What Is Economies of Scope? Definition and Guide

What is economies of scope? Definition and guide

As a business owner, you have a variety of business strategy options for growing your company. One of those options is to lower your costs using economies of scope.

In this article, we'll explain what economies of scope means, and discuss how this concept might benefit your business.

What is economies of scope?

Economies of scope is an economic principle in which a business's unit cost to produce a product will decline as the variety of its products increases. In other words, the more different-but-similar goods you produce, the lower the total cost to produce each one will be.

Economies of scope example

To illustrate how economies of scope work, let's say that you're a shoe manufacturer producing men's and women's sneakers. Adding a children's line of sneakers would increase economies of scope because you can use your existing production process, equipment, supply chain, storage facilities, and distribution channels to create a new line of products. The resulting cost to produce multiple products is lower than if three different companies each produced a line of men's shoes, a line of women's shoes, and a children's line.

But economies of scope don't just provide a cost savings for your new children's product line: they also reduce the average total cost of production for all of your sneaker product lines. That's because you can extend the use of your resources to make more products to be sold to your same target market, helping you continue to drive costs down.

How to achieve economies of scope

Economies of scope occur in a variety of ways.

  • Flexible manufacturing. One of the most common ways to achieve economies of scope is making different products using the same raw materials or manufacturing facilities. For instance, if you own a business that makes custom shirts, you could use excess fabric left over from your production processes to make headbands or handkerchiefs.
  • Shared inputs. Inputs like land, labor, and capital can be used to create multiple products or revenue streams, reducing operating costs. For instance, if you own or lease a warehouse to store your products, you could rent or sublease a portion of it to store goods for another business.
  • Mergers and acquisitions. Economies of scope exist when companies make horizontal acquisitions of companies producing similar or complementary products. Because they use similar raw materials and production process, two separate firms joined by a merger can reduce costs on products made using the same assembly lines, rather than produced separately.

What is economies of scale?

Another economic principle for cost savings, economies of scale enable a business to reduce the unit cost of their product by increasing volume—in other words, by producing additional units of the same product.

By keeping your manufacturing processes focused on one product, scale economies save on costs associated with running multiple product lines, including procuring raw materials, maintaining equipment, and managing various business units. Economies of scale can also provide a competitive advantage, as companies with larger inventories of a given product

Economies of scale vs. economies of scope

While economies of scale and economies of scope both reduce the cost of goods, they do so in different ways. For example, if you were a necklace manufacturer, you could achieve lower average cost per piece through economies of scale by producing more necklaces.

By contrast, with economies of scope, you need to produce more different types of products using the same resources. So instead of producing more necklaces, you would also add new types of products that could be produced with the same equipment and same inputs—bracelets, rings, and earrings, for example.

Should I pursue economies of scope?

The challenge in pursuing economies of scope is the possibility of diluting what your business was originally known for. So, let's say you've built a business based on trendy dog clothes. You supply handmade dog sweaters that are long-lasting and warm and clever. It's what you are known for.

To continue to build your business, you could focus on selling more of what you already sell. That's economies of scale. It also preserves your brand identity as a dog fashion guru.

However, another strategy for growing your business is expanding to new markets by adding products for animals other than dogs, like cats, and pigs, and goats. You can still sell pet sweaters, just to a broader audience. You'd no longer be a dog fashion guru, but rather a pet sweater guru.

There's no right or wrong answer here: it's just a matter of determining what makes the most sense for your business. Do you go deep or do you go broad product-wise in order to grow?

Economies of scope FAQ

How do you determine economies of scope?

To see if you're achieving economies of scope, take the cost of producing two products separately and subtract the cost of producing them together. Divide this number by the cost of joint production. If the result is greater than 0, you have economies of scope.

What is an example of economies of scope?

A typical example of economies of scope would be a dine-in restaurant that also offers a bakery counter for customers to purchase pastries or pies to enjoy at home.

What is an example of economies of scale?

An everyday example of economies of scale are major retailers like Wal-Mart and Amazon, which reduce their unit cost by buying inventory and manufacturing products in huge quantities.