Location and scale

Business A2 · Operations management. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

A location decision is about finding the site that gives the best balance of costs and revenue. Managers look at quantitative factors (site, labour and transport costs, expected sales) and qualitative factors (safety, room to expand, staff quality of life). A decision can be local, national or international.

Offshoring means moving an activity to another country, usually for lower costs or to be near new markets. Reshoring brings it back, often for quality, speed or reputation. Globalisation has made both easier.

Scale is the size of output. As a firm grows, economies of scale lower the cost of each unit. If it grows too large, diseconomies of scale raise the unit cost again.

Rules to remember

average (unit) cost = total cost ÷ output
Offshoring: relocating a business activity to another country. Reshoring: bringing it back to the home country.
Internal economies of scale come from the firm's own growth: purchasing (bulk buying), technical, financial, marketing, managerial.
External economies of scale come from the growth of the whole industry in an area, e.g. skilled local labour and nearby suppliers.
Internal diseconomies of scale: poor communication, slow decisions, weak coordination and low motivation in a very large firm.
External diseconomies of scale: congestion and higher land and labour costs when too many firms crowd into one area.
Qualitative location factors cannot be measured in money, e.g. safety, ethics, infrastructure quality, managers' preferences.

Common mistake

Students say that total cost falls when a firm gets economies of scale. Total cost still rises with output; it is the cost per unit that falls, so always compare average costs.

Worked example

A firm has fixed costs of $300 000 a year and a variable cost of $5 per unit. What happens to average cost when output rises from 50 000 to 75 000 units, and what does this show?

At 50 000 units: fixed cost per unit = 300 000 ÷ 50 000 = $6, so average cost = 6 + 5 = $11.
At 75 000 units: fixed cost per unit = 300 000 ÷ 75 000 = $4, so average cost = 4 + 5 = $9.
Average cost has fallen by $2 because the fixed costs are spread over more units.

Answer: Average cost falls from $11 to $9 per unit, so the firm is gaining economies of scale.

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