Transportation’s Tricky Balancing Act
Done right, economies of scale can lower a carrier’s average costs and the freight rates charged to their customers. Getting it right is a balance.
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In just about every episode of Shark Tank at least one of the wealthy investors will ask an aspiring entrepreneur if the deal they’re pitching is scalable. It’s certainly a good question for investors to ask. After all, they want to make their money back as quickly as possible and then sit back as the profits from sales roll in.
Of course, that would be hard to do if the business in question needs to pile on costs just in order to increase its market share. In other words, investors like to see a business’ sales revenue grow faster than its costs. This is what they mean by scalable or, more specifically, economies of scale.
The term “economies of scale” is a popular one in the business world. Many, however, use the term incorrectly. Furthermore, many shippers who rely on inbound and outbound transportation to bring in raw materials and distribute their finished goods may not realize the multitude of ways that transportation carriers can achieve “scale.”
The good news is that economies of scale can lower a carrier’s average costs and potentially lower the freight rates charged to their shipper customers. The bad news is that economies of scale don’t go on indefinitely. There is a point when average costs will actually rise as scale increases. This is known as diseconomies of scale. Getting this right to maximize your transportation strategy is a balancing act—regardless of the mode or modes of shipping.
How economies of scale affect that balancing act is the subject of this article. We’ll look at the specific costs involved in defining economies of scale and set out three items which are important in the definition. We’ll distinguish between the internal and external sources of economies of scale and diseconomies of scale. Finally, we’ll discuss the various ways “scale” can be achieved by transportation carriers.
Why is this important? Because an understanding of the opposing forces of economies and diseconomies of scale is necessary for shippers and carriers to know how to strike the right balance in their transportation planning.
Defining economies of scale
Let’s start with a definition of economies of scale and consider three critical items. The first item is that the term economies describes what happens to operating cost as the size of the operation itself increases. The term doesn’t directly relate to sales revenue or to profit. Specifically, when a business takes advantage of economies of scale its total costs rise at a decreasing rate.
Many business people make the mistake of thinking that costs will fall when economies of scale are exploited. Sorry, but that’s just not the case. Technically, as total cost rises at a decreasing rate it is only the average cost that is decreasing. After all, it’s hard to think of a business that increases its scale of operation by, say, 25% and finds that with all the extra labor and capital now employed that its total cost has actually fallen.
No, what happened is that the scale of operation increased by 25% while total cost increased by some lower percentage. Because average cost is defined as the ratio of total cost over the current level of production, the ratio declines as scale increases when economies of scale are exploited. Conversely, when facing diseconomies of scale, total cost rises at an increasing rate. The result is that the average cost rises.
Item two is the role of technology. Economies of scale is assumed to occur over a production process experiencing no technological change. The means by which inputs are turned into outputs—an equation that economists call the production function—does not change as the business increases its scale of production. The implication is that more qualitative inputs such as managerial skills remain constant and there are no innovations taking place that would affect the production process.
While these don’t hold in the real world, the assumption is that economies of scale looks at how a given set of inputs are turned into specific outputs. Changing the quality of inputs or substituting in other more innovative inputs means the equation for the production function would have to be redefined to account for these. This changes how total and average cost behave.
In this context, economies of scale have little meaning. The good news for businesses seeking innovations is that technological change has a long history of reducing production costs and bringing improved products to the marketplace. Innovations in science or management can, indeed, make a business more scalable; but one cannot explicitly build innovation into production plans. The sources of economies of scale to be discussed later in this article are more systematic.
The third item to be aware of is that the term economies of scale is what economists call a long run concept. This means businesses must plan in advance for a certain scale of operation and, once achieved, they have to live with the consequences until, in the long run, the plan can be revised to meet new market realities.
This interim period is known as the short run: This is where some components of a business’ operation are fixed in size, such as the capacity of a warehouse, the duration of a lease on a vehicle or union wages set through collective bargaining. Thus, the choice of scale is a strategic exercise because it involves a forecast of what market conditions are expected to be over the short run interim.
Inside and outside
With the definition of economies of scale, now there are three important questions to consider:
- Will the chosen scale provide enough product to meet downstream customer demand?
- Will upstream vendors be able to provide enough inputs to facilitate the level of production necessary to fulfill point (1)?
- Will financial and operational costs be low enough to set a product price that will generate enough sales revenue to stay in business in the long run?
