What Is Economies Of Scope Examples How It Works

What is Economies of Scope?

How does it Work?

Economies of scope can be achieved by producing various products together or offering similar services in one package. Doing this decreases the total cost of productionCost Of ProductionProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more as the production process simultaneously utilizes the same raw materials and facilities for multiple products.For instance, an ecommerce 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. If they were stored individually in separate warehouses, it would have unnecessarily added additional costs.It is important to note that the concept of 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 scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. read more. It reduces the cost of producing additional units due to sharing the same production facilities.Economies of scope usually exist amongst large multinationalsMultinationalsA multinational company (MNC) is defined as a business entity that operates in its country of origin and also has a branch abroad. The headquarter usually remains in one country, controlling and coordinating all the international branches.
read more 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.

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Key Takeaways

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 diversificationProduct DiversificationProduct diversification is a business strategy that involves developing and selling a new line of products, services, or a service division that uses the same or completely different sets of knowledge, skills, machinery, etc.read more, linking supply chain, and M&A.The notion has gained immense popularity and is being adopted across manufacturing, operations, banking, and IT services.

Examples of Economies of Scope

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 bankingInvestment BankingInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more, 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. But, first, we need to consider the production possibility frontierProduction Possibility FrontierThe Production Possibility Frontier (PPF) is a visual representation used to illustrate the maximum possible output combinations of two separate products produced using the same amount of limited resources.read more (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 goodsTC = 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

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.
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 costUnit CostUnit cost is the total cost (fixed and variable) incurred to produce, store and sell one unit of a product or service. It is calculated by adding fixed and variable expense and dividing it by the total number of units produced.read more of the overall average production will come down.

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 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.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.Acquisition of Companies with Similar Products – MergersMergersMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more 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.Diversification – Companies producing products using similar inputs and production processes will improve productivity.