Economies of Scope Examples and Formula

Meaning of economies of scope

Economies of scope is a term that refers to the fall in the cost of production when two or more companies produce a range of products together rather than separately. It also implies that producing one good brings about a reduction in the cost of producing another good that is related. Economies of scope come about when the production of a wider variety of goods or services together is more cost-effective for a firm compared to the production of a less variety or the production of each good independently. In such cases, a company’s long-run average and marginal cost decrease as a result of the act of producing complementary goods and services.

Economies of scope refer to cost savings that arise when the resources used in producing one product are used in producing in another thereby expanding line of products. Also, Economies of scope differ from economies of scale. While economies of scope have to do with efficiencies that come about when varieties of goods are being produced. On the other hand, economies of scale have to do with the volume of goods where larger companies incur a lower cost of production than the smaller ones. Here, there is a decrease in marginal cost when additional units of commodities are being produced.

For economies of scope, the case differs as it has to do with the production of two or more goods together thereby resulting in a lower marginal cost than when a company produces them separately. It can result from co-products or complementary production processes or goods sharing inputs to production.

Therefore, simultaneous manufacturing of different products becomes more cost-effective than manufacturing them individually.

A simple example is where a vehicle can carry both passengers and goods more cheaply than having two separate vehicles where one carries passengers and the other carries goods. In this case, a single-vehicle is meant to carry both passengers and goods and this is far more cost-effective for the transportation company as well as will result in lower ticket or tonnage costs for the vehicle users as well.

Also, another instance is that economies of scope exist between book publishing and magazine publishing if they merge as the same resources used in producing books will be used in producing magazines. This comes about from a merger and acquisition.

How economies of scope can occur

  1. Co-products
  2. Complementary production processes
  3. Shared inputs

The above mentioned are ways in which economies of scope can come about.

Co-Products

Economies of scope stem from co-production relationships that exist between final products. In terms of economics, we call them complements in production. This comes about when the production of one good automatically results in the production of another good as a byproduct or a kind of side effect of the production process. There are times in which one product becomes a byproduct of another but possesses value for use by the producer or for sale.

If a company is able to find a productive use for co-products, this can greatly decrease waste and costs. By implication, revenue will increase.

An example is a situation whereby dairy farmers separate raw milk from cows into whey and curds with the curds becoming cheese. In the process of this, they come out with a lot of whey which they can make use of as a high protein feed for livestock which will reduce their overall feed costs or they can sell it as a nutritional product to fitness enthusiasts who carry weightlifting for additional revenue.

Another example is what is called “black liquor” that is being produced in the course of processing wood into paper pulp. Instead of this being a mere waste product that may be costly to dispose of, one can burn black liquor as a source of energy to fuel and heat the plant. This will therefore save money on other fuels or can even be processed into biofuels more advanced for use on-site or for sale. The production and the use of black liquor help in saving costs on producing the paper.

Complementary production processes

Economies of scope can also emerge from the direct interaction that takes place between two or more production processes. A classic example here is the companion planting in agriculture such as the “Three Sisters” crops that the Native Americans historically cultivated. By planting pole beans, ground trailing squash, and corn together, the “Three Sisters” method brings about an actual increase in the yield of each crop as well as improving the soil. The tall corn stalk serves as a structure for the bean vines to climb up while the beans make the more fertile for the corn and squash to grow and yield properly by fixing nitrogen in the soil.  The squash then shades out weed among the crops with its broad leaves. The three plants benefit from each other from being cultivated together and this will enable the farmer to grow more crops at a lower cost.

The economies of scope aviation example which is a modern example is that the company can be holding a co-operative training program between an aerospace manufacturer as well as an engineering school where students can also work part-time or as interns at the business. Having access to skilled labor can help the manufacturer to reduce its overall costs, as well as the engineering school reducing its instructional costs by effectively outsourcing some instructional time to the training managers of the manufacturer. The final goods being produced here are airplanes and engineering degrees. Although they may not seem to be direct complements or share many inputs, producing them together reduces the cost of both.

