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 diversification, 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 production 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 scale, 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 multinationals 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.
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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 banking, 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).
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 produce 10 goods of P1, 10 goods of P2, 20 goods of P1 and 20 goods of P2.
TC = 10 P1 +10 P2——-20 goods
TC = 0 P1 + 20 P2——-20 goods
TC = 20 P1 + 0 P2——-20 goods
The company has a second production possibility frontier (PPFy) where its production has achieved economies of scope resulting in the TC remaining the same.
TC = 10 P1 + 15 P2 —— 25 goods
The firm produces more goods of P2 for the same cost, or we can say that the company is producing the more number of goods at a lower cost.
As compared to PPFx, in PPFy, since P1 and P2 are jointly produced, it will be cheaper than producing P1 and P2 individually as the total cost will reduce. In short, the overall average unit cost of the overall average production will come down.
The main features that we can encapsulate with the economies of scope are the production of different products using the same production equipment, raw materials, storage space and established distribution channels. The company’s overhead cost will be lower by producing multiple products compared to the company producing only one type of product.
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 – Mergers with horizontal acquisition or strategic acquisitions will help achieve the economies of scope as the company will benefit by 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 –