Leverage economies of scale and economies of scope to increase profitability
Economies of scale: cost advantages because of high volume production
Economies of scale are cost advantages of a company due to its large size. Most companies and businesses can realize advantages of scale that are a result of two effects:
- Fixed costs - spread across large volume of units, decreasing cost per unit
- Variable costs - low due to operational efficiencies and synergies
- Larger production processes can be split into smaller, repetitive and simpler tasks.
- Larger sizes of raw materials and production technologies, resulting in bulk discounts.
- Risks are distributed on a larger scale, leading to less demand peaks.
- Cheap automatized production technologies become feasible.
A power supplier has high initial costs for setting up the infrastructure. Once the infrastructure is set up, the additional costs of providing their service to an additional household is very little. Fixed costs will be split onto more households and sudden demand drops have less impact because other households still require sufficient energy levels.
Economies of scope: cost advantages because of similar processes of different products
Economies of scope are conceptually similar to economies of scale. While economies of scale for a firm primarily refer to reduction in the average cost per unit, economies of scope refer to lowering the average cost for a firm in producing two or more products that could share resources. These two effects lead to economies of scope:
- Bundling effect: a single process serves the production of different products at the same time. Costs are distributed onto a larger product base.
Clustering: because of proximity, infrastructure (as an example) can be used by different companies without additional costs.