Shared inputs

The inputs used in production processes are land, labor, and capital, and because they usually have more than just a single-use, a company can achieve economies of scope from common inputs to the production of two or more different commodities.

For example, a restaurant can produce both chicken fingers and French fries at a lower average cost than it would cost two separate firms to produce these two commodities separately. This is so because one firm can produce both the chicken fingers and French fries using the same cold storage, fryers, and cooks during the production process.

Another excellent example is Proctor & Gamble which is an efficient realization of economies of scope from common inputs since it produces several products that are hygiene-related ranging from razors to toothpaste. Also, it is possible for the company to afford to hire expensive graphic designers as well as marketing experts who can make use of their skills across the entire product lines of the company which will, in turn, add value to each one. If the members of the team are on salary, each additional product that they work on will bring about an increase in the economies of scope of the company because there is a decrease in the average cost per unit.

Economies of scope formula

Economies of scope (S) =(C(q1) + C(q2) – C(q1 + q2)) / C (q1 + q2)

Where;

Economies of scope (S) = The percentage of cost saving when goods are produced together. S will therefore be greater than 0 when economies of scope are in existence.

C(q1) = The cost of producing the quantity of good 1 separately

C(q2) = The cost of producing the quantity of good 2 separately

C (q1 + q2) = The cost of producing the quantity of goods 1 and 2 together

The formula explains that a firm produces two goods Q1 and Q2. for economies of scope to occur, it must be true that the cost of production is reduced while it diversified its products.

Economies of scope example

If a restaurant produces both hamburger and sandwiches, the cost of producing 1,000,000 hamburgers is $0.50 each, the cost of producing 4,000,000 sandwiches is $0.30 each, and the total cost of producing 1,000,000 hamburgers and 4,000,000 sandwiches together by the use of the same preparation and storage facility is $1,500,000, determine the economies of scope.

C(q1) = 1,000,000 x 0.50 = $500,000

C(q2) = 4,000,000 x 0.30 = $1,200,000

C(q1+q2) = $1,500,000

Using the formula;

Economies of scope (S) =(C(q1) + C(q2) – C(q1 + q2)) / C (q1 + q2)

Economies of scope (S) = ($500,000 + $1,200,000 – $1,500,000) / $1,500,000

Economies of scope (S) = 13.33%.

The calculation above implies that the production of hamburgers and sandwiches together is 13.33 less than the cost of producing them in separate ways. This is the firm’s measure of economies of scope.

How to achieve economies of scope

  1. Flexible manufacturing
  2. Related diversification
  3. Mergers
  4. Selling greater diversity of products
  5. Customization of products
  6. Making use of a strong brand name to enter different markets

Flexible manufacturing

Flexible manufacturing comes into existence when a company can produce multiple products with the use of the same manufacturing systems and inputs. For instance, one can use the same storage preparation and storage facilities in making hamburgers and fries instead of using two separate facilities as stated in the example above.

Related diversification

For a company to achieve economies of scope, it is necessary for it to be able to make use of its operational expertise, resources, and capabilities across its organization. With this, it will be able to take advantage of related diversification. For example, a company can hire designers and marketers who can make use of their skills across different lines of product and this will provide room for the production of a wider range of products.

Mergers

Through a merger, a company is able to share the expenses of research and development in order to reduce costs as well as diversify its product portfolio or knowledge. For example, two pharmaceutical companies merged to combine their research and development expenses in order to arrive at the creation of new products. In essence, a company will be able to benefit from synergies as a result of the utilization of similar raw materials, production, and assembly lines. Economies of scope exist when two or more companies merge as costs will decrease while they produce complementary products.

Selling greater diversity of products

To sell greater diversity of products is another way of achieving economies of scope. For instance, a traditional store that is selling beer can as well diversify and sell other related goods. Instead of just selling a beer, the store owner can diversify into the sales of all-day breakfast, coffee, and providing wifi. This can be a logical response to the decline in the demand for beer. With this, the major advantage is the existing infrastructure of supply chains as well as retail premises.