Those are all internal questions that can be answered inside the enterprise. But, it’s not that simple. Outside the enterprise, a business may face competitors who are likewise trying to achieve an appropriate scale of operations.
With a fixed level of consumer demand, vendor supply and financial capital, it becomes harder for one business to achieve higher scale if one or more competitors are already larger and have a lot of market share. Each business is striving for so-called internal economies of scale.
On the other hand, more competition may be beneficial for all competitors in an industry if it attracts external players which help to grow the entire industry. This is what’s meant by the term external economies of scale.
Consider more carefully the internal and external sources of both economies and diseconomies of scale. Internal circumstances can lead to either a decrease or an increase in long run average costs as the business grows larger. As a business increases in scale from a small labor force it makes sense to divide production into more specialized tasks with specific departments set up to manage these tasks.
This division of labor can lead to efficiencies. The modern assembly line is the best example of this. If tasks become too narrow, they can become mundane and quality control can become a problem.
Also, as the business becomes larger it may become more bureaucratic, mired in red-tape and less flexible because more and more time is spent pushing paper and attending meetings. Guarding against these pitfalls is a very important organizational task. In fact, it is a balancing act between lean and lethargy and flexibility and inflexibility.
As for external circumstances, as a business becomes larger it may make sense for local government to improve transport infrastructure in the vicinity in order to get workers, vendor supplies and customers to and from the place of business.
On the other hand, a business can become so large that it creates congestion within a given infrastructure, or it begins to exhaust a free publicly-available input such as clean water, and costs begin to rise. Thus, it’s also incumbent on a business to follow the workings of government and plan accordingly when trying to exploit external economies of scale.
There is also an interplay between internal and external economies of scale through the set-up or sunk costs of a business. Any business will incur such costs because the production plan must be conceived, vendor relationships must be established and distribution channels created. The larger the business the more these set-up costs are distributed over the pool of output.
In this way, long run average cost declines. As a simple example, consider advertising as an upfront cost to setting up a distribution channel. A minute of commercial TV time during the Super Bowl is so expensive it only makes sense for the largest businesses to pay for it. They have more output and sales revenue to validate such a purchase.
Basic economics looks at scale in a singular fashion; just the size of the operation. But for a transportation carrier, the scale of an operation can take many forms. These include: the size of a vehicle or shipping container; the number of vehicles in a fleet; efficiencies in the transportation network; and a shipment’s weight and distance carried. Each of these will be discussed in turn.
But, recall, such sources of economies of scale will eventually become diseconomies of scale. Therefore, striking the right balance in transportation planning is very important. With that as backdrop, let’s look at it in the context of transportation, using size as it applies to the most prevalent modes of truck, rail car, airplane, water vessel and pipeline.
Vehicle/container. Economies of vehicle or container size come about because the volume or carrying capacity of a truck trailer, rail car, airplane, water vessel or pipeline increases faster than the quantity of side material needed to build it. For example, compare a 3’x 3’x3’ container with a 6’x 6’x 6’ container. The material used on each side would increase by four times; that is, each side increases from 9 square feet to 36 square feet. However, the capacity of the smaller container is 27 cubic feet while the larger one is 216 square feet, an increase of eight times.
The good news is that carrying capacity, an important source of carrier revenue, increases faster than the material cost involved in expanding that capacity. The bad news, however, is that the vehicle or container can become too big to haul shipments along a given road or canal. An airplane could be so big that it takes too long to load and unload passengers. The pipeline could collapse under its own weight when loaded. These are all examples of diseconomies of scale.
Fleet. Economies of fleet size come about when considering how vehicles can be deployed efficiently within an interconnected market area. Consider one truck that heads only north-south and another that only travels east-west. Suppose their routes cross each other at some point. These trucks are independent operations within the motor carrier’s fleet. However, the cross-point offers the opportunity to interline, or exchange cargo at a warehouse.
The good news is that this interconnectivity effectively offers six routes of service instead of just two. Such interline points are essential in less-than-truckload (LTL) operations which are characterized by trucks filled with multiple shipments going to multiple locales. The bad news comes when the warehouse becomes too congested to effectively offer LTL service in a time frame that shippers are willing to pay for. Examples of important interline points are Chicago, where all seven Class I railroads converge, and Memphis, where FedEx maintains its “super hub” with all of its air cargo routes spreading worldwide.
