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What’s it: Economies of scope is a reduction in the unit cost of production when companies produce two or more products using the same production facilities or resources.
The example is more or less like this. Automakers use one production facility to produce two products: passenger vehicles and commercial vehicles. They can spread fixed assets into two product lines.
Not only that. Because the company also uses the same raw materials, carmakers save on warehousing or inbound logistics costs. So, it is cheaper than producing both individually using different production facilities.
Why are economies of scope important
Economies of scope give companies benefits not only in terms of cost but also in diversification. It does reduce costs through the production of a variety of products.
But, there is another benefit. Companies can sell more varied products. It is essential to meet consumer needs and wants, which also vary. So, companies are more flexible in anticipating changes in consumer preferences.
By selling various products, the company reduces the risk of weakening demand in one product line. For instance, carmakers produce conventional cars and electric cars. Sales of electric vehicles could compensate for the decline in conventional vehicle sales when oil prices soared.
Differences between economies of scope and economies of scale
You may often encounter articles relating economies of scale to economies of scope. Articles usually discuss unit costs (average cost).
Yes, both are essential concepts for explaining how a company can generate lower unit costs.
But, the two are slightly different, especially concerning the source of the average cost reduction. As the definition above, economies of scope arise because a company can expand its variety using the same production facilities.
Meanwhile, economies of scale arise when firms increase production volume. When it reaches economies of scale, firms can spread total fixed costs over many outputs.
Let’s take a simple example. Say, the company bears the total fixed costs of $100 for its production machines. The maximum capacity of the machine is 10 units.
Let’s say the firm produces 2 units and 5 units of product A. To produce both, the firm bears the same total fixed costs, $100. But, it’s not with the average fixed cost. With an output of 5 units, the firm incurs less per unit fixed costs ($20 = $100/5) than when producing 2 units ($50 = $100/2).
With an output of 5 units, production capacity is still available. The firm then uses the same machine to produce 4 units of product B. That will undoubtedly result in a reduction in average costs. However, because the products are different, in this case, we call it economies of scope, not economies of scale. I will explain the formula and calculations later below.
To get more benefits, companies usually try to achieve economies of scale and economies of scope simultaneously. That way, they can reduce the cost per unit even more significantly.
Another example of economies of scope
Economies of scope arise when companies can share and utilize more expensive resources or capabilities to produce several products.
For example, a company can use a flexible manufacturing system to achieve economies of scope. This system enables fast and inexpensive switching from one product line to another.
Furthermore, companies can also add various new products to their current line to meet changing consumer needs. For example, a mobile phone company produces small-screen phones and tablets, using the same production facilities.
You need to remember. This concept does not only apply to production facilities. It also applies to the company’s other resources and capabilities, including expertise, distribution channels, advertising campaigns, and research and development laboratories.
For example, the company combines two products and sells them as a bundle. For promotion, the company only uses one advertisement for the bundled product. Using one ad is undoubtedly more cost-efficient than if the company operates two different advertisements for each product.
How to calculate economies of scope
Mathematically, the formula for economies of scope is as follows:
Where:
- C (Qa) is the cost of producing product A separately.
- C (Qb) is the cost of producing product B separately.
- C (Qa + Qb) is the cost of producing product A and product B together.
S is the percentage cost savings when the company produces goods A and B together. When economies of scope exist, S will be greater than 0. The higher the value of S, the higher the potential cost savings.
All right, let’s take a simple example. A company produces product A and product B.
The cost of making 1,000 units of product A is $50. Meanwhile, the cost of producing 2,000 units of the product is $30. Furthermore, the cost of producing 1,000 items A and 2,000 items B together is $100,000.
From this data, we know that:
- The total cost of producing product A is $50,000 (1,000 x $50)
- The total cost of producing product B is $60,000 (2,000x$30)
- The total cost of producing goods A and B together is $100,000.
Input those data into the formula above.
S = ($50,000 + $60,000- $100,000)/$100,000 = 10%.
Since the value of S is more than zero, the company achieves economies of scope when producing both together. How much can the company save costs? Let’s compare.
When producing products A and B separately, the company incurs a total cost of $110,000 ($50,000 + $60,000).
But, if it produces both together, the company bears the total cost of $ 100,000 or 10% less than making the two separately. Lower costs because the company uses the same machines and raw materials.