Customization/diversification of products

Rather than producing just one product, a firm can produce a greater range of products to meet every taste and preference of consumers. With this, the firm will be able to generate more revenue and produce more at lower costs. If a company produces products using the same inputs and production processes, it will improve its productivity.

Making use of a strong brand name to enter different markets

A brand name is an important tool that a company can use to achieve economies of scope. A strong brand name will help in reaching out to the larger audience which in turn will encourage product diversification.

Economies of scope advantages

  1. Decrease in cost of production
  2. Increase in efficiency
  3. Increase in product variety
  4. Improvement in customer satisfaction
  5. Decrease in business risk
  6. Automation
  7. Flexibility
  8. Greater control, accuracy, and repeatability of processes
  9. More predictability of costs
  10. Distributed processing capability

Decrease in cost of production

A major advantage of economies of scope is the decrease in the cost of production which comes about as a company diversifies its product offering while making use of the same set of resources.

Increase in efficiency

With economies of scope, a business can increase its efficiency since it has to do with the creation of multiple types of products while making use of the same resources. This helps to reduce the wastage of resources. Costs can result from the waste of resources, this economic concept helps in preventing such scenarios.

Increase in produce variety

Another advantage of economies of scope is that a company will be able to increase the variety of products that it offers. With this, a company diversifies its products and this allows the business to appeal to a wider potential customer base.

Improvement in customer satisfaction

Through the increase in the variety of products, economies of scope are helpful to a company or a business in improving its customer satisfaction. Furthermore, if a business improves its customer satisfaction, this will contribute immensely to the overall success of the business. In other words, a company will be able to respond swiftly to the changes in the preferences of consumers as well as the life cycle of products which can bring about stagnating sales. Diversification is usually a response to the changes in demand and this can return a business to profitability if it has become unprofitable.

Reduction in business risks

Through economies of scope, a company is able to reduce its risks and this is possible through the diversification of products. A business can sell many lines of products in different regions and countries. If for example, a line of a product falls out of fashion and demand decreases, or if one country is experiencing an economic downturn, the company will have a greater chance of continuing its trade.

Automation

Economies of scope foster speed in production which is a result of automation. When technology improves, it becomes easier for a company to produce variations of the same products. This automated process makes it easier to respond to consumer preferences as well as produce a variety of products in the same firm.

Flexibility

Economies of scope foster flexibility in production processes, product design, and product mix. The tendency of rigidity that may slow down the success of a company reduces. Furthermore, flexibility enables a business to diversify products and adjust to the changes in consumer preferences and demand.

Control

This concept helps a firm to have greater control over its production processes and the costs involved, and it fosters accuracy. Also, one will be able to repeat the production processes while minimizing cost.

More predictability of costs

It becomes easier for a firm to firm to predict future costs and their outcomes through automation and product diversification.

Distributed processing capability

By encoding process information in software that is easily replicable, distributed processing capability is made possible.

Economies of scope disadvantages

  1. Less knowledge in new products
  2. Damage to brand name
  3. Potential diseconomies of scale

Less knowledge in new products

One major disadvantage that may come with economies of scope is the danger that is associated with over-extending product lines. This is because the buyers and sellers may lack the specialized knowledge required for finance with regard to the new product as well as credit cards. On part of the buyers, the products that came about in the process of producing another product may not be well known by them. With this, there will be a need for the company to spend on sales promotion and advertisements to bring these products to the knowledge of the public.

Damage to brand name

There are times that a unique selling point becomes the best in a specific niche. However, if a company wants to try producing everything, there is a possibility of losing its position in the market as a brand image that is dominant. The common language is that the company may become a “Jack of all trades, master of none”. For example, if one owns an expensive fashion label such as Prada, Gucci, and Versace, it would certainly be hurtful to the business to diversify into selling different products.

