An economic scale, more commonly known as economies of scale, is a company’s ability to produce goods and services on a larger scale with fewer costs. Economic theory states that as companies grow in size and production capacity, costs decrease from these expanded operations. Adam Smith, author of “The Wealth of Nations,” published in 1776, believed that the division of labor and specialization of production duties could achieve advanced economies of scale. This theory has proven itself again through the business factors of technology, efficient capital, trained labor, and cheaper materials.
Modern technology allows companies to automate production processes and reduce errors resulting from human labor. Computers, business software, production robots, and the Internet are a few technological items companies use to develop an economy of scale. Companies also use technology to develop specific production techniques that may give them a competitive advantage over other companies. Increased production efficiency from business technology allows companies to reduce infrastructure expenses. Reduced expenses means companies have more cash to spend on operational expansion.
Capital is financial resources available to companies for expanding or improving their operations. Economies of scale may be achieved through effectively using a mix of debt and equity financing. Creating positive cash flows through profitable operations is another important factor of economies of scale. Companies with higher amounts of available cash can operate better because they focus less on generating cash and more on using available cash balances to improve operations.
Experienced or specially-trained labor improves a company’s production process because employees are more capable of completing complex tasks. While specially-trained labor may be costlier than untrained labor, the benefits of improved operations outweigh the costs. Trained labor may be able to complete more tasks with fewer workers. This saves cash and lowers a significant portion of product costs. Companies hiring a large number of trained labor may also reduce this workforce for competitors, who must employ untrained workers for their company. Efficient workers improve economies of scale by producing more goods in less time and may be able to offer suggestions to improve production methods.
Larger companies may be able to negotiate better material prices from vendors and suppliers. They are able to accomplish this by purchasing a higher volume of goods for their operations, which lowers the cost of materials used during the production process. Purchasing lower quality materials usually does not increase a company’s economy of scale. Lower quality goods will produce an item that consumers may find inferior to other products. This results in a diseconomy of scale because management decisions have negatively affected the production process.