Economies of Scope

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.

Key Takeaways

How does it Work?

Economies of Scope

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Examples of Economies of Scope

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 more of the overall average production will come down.

Ways to Achieve Economies of Scope

  1. 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.
  2. 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.
  3. Acquisition of Companies with Similar ProductsMergersMergersA merger is a voluntary fusion of two existing entities equal in size, operations, and customers deciding to amalgamate to form a new entity, expand its reach into new territories, lower operational costs, increase revenues, and earn greater control over market more 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.
  4. 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 –