Question

How do economies of scale and lumpy assets affect financial forecasting?

refer text book FINANCIAL MANAGEMENT THEORY AND PRACTICE by BRIGHAM and EHRHARDT

Answer 1

Ans - Assets are said to be lumpy when it cannot be bought in small increments it can only be bought in large discrete units that mean it cannot buy in small quantity. E.g Real state is one of the best examples of lumpy assets. other examples can be considered as plant, machinery. These types of assets are illiquid. In manufacturing industries, these types of assets are being used. It also affects the Fixed assets/ sales ratio.

Economies of scale - It refers to cost savings in unit production when the quantities are increased for manufacturing the products. In other words when large outputs are being produced then there is a reduction in the cost per unit, it is known as economies of sale.

Lumpy assets and economies of scale can be very helpful while making financial forecasting. The below diagram will help us understand

In the above diagram of economies of scale, it is clear that the inventory/sales ratio goes on declining when the production increases which in turn will also cost less production cost per unit. In this scenario, very higher sales would require less inventory.

Lumpy assets affect the fixed assets/ sales ratio. In the lumpy asset's diagram, there is a point at which Fixed assets is $75 and sales is $50 so the FA/Sales = $75/50 is 1.5, but here we can increase the sales to $100 by no increase in Fixed costs hence FA/Sales ratio would be $75/100 =0.75. Therefore when a firm is operating at low capacity even small changes in sales would bring down large financial investment.

Excessive capacity is a point when the company's production is less than the amount achievable. This states the demand in the market is low as compared to firms ability to supply. These factors can bring down the cost also it can increase the profit at the same time. Therefore proper planning is needed while manufacturing to bring down the cost of the firm.

All these factors are very important while considered during financial planning and forecasting because the firm main goal is to maximize profit with minimum investment. Therefore the management should consider all these factors like lumpy assets, economies of scale in account to maximize the company's profit with minimum loss.