In order to make a profit, businesses seek to increase revenues and control costs. From a manufacturing perspective, one way to do this is to produce the right amount of goods in order to lower your costs efficiently and to maximize your profit. Understanding and applying the economic concept of the spreading effect can allow you to do both.
In order to comprehend the spreading effect, you must begin with the difference between fixed and variable costs. A fixed cost is a cost that remains the same regardless of how many products you produce. If you are a shoe company, for example, the total amount of your fixed costs would stay constant whether you produce 100 pairs or 100,000 pairs of shoes. Examples of fixed costs include the rent on your stores and buildings, management salaries and the purchase of manufacturing machinery.
How it Works
The spreading effect works to lower fixed costs. As you produce more goods, your fixed costs are spread out over a greater amount of production, reducing the unit cost of each product. For example, if you pay monthly rent on your factory of $50,000 per month, your landlord will expect you to pay that rent whether you've produced five pairs of shoes or 50,000 pairs. If you only produce five pairs of shoes, then the average fixed cost per pair is $10,000. On the other hand, if you produce 50,000 pairs of shoes in a month, that average fixed cost is reduced to only $1 per pair.
When production numbers are low, the spreading effect is very dramatic. Each extra item produced lowers costs dramatically. As production increases more and more, however, the benefits of the spreading effect are reduced. At some point, average fixed costs can no longer be substantially reduced. For instance, if your fixed costs are $50,000 per month, increasing production by 10,000 pairs from 50,000 pairs of shoes to 60,000 lowers your costs from $1 per pair to 83 cents per pair. This reduction is less impressive than the first 10,000 pairs that lowered cost per pair from $50,000 to $5.
As you increase production to lower fixed costs, keep in mind that, unlike fixed costs, variable costs always change with increases in the amount of goods produced. As you crank out more pairs of shoes, variable costs might include the leather used to create the shoes at your shoe factory or the hourly wages paid for the extra employees required for increased production. So, as you ramp up production to reduce fixed costs, be careful that variable costs don't get overwhelming or actually increase unit costs -- as, for example, when you have to start paying overtime to your workers.
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