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.
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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 formula
One way to conceptualize economies of scope is through the following cost relationship:
C(Q1+Q2) < C(Q1) + C(Q2)
- C (Q1 + Q2) is the cost of producing products/services Q1 and Q2 together.
- C (Q1) is the cost of producing product/service Q1 independently.
- C (Q2) is the cost of producing product/service Q2 independently.
Examples of economies of scope
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.
If you plug some numbers into the formula above, here’s how it plays out.
Separate production costs:
- Cost of producing men’s sneakers equals $200,000 per month.
- Cost of producing women’s sneakers equals $180,000 per month.
- Projected cost of producing children’s sneakers equals $150,000 per month.
Joint production costs:
- Cost of producing men’s, women’s, and children’s sneakers together equals $450,000 per month.
Now applying the formula:
C (Men’s + Women’s + Children’s) < C (Men’s) + C (Women’s) + C (Children’s)
$450,000 < $200,000 + $180,000 + $150,000
$450,000 < $530,000
Now to calculate the percentage savings (PS):
PS = (Savings / Total Separate Production Cost) × 100
PS = ($80,000 / $530,000 ) x 100
PS = (0.1509) x 100
PS = 15.09%
So, by producing men’s, women’s, and children’s sneakers together, the company saves approximately 15.09% compared to producing them separately.
Economies of scope don’t just provide a cost advantage 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.
1. 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.
2. 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.
3. 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 processes, two separate firms joined by a merger can reduce costs on products made using the same assembly lines, rather than produced separately.
Economies of scale vs. economies of scope
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
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.
Is economies of scope right for you?
If you’re looking for economies of scope, like expanding your product line, you have to make a strategic decision. Let’s say you’re a business known for its trendy, handmade dog sweaters. Your reputation depends on these products.
You have to decide if they should specialize in dog fashion (economies of scale) or expand to other animals like cats, pigs, and goats, thus appealing to a broader audience (economies of scope).
Some criteria to consider when evaluating whether to pursue economies of scope include:
- Market demand. Investigate the demand and customer interest for your new products or services.
- Brand identity. Consider how diversification aligns with or affects your established brand reputation.
- Cost-benefit analysis. Evaluate the costs of diversification against potential revenue and profit benefits.
- Supply chain considerations. Determine if your supply chain can accommodate new products or services.
- Financial implications. Analyze the investment needs and cash flow changes due to diversification.
- Competitive positioning. Understand how the expanded scope positions you within the competitive landscape.
- Sustainability. Factor in the long-term sustainability and impact on your business growth.
It’s not about right or wrong whether you diversify your product line; it’s about evaluating it methodically and figuring out if it’s worth it. To determine if economies of scope makes sense, the business needs to look at its core competencies, market opportunities, and long-term strategic goals.