What is Economies of Scope?
Economies of Scope is an efficiency-enhancing notion that promotes cost-saving from using similar operations to simultaneously manufacture distinct products instead of going for one at a time. It occurs when the total cost of producing two or more types of output is lower than the total cost of producing each type of output separately.
- Economies of scope can be described as producing two or more products simultaneously at a lower cost than producing them individually.
- For example, a company using similar raw materials and production units to produce a variety of products instead of going for one at a time.
- It is a fantastic concept that can be achieved by adopting different strategies like flexible manufacturing, product diversificationProduct DiversificationProduct diversification is a business strategy that involves developing and selling a new line of products, services, or a service division that uses the same or completely different sets of knowledge, skills, machinery, etc., linking supply chain and M&A.
- The notion has gained immense popularity in recent times and is being adopted across sectors ranging from manufacturing, operations, banking to IT services.
How does it Work?
- So, what is the way to achieve economies of scope? It is achieved by producing a variety of products together or by offering similar services in one package. Doing this decreases the total cost of productionCost Of ProductionProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. as the production process simultaneously utilizes the same raw materials and facilities for multiple products.
- For instance, an e-commerce platform offers a mindboggling variety of products to suit the needs of its enormous customer base. Yet it enjoys a low unit cost for handling these products which is a result of many things, one being that the products are stored together in a warehouse. Had they been stored individually in separate warehouses, it would have unnecessarily added to the additional costs.
- It is important to note that the concept of economies of scope and scale should not be treated as the same. The cost is reduced in economies of scope using similar resources to support large scale production of distinct goods. On the other hand, in the economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. , cost-saving flows from increasing the volume of a single product. It reduces the cost of producing additional units due to the sharing of the same production facility.
- Economies of scope usually exist amongst large multinationalsMultinationalsA multinational company (MNC) is defined as a business entity that operates in its country of origin and also has a branch abroad. The headquarter usually remains in one country, controlling and coordinating all the international branches. with a massive product portfolio. The wider it becomes, the more it causes the fixed cost to spread over each of the individual products amongst the variety they offer.
Examples of Economies of Scope
- Many sectors are exploring ways to improve businesses using economies of scope, which we will explain with an example.
- Apart from e-commerce, the banking sector is also capitalizing on economies of scope. Banks that have developed a robust IT infrastructure offer a plethora of services such as traditional banking, investment bankingInvestment BankingInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc., credit card services, trading services, wealth management and mutual fund services.
- After the initial set up of the IT infrastructure, the tech-savvy banks could provide so many services without incurring additional cost which would have arisen from arranging additional units for each service.
How to Determine Economies of Scope?
In terms of Mathematical explanation, we can illustrate the economies of scope as follows.
We need to consider the production possibility frontier (PPF).
#1 – First Production Possibility Frontier (PPF)
In the case of PPFx, the total cost of production is (TC). Suppose, P1 and P2 are the products that are produced. Let the Company 20 goods of P1 and 20 goods of P2.
TC = 0 P1 + 20 P2——-20 goods
TC = 20 P1 + 0 P2——-20 goods
Suppose, the total cost incurred in the first case is 100 for producing 20 units of P1 which are a kind of candle. In the next case, the business is producing 20 units of another variety of candle at 100. They are both being produced separately.
#2 – Second Production Possibility Frontier (PPFy)
The company has a second production possibility frontier (PPFy) where its production has achieved economies of scope resulting in the TC either being the same or lower while more products are being produced.
TC2 = 10 P1 + 15 P2 —— 25 goods
1.How is that possible? Suppose a business deals in offering storage facilities for goods. There is a warehouse storing different products. Earlier, it was storing 20 units of P1 and P2. The manager noticed more availability of space, so added 5 more units of P2 in the same warehouse. So, the storage cost remains the same. As such if earlier 20 units of P1 and P2 could be stored at 100, now 25 units of P1 and P2 will be stored at 100.
2. Taking the candle example again. The owner sees the possibility of reducing the production cost of the two varieties of candles by using the same workers, materials, storage and delivery facility. The same workers who were earlier producing 5 candles in a day will do 6 now at the same cost. The same machines will also simultaneously mould the additional candles.
The same storage and delivery will simultaneously carry the new variety as well. The marginal cost enhancement will come off from using more of the current stock to produce the additional unit. As such, 10 units of P1 and 15 units of P2 will cost TC2 which will slightly be over 100. Although overall, the cost will still be less as compared to producing them separately. In short, the overall average unit costUnit CostUnit cost is the total cost (fixed and variable) incurred to produce, store and sell one unit of a product or service. It is calculated by adding fixed and variable expense and dividing it by the total number of units produced. of the overall average production will come down.
Ways to Achieve Economies of Scope
- Adopting Flexible Production and Manufacturing Processes – The easiest way is by sharing raw materials and production facilities when producing distinct but related products. Companies can quickly and effectively enhance manufacturing processes by taking this route. Another means to achieve this is by opting for centralized functions in departments like finance and marketing.
- Linking the Supply Chain – Integrating vertical supply chain assists in reducing costs and wastage. For example, operating multiple businesses under the same entity or having combined management rather than running as separate entities.
- Acquisition of Companies with Similar Products – MergersMergersMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm. with horizontal acquisition or strategic acquisitions will help achieve the economies of scope as the company will benefit from synergies due to utilization of similar raw materials, production and assembly lines.
- Diversification – Companies producing different products using similar inputs and production processes will improve productivity.
This article has been a guide to What is Economies of Scope?. Here we discuss how does it work, how to determine it along with an example and ways to achieve it. You may learn more about financing from the following articles –