Economies of Scale

There are economies of scale in the use of many kinds of assets, and when economies occur, the ratios are likely to change over time as the size of the firm increases. For example, retailers often need to maintain base stocks of different inventory items, even if current sales are quite low. As sales expand, inventories may then grow less rapidly than sales, so the ratio of inventory to sales (I/S) declines. This situation is depicted in Panel b of Figure 11-2. Here we see that the inventory/sales ratio is 1.5, or 150 percent, when sales are $200 million, but the ratio declines to 1.0 when sales climb to $400 million.

The relationship in Panel b is linear, but nonlinear relationships often exist. Indeed, if the firm uses one popular model for establishing inventory levels (the EOQ model), its inventories will rise with the square root of sales. This situation is shown in Panel c of Figure 11-2, which shows a curved line whose slope decreases at higher sales levels. In this situation, very large increases in sales would require very little additional inventory.

See the Web Extension to this chapter for more on forecasting when variables are not proportional to sales.

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