Network. Economies of network efficiency come about when the design of the system of routes allows for the fleet configuration to be diversified. Consider the hub-and-spoke network that airlines have deployed since deregulation in 1978. Large capacity airplanes carry passengers from hub-tohub while smaller airplanes are used along the spokes around an air carrier’s hub airport. For example, a commercial flight from Anchorage, Alaska to Spokane, Washington will likely route through the SeaTac airport hub.
Without hub airports it is unlikely that many city-to-city combinations would be cost effective. Of course, diseconomies of scale sets in when the hub airport becomes congested due to the multitude of spoke routes and their incoming and outgoing passengers. It certainly does not help that airspace in the United States isn’t as efficiently utilized as it might be due to antiquated air traffic control systems.
Shipment. Economies of shipment weight and distance come about when considering all the costs that increase as a shipment’s characteristics change. For example, doubling the size of a given shipment or hauling a given shipment double the distance should not double all of the costs associated with that delivery. Just one pilot and one copilot are necessary for a fully laden cargo jet travelling 5,000 miles or 10,000 miles, or carrying 50% or 100% capacity.
These costs will taper off as weight and/or distance increase. In other words, these costs are spread over the extra revenue to be had through hauling more or hauling for longer distances. That’s the good news. The bad news is that this only continues until it’s necessary to increase the labor involved in the shipment. This could involve adding more shifts of drivers over long distances or more personnel to load and unload vehicles. Diseconomies of scale also occur when an infrastructure’s capacity must be expanded but indivisibilities require expansions larger than needed.
For example, if a truck trailer is at capacity and the motor carrier wants to expand operations, it must increase in increments of one trailer even if that is much more capacity than is desired. If a road is congested it must be expanded in increments of an extra lane. But, if market demand sufficiently expands then the investment in a new trailer or extra lane offers economies of scale up and until capacity is maximized again.
Scale and scope
Two other related terms are worthy of mention in a transportation context. One is constant returns to scale. This is the absence of either economies or diseconomies of scale. The other is economies of scope. In this case, the carrier is trying to achieve efficiencies through a mixture of services instead of through a larger scale of one service. Constant returns to scale occurs when there is a built-in rigidity or independence to the operation while economies of scope indicate a degree of flexibility.
As an example of constant returns to scale, consider U.S.-Asia ocean vessel shipping. Many container vessels travel to and from ports on the U.S. West Coast to ports in Japan, South Korea and China with no stops along the way. Of course, the vastness of the Pacific Ocean necessitates this non-stop service.
These vessels follow similar routes along the “great circle” between the U.S. West Coast and Asia, taking them through or near the Aleutian Islands in Alaska. While their routes may cross, there is no possibility of interlining in the way truck, rail and air carriers can. Each vessel in the ocean carrier’s fleet in these waters serves as an independent network and enjoys no economies of fleet size.
Expanding operations in these waters requires a different vessel, crew and port dockage authority. For these reasons, the carrier does not see its average cost rise or fall as the fleet expands. Long run average costs are constant and face indivisibilities as the fleet expands one vessel at a time. Of course, interlining in the ocean vessel sector does occur in other routes. The Port of Singapore is an example of an important container transfer point in Europe-Asia trade lanes.
Economies of scope offers carriers a chance to diversify their operations in order to expand market share or mitigate a decline in a current market. Many examples exist in transportation. A commercial airline can offer charter service if scheduled service is in less demand. A less-than-truckload (LTL) carrier can offer truckload service (TL) if the shipper is willing and able to fill an entire truck and pay a dedicated freight rate. Of course, it is certainly easy enough for a rail carrier to attach boxcars to passenger cars and provide a mixture of services.
Diseconomies of scope emerge, however, when the carrier begins to forget its core competency and diverts too many resources into its secondary operation. In transportation, this is best explained in terms of cargo services versus passenger services. Cargo transport is always a part of the production process while passenger travel is often a part of the consumption process. Inputs such as cargo and carriers facilitate the production process by moving inputs to where they need to be.
Passengers on vacation are enjoying the “consumption” of their leisure time and carriers facilitate this consumption process. Indeed, cruises and train tours are themselves an act of consumption. Why is this distinction important? Because production is governed by the state of technology and this is a large factor used in pricing the provision of transportation.
