European Business Review

The continuing importance of economies of scale in the automotive industry

Rumy Husan
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The continuing
importance of
economies of scale in
the automotive
industry
Rumy Husan
Downloaded by Management and Science University At 18:22 16 November 2016 (PT)
The author
Rumy Husan is Research Fellow in the School of Business
and Economic Studies, University of Leeds, Leeds, UK.
Abstract
The considerable attention given to flexible methods of
production and work organization as a fundamental
determinant of achieving international levels of competi-
tiveness in the manufacturing industry (and of late, in
service industries also) in the wake of Japanese dominance
over the past two decades has, as a corollary, seen a
tendency to neglect the importance of economies of scale
(EOS). Despite the indubitable importance of flexibility,
argues that EOS remain an essential determinant for cost-
efficient production, and that without sufficient EOS, high
levels of flexibility cannot alone translate into world
competitive production. Summarizes the reasons for the
continued importance of EOS, and provides a discussion on
the levels of EOS (in particular, minimum efficient scale)
that are necessary for efficient automotive manufacturing.
It is assumed that EOS are optimal only when a plant is
operating at high capacity utilization levels, and that
where this is not the case penalties are severe.
European Business Review
Volume 97 Number 1 1997 pp. 3842
MCB University Press ISSN 0955-534X
38
The considerable attention given to flexible
methods of production and work organization
as a fundamental determinant of achieving
international levels of competitiveness in the
manufacturing industry (and of late, in ser-
vice industries also) in the wake of Japanese
dominance over the past two decades has, as a
corollary, seen a tendency to neglect the
importance of economies of scale (EOS).
Indeed, in regard to the automotive industry
(the first to introduce rapidly various methods
of increasing flexibility), it has been suggested
that the importance of EOS has been reduced
as a result of the introduction of increased
flexibility in motor manufacturing . This
indeed was the conclusion of the first major
report on the automotive industry conducted
by the International Motor Vehicle Program
(IMVP) under the auspices of the Massachu-
setts Institute of Technology (Altshuler et al.,
1984), while the second IMVP report
(Womack et al., 1990 the largest survey of
any industry) and the survey on manufactur-
ing productivity by the McKinsey Global
Institute (1993), in their respective analyses of
the various determinants of competitiveness
in the motor industry, did not cite economies
of scale.
Despite the indubitable importance of
flexibility, it is argued here that EOS remain
an essential determinant for cost-efficient
production, and that, without sufficient EOS,
high levels of flexibility cannot alone translate
into world competitive production. This
paper summarizes the reasons for the contin-
ued importance of EOS, and provides a dis-
cussion on the levels of EOS (in particular,
minimum efficient scale) that are necessary
for efficient automotive manufacturing. It is
assumed that EOS are only optimal when a
plant is operating at high capacity utilization
levels, and that where this is not the case
penalties are severe.
As a rule, EOS arise from the fact that an
increase in output (of one or more products)
does not give rise to a proportional increase in
cost hence the longer the production run
over a period of time, the lower the unit costs
will be, until the minimum efficient scale of
production (MES) for the product(s) in
question has been reached. Most economies
are internal to the manufacturer, although
external economies also exist. Internal
This paper draws on Husan (1996). My thanks are
due to Sanjaya Lall for helpful comments.
 Importance of economies of scale in the automotive industry
Rumy Husan
economies also known as technical
economies relate to production costs and
emanate from a variety of sources. Pratten
and Dean (1965, pp. 17-20) list the following:
The existence of indivisibilities (for exam-
ple of capital equipment), which results in
economies accruing from the attainment of
full plant capacity.
Economies of increased dimension where
cost increases less rapidly than capacity,
a phenomenon known to engineers as the
0.6 rule (Hay and Morris, 1986, p. 42)
or two-thirds rule (Scherer and Ross,
1990, p. 98). Economies arise from the fact
that, generally speaking, costs increase with
surface area, while output increases with
Downloaded by Management and Science University At 18:22 16 November 2016 (PT)
volume (or capacity) of additional units of
plant and equipment hence, for example,
a 100 per cent increase in output will
necessitate only a 60 per cent (or 66 per
cent, depending on the rule adopted)
increase in costs.
Economies of specialization whereby
higher output provides opportunities for
greater division of labour into specialist
tasks, together with increasingly more
sophisticated equipment which further
specialize (hence quicken) and improve
quality of tasks.
Economies of massed resources where
higher levels of production yield propor-
tional savings in stocks, spare parts, and, as
Silberston (1972, p. 374) argues, larger
output per unit of time allows flow produc-
tion to replace batch production.
Superior organization of production here
economies emanate from the possibility of
planning more efficient forms of organiza-
tion.
The learning effect in other words,
economies from learning by doing.
Clearly such economies exist for all levels
of output, and it is by no means certain that
long, sustained output of an unchanged
product yields significantly more
economies from the learning effect in
comparison with shorter runs of output
where the full learning effect has taken
place.
The existence of EOS implies that those
manufacturers not operating at the MES will
incur a cost-penalty vis--vis competitors who
are. Pratten (1971, p. 26) defines the MES as:
the minimum efficient scale above which any
possible subsequent doubling in scale would
39
European Business Review
Volume 97 Number 1 1997 3842
reduce total average unit costs by less than 5%
and above which any possible subsequent
doubling in scale would reduce value added per
unit (total costs less the cost of bought out
materials, services, and components) by less
than 10%.
Scherer and Ross (1990, p. 103) , authors of a
major work that deals substantively with EOS,
provide a rather imprecise, circular definition:
the smallest scale at which minimum unit
costs [are] attained. They in their work list
three types of EOS: product-specific, plant-
specific and firm-specific. Conventional
thinking on the motor industry has limited
EOS to only the product-specific type in
other words, output of various processes for
either a single product or related products, is
considered the most important factor in
determining EOS and MES. But plant size is
also an important determinant of product
cost.
However, in practice, this need not alter
the conventional view of EOS. Firms choos-
ing to expand output (of one or more of their
products at one or more of their plants) are
obliged to consider the nature and method of
expanding capacity in tandem: product-
scale is therefore inextricably linked to
plant-scale.
What are the levels of volume needed to
attain MES in the volume car industry? These
vary according to the process under consider-
ation. Estimates tend to be notional, so have
to be treated with caution, and vary according
to year and assumptions made. A clear exam-
ple of the magnitude of economies possible
comes from Fords production of the model T
before and after the use of the assembly line in
1914 when a cost reduction of 50 per cent
accrued over the following five years, in line
with a rapid increase in scale (Maxcy and
Silberston, 1959, p. 78). Table I gives various
estimates for MES levels for the major manu-
facturing processes for volume cars.
Notwithstanding the fact that the data are
rather dated (more recent figures being
unavailable)[1], the most striking aspect of
Table I is the large variance in figures for all
processes except for final assembly, which is
remarkably uniform. Thus generalizations
cannot be made with a high degree of validity.
But having made these cautionary remarks,
the figures do reveal two loose trends worth
commenting on: first, there appears to be a
gradual increase in MES levels over time;
 Importance of economies of scale in the automotive industry European Business Review
Rumy Husan Volume 97 Number 1 1997 3842

