An Economy of Scale is a microeconomics term that describes the cost advantages that large companies have over smaller ones. By producing a higher quantity of product, companies are able to spread out their fixed costs over more units, and they can reduce variable costs by purchasing needed inputs in bulk. However, there is an optimal output amount, after which point the average costs begin to rise. This is because if there is too much product being produced, it may be necessary to higher more managers, or it may be necessary to source more expensive raw materials, either of which reduces the benefit of economies of scale.
The chart above shows an example of the long run average cost, or LRAC. You can see that at output Q, the average cost is relatively high. At output Q2 , you reach the low-point of the LRAC. At this point, you are optimizing for the cheapest per-unit cost, although you are not optimizing profitability. It is possible that you will want to produce more units even at a higher LRAC value if you are still able to be profitable at those levels. Output Q2 represents the largest potential profit margin for the company.
There are a number of fixed costs associated with building and selling a product or service. These include managerial costs, capital-equipment costs, capital-financial costs, marketing costs, and technological costs. As more units of product are being produced, these fixed costs can be spread out over a larger number of units.
Variable costs are the costs that go into a single unit of product, in the form of labor hours and raw material. Variable costs can also be reduced to a point when negotiated in bulk.
Building economies of scale, while providing an advantage over smaller competitors, should not be considered a source of sustainable competitive advantage. It is too easy for competitors to raise capital and to compete by also optimizing their operations for scale. But for your organization, consider whether you can scale in a way that will reduce your costs and increase your profit margins. If you can, consider economies of scale as a way to help determine the optimal size for your organization.
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