Consumption is governed by tastes and preferences and pricing transportation is more nebulous in this case. Furthermore, passengers are “freight that complain” and, therefore, must be treated differently than cargo. As noted above, economies of scale don’t directly relate to a business’ sales revenue and profit. Achieving the lowest long run average cost makes sense when market conditions suggest that low cost businesses will have staying power. But there is no reason to believe that such a business will maximize profits. Markets that are easy to enter and exit tend to be very competitive and do not offer many options to increase scale at the expense of competitors.
However, for businesses such as the railroads and pipeline companies, economies of scale can act as a barrier to entry for other competitors. Once the railway or pipeline infrastructure is in place there is little incentive for a direct competitor to challenge the incumbent along that route. In this way, monopolistic profits are possible if the market is unregulated or uncontestable.
Finally, when considering transportation hubs, it is no coincidence that shippers and carriers tend to locate in areas which are hospitable to them. As noted above Chicago, Memphis and Singapore are important examples. These are also sources of external economies of scale because business and government are able to serve each other’s needs, with the latter via infrastructure provision and the former via taxes and fees.
Urbanization policies that take into account these businesses help to insure a steady pool of labor, vendors and customers. Applicable R&D through local universities may come about as well. Of course, as noted above, R&D benefits deviates from the assumption of constant technology. Nonetheless, these are all very important aspects of successful logistical hubs and knowledge clusters.
While all five modes of transport (truck, rail, air, water vessel and pipeline) have been used to illustrate various examples of economies of scale, some modes are more prone to it than others. For various reasons, it is more likely that less competitive markets will benefit from economies of scale. Why? Barriers to entry in the form of set-up costs. As long as most roads are publicly provided it will always be easier for a motor carrier to buy a truck and offer, say, a 100-mile route than would a railway or a pipeline company.
Worse still, if railways and pipeline companies are less competitive, why should they take full advantage of economies of scale and try to lower the costs of their operations? In part, the answer lies with intermodal competition. If one mode offers some level of alternative service in the eyes of shippers then these “contestable” markets may see a greater exploitation of economies of scale than might otherwise be the case. Shippers must maintain a discriminating eye for the mode of transportation.
While it might seem that this balancing act is something for the transportation carrier to handle alone, it’s not. Their shipper customers have a role to play as well. After all, transportation is part of supply chain management which is, of course, at its most effective when collaboration takes place both upstream and downstream. As we’ve seen, shippers can wait for, or hope for, scientific innovations to help lower the cost of transportation. But until then a transportation carrier has a menu of options through which to find appropriate economies of scale when providing services to shippers. Collaboration would certainly improve the flow of raw material, components and goods along the supply chain.
Consider economies of scale from the shipper’s perspective: Shippers who are able to provide loads that fully utilize vehicle capacity can reap the benefits of economies of vehicle/container size. Because the carrier’s costs do not rise as fast as its carrying capacity it’s likely that the freight rates paid by the shipper won’t rise as fast either.
But what about small shippers who can’t provide such large shipments? Well, they have the option to utilize the services of a thirdparty logistics provider (3PL) whose job it is to consolidate small loads into larger ones and negotiate favorable freight rates with the carriers. This intermediate step helps to create loads with similar physical and delivery characteristics which, in effect, passes the benefits of economies of vehicle/container size on to many shippers within a transportation network.
If shippers are moving numerous loads from multiple origin-destination points within a given transportation network, there is a benefit in timing the pick-up and delivery requirements so that the loads can be interlined by the carrier at appropriate cross-points and hubs. Doing so helps the carrier achieve economies of fleet size.
Barring any emergencies most shippers prefer lower cost to faster delivery within the norms of a given mode of transport. Transportation carriers, therefore, have incentives to design intricate transportation networks. By routing the heaviest traffic from hub-to-hub and moving lighter traffic along spokes, carriers can take advantage of the economies of network efficiency.
Routing through hubs may add more time to the delivery of shipments but the cost efficiencies can help keep freight rates paid by shippers lower than they would be with more direct transport. Finally, globalization and the rise of information technology have made it easier for businesses to seek out vendors and customers all over the world. Off-shoring parts of the supply chain has necessarily increased the distance of shipments. Bulk discounts when available have necessarily increased the weight of shipments. In other words, longer supply chains created by their shipper customers have prompted carriers to take advantage of the economies of weight and distance.
Transportation planning is a complex task. It is dependent on the nature of the marketplace, the state of technology, government regulation and cost control. As we’ve seen, economies of scale is an important concept when it comes to cost control.
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