Economies of Scope

Updated on April 5, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Economies Of Scope?

Economies of scope is an efficiency-enhancing notion that promotes cost-saving mechanisms. Similar operations are simultaneously used to manufacture distinct products instead of going for one at a time. It occurs when the cost of producing two or more output types is lower than the cost of producing each output type separately.

Economies of Scope

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Manufacturing goods and services using the above method reduces the production cost per unit, leading to better product diversification, quality improvement, and efficiency. Thus there is an optimum utilization of factors of production, along with cost control and waste reduction.

Key Takeaways

Economies Of Scope Explained

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Economies of Scale vs Economies of Scope Video

 

Types

  1. Adopting Flexible Production and Manufacturing Processes – The easiest way is by sharing raw materials and production facilities when producing different 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 the vertical supply chain assists in reducing costs and wastage. For example, operating multiple businesses under the same entity or combining management rather than running as separate entities is beneficial.
  3. Acquisition of Companies with Similar ProductsMergersMergersMerger 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.read more with horizontal acquisitions or strategic acquisitions will help achieve the economies of scope. The company will benefit from synergies due to utilizing similar raw materials, production, and assembly lines.
  4. Diversification – Companies producing products using similar inputs and production processes will improve productivity.

Examples

Let us understand the degree of economies of scope with some examples.

Example#1

Example#2

In terms of mathematical explanation, we can illustrate the economies of scope. But, first, we need to consider the production possibility frontierProduction Possibility FrontierThe Production Possibility Frontier (PPF) is a visual representation used to illustrate the maximum possible output combinations of two separate products produced using the same amount of limited resources.read more (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 manufactured. Suppose the company created 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 type of candle. In the next case, the business produces 20 units of another variety of candles at 100. They are both being produced separately.

#2 – Second Production Possibility Frontier (PPFy)

The company has a second production possibility frontier (PPFy). 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 space availability, so he added five more units of P2 in the same warehouse. So, the storage cost remains the same. If earlier 20 units of P1 and P2 could be stored at 100, 25 units of P1 and P2 will be stored at 100.

2. Take 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 produced five candles in a day will do six now at the same cost. The same machines will also simultaneously mold the additional candles.

The same storage and delivery will simultaneously carry the new variety as well. The marginal cost enhancement will come from using more current stock to produce the additional unit. As such, ten 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 than 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.read more of the overall average production will come down.

Thus the above examples give a clear idea about the financial economies of scope in a business.

Advantages

  1. Greater market share – The business can gain a more significant market share through operational economies of scope because the product varieties expand to cater to many customers.
  2. Adjust products as per demand – Customer demand and preferences keep changing. This mismatch matches the types of goods and services offered along with changes in preferences.
  3. Reduce risk. Due to expansion in product variety, the business can keep up with the market competition through innovation and product advancement.  

Disadvantages

  1. Diversion from core competency – Due to increase in product variety, a business may tend to move away from its main product line that brings maximum revenue, resulting in reduced profits.
  2. Lack of knowledge – Companies may not always have the efficiency of technology level required to product the best type or level of products that can fight competition.
  3. Damage the brand – A huse rage of goods and services may damange the brand name because it is not necessary that all products will perform equally well and increase revenue.

Economies Of Scope Vs Economies Of Scale

Economies of scope deals with how to control unit cost by producing variety of goods whereas economies of scale deal with how to control cost by producing more products. Let us look at the differences between them.

Economies Of ScopeEconomies Of Scale
Cost reduction by increase in variety of goods.Cost reduction by producing more goods.  
It reduces cost of many products.  It reduces cost of a particular product.
Less use of factors of production.More use of factors of production.
It leads to cost reduction and market expansion.It mainly leads to cost reduction.
It is a continuous process.There is a limit to the capacity expansion process.
Too much variation in products may lead to diversion from core competency.The business is able to stick to its core competency and increase its production.

Frequently Asked Questions (FAQs)

How to calculate economies of scale?

Divide the percentage change in cost by the percentage change in output to calculate economies of scale. If the outcome is less than one, economies of scale are present. A corporation can cut costs better as it expands and produces more.

What is an example of economies of scale?

The most prevalent illustration of economies of scale is a supermarket. They receive discounts since they purchase things in quantity. As a result, they benefit from lower average costs. In other words, it calculates how much money is required for each company’s production unit.

Do economies of scale give rise to international trade?

The reallocation of resources can increase global productive efficiency, which is the major way economies of scale can result in trade profits.

This article has been a guide to what is Economies Of Scope. We explain it with examples, difference with economies of scope, types, advantages and disadvantages. You may learn more about financing from the following articles –