The two cost components
Total cost = fixed costs + (variable cost per unit × units produced). Fixed costs (rent, equipment, salaried staff) don't change with production volume — they're paid whether you make 10 units or 10,000. Variable costs (raw materials, per-unit labor, packaging) scale directly with volume — each additional unit adds the same fixed variable-cost amount to the total.
Why cost per unit isn't constant
Cost per unit = total cost ÷ units produced. Because the fixed-cost portion of total cost stays the same no matter how many units are made, spreading it across MORE units means each individual unit carries a SMALLER share of that fixed cost — cost per unit falls as volume rises, even though total cost itself is still increasing (just more slowly, on a per-unit basis, than the unit count grows).
A worked example
With ₹50,000 in fixed costs and ₹20 variable cost per unit: producing 1,000 units gives a total cost of ₹70,000 and a cost per unit of ₹70. Producing 5,000 units (5x the volume) with the identical fixed and variable cost structure gives a total cost of ₹1,50,000 (just over double, not 5x) and a cost per unit of only ₹30 — well under half the per-unit cost at the lower volume, purely from spreading the same ₹50,000 fixed cost across 5x as many units.
Why this is called "economies of scale"
This falling-cost-per-unit effect, driven purely by spreading fixed costs across more output, is one of the core mechanics behind economies of scale — the common business observation that producing more tends to reduce the average cost of each unit. It's not that materials get cheaper per unit at higher volume (that's a separate effect, bulk purchasing discounts) — it's simply that the same fixed overhead gets divided among more units.
Why this matters for pricing decisions
A business planning to price at a specific margin or markup over cost (covered in companion articles on this site) needs an accurate cost-per-unit figure at the ACTUAL planned production volume, not an arbitrary or outdated one — pricing based on a cost-per-unit figure calculated at a much smaller volume than what's actually produced will overstate true cost, potentially pricing the product higher than necessary and less competitively than a correctly-costed alternative.
The limits of this simple model
This model assumes variable cost per unit stays constant regardless of volume — in reality, very high volumes can sometimes unlock bulk-purchasing discounts (reducing variable cost per unit further) or, conversely, require additional fixed investment (new equipment, more space) once a facility's capacity is exceeded, which would increase the fixed-cost baseline at that point. This formula gives an accurate answer within a given fixed-cost/variable-cost structure, but that structure itself can change at different volume scales.