Potential diseconomies of scale

From an increased size of a firm, there may be potential diseconomies of scale. If the firm becomes exceedingly ambitious and increases in size without taking cognizance, it would become more difficult to manage and coordinate the various groups of business and products.

Economies of scope vs economies of scale

  1. How costs decrease
  2. Limitations
  3. Number of products
  4. Resources required
  5. Age of concept

The above mentioned are the areas of the differences between economies of scope and economies of scale and this will be explained later.

Both economies of scale and economies of scope are important financial concepts that can be used by companies to cut their costs of production. These terms sound similar but important differences exist between them that should be noted. For a business to gain a competitive advantage, it is important to have a clear understanding of these two financial concepts. Here are the differences explained;

How costs decrease

One major difference that exists between economies of scale and economies of scope is the exact manner in which they cause the costs of a business to decrease. While in economies of scale, the costs of businesses decrease when they increase their production which in turn allows them to decrease the cost of production, in economies of scope, the costs of businesses reduce when they diversify their products.

Limitations

Another area of difference is that the limitations of the two concepts differ. In economies of scale, a company gets to a point whereby its costs no longer decrease and this implies that companies can stop creating economies of scale when their production starts becoming too large. In economies of scope on the other hand, one of the limitations is that companies may not have adequate knowledge with regard to expanding their product offering. Also, through product diversification or expansion of product offering too far away from its basic competencies, a company’s branding may be weakened.

Number of products

When it comes to the number of products they apply to, the two concepts differ also. A company uses economies of scale for a single product that they are specialized in producing. Here, the company will then scale its production of that commodity until it gets to a point where costs begin to decrease. On the other hand, economies of scope have to do with the production of multiple products by a company using the same set of resources thereby reducing costs of production.

Resources required

Another area of difference that exists between economies of scale and economies of scope is in the resources that are required to create or achieve each. Typically, a company requires more resources to create economies of scale than economies of scope. This is as a result of the fact that economies of scope are not dependent upon mass production, it is rather a variety of products produced in a single operation.

Age of concept

While the concept of economies of scale is quite traditional and widely used across many firms and industries, the concept of economies of scope tends to be relatively new and this implies that companies/businesses are still in the beginning stages of adopting it. Therefore, the two concepts differ in their ages.

FAQs on economies of scope

What are economies of scope?

Economies of scope refer to the decrease in average total cost that can occur when a firm produces a range of products using the same resources rather than separately. Firms seek to create value from economies of scope in order to expand their customer base and increase efficiency in production. When discussing economies of scope, it involves the understanding that they reduce the cost of production and facilitate the production of a wider range of output using the same resources.
If a firm experiences economies of scope, it will have greater control and will be able to diversify products. Production processes that can produce a range of products are said to have economies of scope. Therefore, the concept of economies of scope is best described as a decrease in the cost of production through product diversification or expanding lines of products.

What are diseconomies of scope?

Diseconomies of scope are situations whereby the diversification of products brings about an increase in the cost of production.

What is the difference between economies of scale and economies of scope?

Economies of scope differ from economies of scale in that the former tends to be more traditional while the latter is modern. Also, economies of scale have to do with a decrease in the cost of production as a result of an increased output while economies of scope typically involve a decrease in the cost of production through product diversification. A company requires more resources to create the former than the latter.

What is an example of economies of scope?

A simple example is where a vehicle can carry both passengers and goods more cheaply than having two separate vehicles where one carries passengers and the other carries goods. In this case, a single vehicle is meant to carry both passengers and goods and this is far more cost-effective for the transportation company as well as will result in lower ticket or tonnage costs for the vehicle users as well

What steps should a firm take when it realizes that it does not have economies of scope?

For a firm to create economies of scope, it has to adopt flexible manufacturing. Secondly, there should be related diversification and the sale of a greater diversity of products. Another important step to take is a merger where two or more companies come together to form a larger company or acquisition where one company purchases another.

What happens when the demand for one good increases in economies of scope?

There firm will be more successful in that product and more efficiencies will be achieved in production while costs decrease and revenue increases.

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