dependence of this industry on imports of meat, a concern has been created over the recent years due to the rising prices of meat in international markets and the resulting negative impacts Benchmarking: An International on the cost of production of meat products in Greece.

Thus, the interest of managers and Journal Vol. Pappa for participating in the collection of the data, which has been partially used in this paper. It is argued that one solution is to improve its performance.

A practical question arises, concerning to what extent the manufacturing companies of meat products in Greece can enhance their performance, and how it should be measured. Although numerous models have been proposed for assessing efficiency, a new methodological proposition to capture overall firm performance has been recently developed by a team of few researchers.

According to this line of research, the division of the production process into stages is needed for measuring the real firm performance. Supporting this view, authors Seiford and Zhu measure performance in terms of profitability and marketability, by using two independent data envelopment analysis DEA models where the outputs of the first model are the inputs of the second model.

Few authors extend this research methodology by measuring the efficiency of a three-stage production process via the use of a triangular DEA model Keh et al. In recent years, however, the literature states that the conventional DEA model is not an appropriate decomposition approach for performance evaluation, because it cannot take into account the series relationships of stages within the overall process Kao and Hwang, ; Chen et al.

For this purpose, new performance decomposition models are developed to provide more accurate estimates of the performance of a two-stage production system, such as the model of Kao and Hwang and the additive performance decomposition model of Chen et al. Despite this growing body of literature, no evidence was found on firm performance and the association between efficiency and profitability for the meat processing industry.

This paper intends to contribute to this insight by evaluating the performance of Greek meat processing companies in terms of technical efficiency and profitability for the period For this, the model proposed by Chen et al.

relationship between efficiency and economies of scale

Further, the division of the production process into the stages of efficiency and profitability contributes to the discovery of the drawback areas within each company in our sample so that appropriate efforts can be devoted to improve its overall performance. The discussion on these issues is becoming increasingly important, because during the last decades, Greece came to a phase where the financial difficulties of companies and the relocation of several industrial activities in other countries to lower costs put in question the survival of a number of manufacturing sectors.

Notwithstanding, our findings relate to the context of meat processing production in Greece, they may be valuable for developing appropriate strategies to enhance performance in meat processing industry across the world. The next section explains the methodology and describes the data used in this paper. The third section presents the results regarding performance, profitability and efficiency assessment. The fourth and final section discusses and provides a summary of the results obtained from the analysis.

Methodology Efficiency and An approach for measuring the performance of two-stage production systems profitability Performance is considered a significant factor influencing the survival of a firm. As a result, it has received increased attention of empirical and theoretical works in industrial organisation and strategic management.

The last decade has seen an increase in the number of studies that are devoted to measuring the performance of two-stage production systems Seiford and Zhu, ; Karlaftis, ; Ho and Zhu, ; Ho, ; Mouzas, ; Tsolas, ; Kumar and Gulati, ; Eken and Kale, This approach assumes a two-stage production process with n decision-making units DMUs.

It was common practice to measure the efficiencies of two individual stages, E 1k and E 2kby applying a conventional DEA model proposed by Farrell and Charnes et al. In each initial formulation, the decomposition performance approach treated the two stages as if they operated independently. The standard DEA model for evaluating the performance of two-stage production systems was criticized recently in literature.

According to this critical analysis, the traditional DEA approach could generate a potential contradiction among the individual stages derived from the use of intermediate products Kao and Hwang, ; Chen et al. This is because the actions for improving the efficiency of the second stage e. Several attempts have been made to address this problem. Related work is given in Kao and Hwangwhich incorporates the assumption of series relationships between the variables of the first and second stage in a new model of a two-stage production process under constant returns to scale CRS.

This approach continues to decompose performance into the product of efficiencies of individual stages. A similar methodology is developed by Chen et al. Evaluation performance of a two-stage meat production process Taking into account the objectives of sample firms, the paper decomposes the meat production process into two individual stages connected in series, as shown in Figure 1.

The first stage concerns their own efficiency, namely the firm ability to achieve a minimum inputs cost for a given output.

The second stage is devoted to their profitability, namely the firm capacity to generate the maximum profits, by the revenue it creates.

  • Economies of Scale
  • Economies of scale

A two-stage performance evaluation model Xik Zjk Ypk BIJ the cost of capital, calculated as the sum of depreciation and interest, the cost of raw 20,5 and auxiliary materials, and the number of full-time employees is used. The set of outputs zjk of the first stage is the total sales value. The specific variable is an intermediate product that is also taken as the input variable in the second stage devoted to the production of final output ypkwhere in our case, the output is the profits.

This paper seeks to avoid bias in measuring of profits owing to possible tax avoidance and tax-evading companies, by using as profit proxy the total value added decreased by the total amount of expenditures for salaries and depreciations as proposed by Boyer and Freyssenet Efficiency, profitability and overall performance scores of an individual sample company were measured here via the additive performance decomposition model as proposed by Chen et al.

Overall, performance Ek of a firm is thus calculated as the weighted sum of its efficiency and profitability, as it is given by the formula: In the case of an input oriented VRS model, as the one adopted here, the weights w1k and w2k are defined as: Further, the formulation of Chen et al. So, the overall performance is given by the following linear program: To achieve that, one has to select which of the two stages is most important. So, by assuming priority for first stage devoted to efficiency, it is calculated by the following linear program: Following this assumption, the profitability of the other stage E 2k can be obtained by solving equation 1.

A similar approach can be written by giving priority to the second stage. A thorough review of the current approaches in the area of efficiency decomposition in the two-stage is described in Cook et al.

The described above performance decomposition model of Chen et al. This sample consists of the seven largest companies of the sector. A number of medium firms with employees and small companies with less than 49 employeesselected randomly by size, are included in the sample, too.

The required data for calculating efficiency and profitability scores were drawn from the annual balance sheets of companies published in the Greek Government Gazette. Further information for the number of employees, the cost of labour, and raw and auxiliary materials, that was not readily available, was compiled by a questionnaire survey conducted from March to June by the Panteion University of Athens. Late entries and early exits from the market are the main reasons that we use an unbalanced panel data including observations.

Empirical results Measures of efficiency, profitability, and overall performance Table I reports the measures of overall performance for each sample company that have been estimated by using an input-oriented VRS model over the period According to these estimates, the sample firms display on average a level of performance amounting to 0.

relationship between efficiency and economies of scale

Especially, only one company achieved a performance score equal to one and, thus, has the best practice in efficiency and profitability aspects simultaneously. All the other companies underperformed with a degree of underperformance that tends to be increased in the study period Figure 2.

An average firm in the industry had room to improve its performance from 25 to 38 percent in the different years, whether the firm used best practice in using its available resources without waste and in creating profits.

Economic Efficiency

Findings on performance by firm size categories, which is presented in Table II, reveal that smaller firms perform better than the medium-sized ones 0.

Looking at the estimated technical efficiency scores also presented in Table I, we conclude that one of the reasons for underperformance of Greek meat processing firms is their technical inefficiency, as only few companies, consisting The average technical inefficiency ranged from 10 to 19 percent in different years of the considered period. The analysis of technical efficiency scores by firm size Table IIillustrates that in most years, large firms have a greater level of technical efficiency than smaller ones 0.

OP and n stands for overall performance score and the number of firms; while E1, E2 stands for and number of firms by the average of technical efficiency and profitability score, respectively, by given priority for first stage size categories, A more aggravated image is presented by the profitability scores, as can be seen from Table I. The average profitability score for the entire period was 0.

According to profitability measures, only one company obtained a profitability score equal to one.