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.

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.

• 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 uses similar raw materials and production units to produce various 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 and is being adopted across manufacturing, operations, banking, and IT services.

• The degree of economies of scope can be achieved by producing various products or 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 mind-boggling variety of products to suit the needs of its enormous customer base. Yet it enjoys a low unit cost for handling these products, which results from many things: the products are stored together in a warehouse. It would have unnecessarily added additional costs if they were stored individually in separate warehouses.
• It is essential to note that operational economies of scope and scale should not be treated the same. The cost is reduced in economies of scope using similar resources to support the large-scale production of distinct goods. On the other hand, cost-saving flows from increasing the volume of a single product in the economies of scale. It reduces the cost of additional units due to sharing the same production facilities.
• Economies of scope business usually exist amongst prominent multinationals with a massive product portfolio. The wider it becomes, the more it causes the fixed cost to spread over each product amongst the variety they offer.

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 Products - Mergers 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.

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

Example#1

• Many sectors are exploring ways to improve businesses using economies of scope, which we will explain with an example.
• Apart from e-commerce, the banking sector also capitalizes on economies of scope. Banks that have developed a robust IT infrastructure offer many 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.

Example#2

In terms of mathematical explanation, we can illustrate the economies of scope. But, first, we need to consider the production possibility frontier (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 cost 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.

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.  

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 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.

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 –

• Economies of Scale vs Economies of Scope
• Diseconomies of Scale
• Average Cost