Economy of Scope Explanation, Formula, and Calculation Methodology
Economies of scope, a lesser-known yet significant concept, offers businesses more than just cost benefits; it also aids in diversification. This strategy involves reducing the unit cost of production when companies produce two or more products using the same production facilities or resources.
Calculating Economies of Scope
The formula for calculating economies of scope is straightforward:
Here, represents the percentage cost savings, is the cost of producing product A separately, is the cost of producing product B separately, and is the cost of producing both products together. The higher the value of , the higher the potential cost savings when producing multiple products together.
The Difference between Economies of Scale and Economies of Scope
While economies of scale refer to cost advantages gained by increasing the quantity of a single product produced, economies of scope occur when a business lowers its average total cost by producing a variety of different but related products together. This cost reduction arises from sharing resources, inputs, or capabilities across multiple products.
Real-world Examples of Economies of Scope
Consider a company that produces 1,000 units of product A and 2,000 units of product B separately, incurring a total cost of $110,000. However, when they produce both products together, the total cost drops to $100,000, resulting in a cost savings of 10%.
A flexible manufacturing system can enable fast and inexpensive switching from one product line to another, allowing a company to achieve economies of scope. Companies can add new products to their line to meet changing consumer needs, using the same production facilities, resources, expertise, distribution channels, advertising campaigns, and research and development laboratories.
Benefits of Economies of Scope
Economies of scope offer several advantages. For instance, a bundled product can be promoted with a single advertisement, which is more cost-efficient than separate advertisements for each product. Additionally, companies that sell various products reduce the risk of weakening demand in one product line.
Moreover, economies of scope allow companies to be more flexible in anticipating changes in consumer preferences. For example, automakers using one production facility to produce both passenger vehicles and commercial vehicles can save on warehousing or inbound logistics costs.
The Importance of Understanding Economies of Scope
Understanding economies of scope is essential for businesses to achieve cost savings and increase efficiency. By diversifying their product offerings, companies can unlock hidden cost savings and become more resilient to market fluctuations.
For further learning, one can explore topics such as external economies of scale, minimum efficient scale, types and benefits of economies of scale, diseconomies of scale, economic profit, fixed cost, marginal product, abnormal profit, and scaling up.
Investing in the production of multiple related products within a business can lead to economies of scope, as demonstrated by the cost savings achieved by producing product A and B together instead of separately. This strategy, which involves sharing resources and capabilities across different product lines, can also provide benefits such as cost-efficient promotional opportunities and risk diversification.
Understanding economies of scope is crucial for businesses aiming to increase efficiency, as it allows them to unlock hidden cost savings, diversify their product offerings, and become more resilient to market fluctuations. This knowledge can be further expanded by exploring topics such as external economies of scale, minimum efficient scale, types and benefits of economies of scale, diseconomies of scale, economic profit, fixed cost, marginal product, abnormal profit, and scaling up, all of which are relevant to finance and investing in a business context.