Table I MES estimates (in thousand units p.a.) for major manufacturing operations

Foundry/ Final
Source Year forging Pressing Powertrain assembly
Maxcy and Silberston 1958 1,000 500a 100
Toyota 1960 180-360b 480-600 120-240c 96-180
Pratten 1971 1,000 500 250 300
White 1971 Variable 400 260 200-250
Rhys 1972 200 2,000 1,000 200
McGee 1973 2,000
Ford UK 1974/5 2,000 300
CPRS 1975 100 500 250
Euroeconomics 1975 2,000 2,000 1,000 250
Notes:
a This is for machining only; b Forging only; c Machine fabricating

Sources:
Adapted from Central Policy Review Staff (1975, p. 16); Euro-Economics (1975); Ford UK (1975); McGee
Downloaded by Management and Science University At 18:22 16 November 2016 (PT)

(1973); Marsden et al. (1985, Table 4, p. 43); Maxcy and Silverston (1959, pp. 84-6); Odaka et al. (1988, p. 63
(cite Toyota figures)); Pratten (1971, p. 243); Rhys (1972); White (1971)

second, MES levels decline, the further
downstream a process is.
The first trend can be attributed to the fact
that the constant revolutionizing of technolo-
gy and methods of work organization yield
significant economies beyond the prevailing
MES levels: so applying Prattens definition,
total average unit costs would be reduced by
more than 5 per cent if production were to be
doubled: thus, there is a shift in the MES.
Figure 1 demonstrates this.
Long-run cost-curve A for a motor manu-
facturer gives MES1 the point at which the
scale curve A becomes horizontal (Silberston,
1972, p. 376). Improvements in technology
and methods of work organization, ceteris
paribus, yield cost-curve B, with a shift in
MES from MES1 to MES2. DOS1 and
DOS2 are respective diseconomies of scale,
arising from managerial or bureaucratic
drag. To this can be added two other
Figure 1 Illustrative MES Cost Curves
Unit
costs
A facturer would be to have eight assembly
B It is clear that only the largest manufactur-
Scale MES1 MES2 DOS1 DOS2
possible, related, factors giving rise to disec-
onomies: first, imperfect expansibility of the
management factor, i.e. management is less
efficient in larger firms, and second, diminish-
ing returns of management (Bain, 1956,
p. 61).
The second trend arises from upstream
processes being more capital and material-
intensive[2]. Thus they require higher levels
of output to ensure economic unit-contribu-
tion to plant costs both fixed and variable.
Herein lies a great advantage for the large
manufacturers and a major barrier to entry to
newcomers. Those manufacturers able to
fulfil MES levels for upstream operations, i.e.
2 million plus for foundry, forging and press-
ing, in conjunction with multiple plants for
assembly operations the least common
principle incur decisive unit-cost savings
over smaller manufacturers who are able to
achieve MES levels for final assembly opera-
tions but not for others. The least common
principle is simply the least common denomi-
nator for each operation. Thus if MES for
assembly is 250,000, for engine and transmis-
sion 1m, and for forgings/foundry and press-
ings 2m, the least common principle suggests
that the optimum configuration for a manu-
plants and two powertrain plants for each
pressings and forging/foundry plant.
ers will have resources for this. Such manufac-
turers are few in the motor industry just two
in the USA (GM and Ford); two in Japan
(Toyota and Nissan); and possibly three in
40
 Importance of economies of scale in the automotive industry European Business Review
Rumy Husan Volume 97 Number 1 1997 3842

