Cost benefits from producing a greater variety of goods
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Economies of scope is an economic concept that refers to the decrease in the total cost of production when a range of products are produced together rather than separately.
Formula for Economies of Scope
C(qa) is the cost of producing quantity qa of good a separately
C(qb) is the cost of producing quantity qb of good b separately
C(qa+qb) is the cost of producing quantities qa and qb together
Economies of Scope (S) is the percentage cost saving when the goods are produced together. Therefore, S would be greater than 0 when economies of scope exist.
Example of Economies of Scope
For example, a restaurant produces both hamburgers and sandwiches. The cost of separately producing 1,000,000 hamburgers is $0.50 each. Likewise, if 4,000,000 sandwiches are produced separately, the cost is $0.30 each. If 1,000,000 hamburgers and 4,000,000 sandwiches are produced together (by using the same preparation and storage facility), the total cost is $1,500,000.
To determine the economies of scope:
Determine C(qa) = 1,000,000 * 0.50 = $500,000
Determine C(qb) = 4,000,000 * 0.30 = $1,200,000
Determine C(qa+qb) = $1,500,000
Plug the numbers into the Economies of Scope formula
($500,000 + $1,200,000 – $1,500,000) / $1,500,000 = 13.33%. Therefore, the cost of producing hamburgers and sandwiches together is 13.33% less than the cost of producing them separately.
How to Achieve Economies of Scope?
1. Flexible Manufacturing
Flexible manufacturing exists if multiple products can be produced using the same manufacturing systems and inputs – for example, using the same preparation and storage facilities when making hamburgers and fries, as opposed to using two separate facilities.
2. Related Diversification
If a company is able to use its operational expertise, resources, and capabilities across its organization, then it can take advantage of related diversification. For example, hiring designers and marketers who can use their skills across different product lines allows for the production of a wide range of products.
Mergers often enable a company to share research and development expenses to reduce costs and diversify its product portfolio or knowledge. For example, two pharmaceutical companies might merge to combine their research and development expenses to create new products.
Economies of Scope vs. Economies of Scale
Economies of scope are often confused with economies of scale. The former refers to the decrease in the average total cost of production when there is an increasing variety of goods produced. On the other hand, economies of scale refer to the cost savings achieved from increasing the scale of production of a single good.
Economies of scope: Savings in cost due to the increased production of distinct products using the same operations. Economies of scope reduce the average cost of producing multiple products.
Economies of scale: Savings in cost due to the increased production of the same product. Economies of scale reduce the average cost of producing one product.
The Importance of Economies of Scope
Economies of scope allow a company to gain efficiency from producing a larger variety of products. A company is able to sell a greater range of products and also respond to changes in consumer preferences. It reduces risks for a company by allowing for related diversification. If a major car producer only produced SUVs, the company would be vulnerable to market changes (if, for example, oil price spikes and consumers switch to buying more eco-friendly cars).
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