Europe (VW, Fiat and PSA)[3]. Dunnett Table II Total production cost penalties from sub-optimal scale (Whites
provides figures to show that for the pressings estimates)
operation, between 1947-77, no UK manu-
Level of
facturer was anywhere near able to exploit all
production 50,000 100,000 200,000 400,000 800,000
scale economies, and that for example, in
Total cost-
1977, total production of pressings was only
penalty (%) 20 10-15 3-5 0 1
two-thirds of the MES level, while that of the
Source: White (1971)
largest manufacturer was one-third of the 2m
MES level (Dunnett, 1980, Table 2.4, p. 23).
What are the cost penalties associated with Table III Total production cost penalties from sub-optimal scale (Waverman
sub-MES production? Again, estimates vary. and Murphys estimates)
Pratten (1971, p. 271), in a study of various Size of plant
UK industries (on the basis of interviews and (% of MES) 100 80 60 30 10
examination of the technical literature) esti- Cost penalty 0 3 6.8 19.5 34.5
mated that, for the passenger car, the percent- Source: Waverman and Murphy (1990)
age increase in cost at 50 per cent MES level
was approximately 6 per cent per unit.
Downloaded by Management and Science University At 18:22 16 November 2016 (PT)

White provides the following estimates for

vertical integration; capital-raising
total production cost penalties at sub-optimal
economies; economies of large-scale promo-
scale of production (see Table II):
tion; economies of research and development
Waverman and Murphy, in a more recent
which become more important as technolo-
survey, provide the following estimates of cost
gy change increases and so are particularly
penalties (in 1984)[4].
relevant for the motor industry; and
Whites estimates are the least penalty-
economies of scope where economies
incurring, while Prattens (1971) and Waver-
accrue from transfer of knowledge across
man and Murphys (1990), assuming MES of
different, but related, product lines. The
250,000, are similar, at approximately 6 per
principle remains the same for these as for
cent; a significant sum, given the highly com-
EOS, i.e. the larger the manufacturer, the
petitive nature of the international market,
greater the ability and opportunities to
and an explanatory factor in the difficulty of
achieve economies. Indeed, under the prevail-
smaller manufacturers to remain independent
ing situation of rapid technological change,
(see Table III). For manufacturers operating
economies derived from R&D and from
at below 50 per cent MES, cost penalties
promotion have become increasingly
increase exponentially. This corroborates a
important.
commonly observed phenomenon in develop-
One can conclude that reduction in MES
ing countries: that, despite lower labour costs,
levels for a single model through increased
average unit costs tend to be substantially
flexibility assumes the existence indeed
higher for similar vehicles in comparison with
requires it of other models for the attain-
those produced by MES manufacturers.
ment of overall line or plant MES. So, in spite
EOS also accrue in just the same way for
of there existing greater flexibility of manufac-
component manufacturers and other suppli-
turing, EOS and related economies remain
ers. If all these operate at their respective
crucial for competitive production. Hence,
MES levels, then ceteris paribus, costs to
implementation of flexibility in the manufac-
OEMs[5] will be optimal. Whether suppliers
turing system does not constitute a substitute
are able to achieve MES levels will, above all,
for EOS, but rather is incremental to it.
depend on levels of demand from the OEMs.
It is therefore clear that there exist
national/regional economies which emanate Notes
from the existence of high demand, high
output, and large firms which augment the 1 Indeed, one can conjecture that this is a consequence
purely product, plant or firm-specific of the focus of attention so significantly shifting to
flexibility issues over the past decade and a half.
economies. This reinforces the disadvantage
2 Rhys much lower figure for the foundry operation
experienced by relatively small manufacturers
stems from his assertion of this being highly labour-
in low-demand, low-output regions. intensive. However, he later qualified this by stating:
Alongside EOS arise various other related at present, the optimum size of the foundry is quite
economies. These are: economies from small, but the increased use of machinery plus the
41
 Importance of economies of scale in the automotive industry
Rumy Husan
need to work with new sophisticated metals may
increase the optimum, especially if more specific
equipment is used (Rhys, 1972, Table I, 285-6).
3 Although Fiats production has declined markedly in
the early 1990s (1990). GM Europe, Ford Europe and
Renault could also be added to the list.
4 It should be noted that Waverman and Murphy
assume assembly plant MES of 400,000. They mistak-
enly attribute this to White; but Whites (1971)
estimate for assembly MES was between 200-250,000
(see Table I) he had, as can be seen from Table II,
estimated total production economies could be
utilized at 400,000 units p.a.
5 OEMs (original equipment manufacturers) manufac-
ture and assemble components for new vehicles. They
are also known as final assemblers or simply as
vehicle manufacturers.
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Volume 97 Number 1 1997 3842
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