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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Economies of Scope

What it is:

Economies of scope is a term that refers to the reduction of per-unit costs through the production of a wider variety of goods or services.

How it works (Example):

Let's assume Company XYZ strictly manufactures vacuum cleaners. What would happen if the company decided to branch out into brooms? Adding brooms to the product line would allow XYZ to spread certain fixed costs over a larger number of units. Thus, the company could reach more customers with its advertising budget, its sales force could be used to sell both products, brooms could be stored and shipped from the firm's existing vacuum warehouse, and the company's factory could turn leftover broom bristles into cleaning brushes for its vacuums. Furthermore, XYZ could then market itself as a "cleaning products" company rather than just a "vacuum" company.

In this example, XYZ increased the variety of items produced rather than increasing the number of vacuum cleaners produced. As a result, the company's advertising, selling, and distribution costs may generally remain the same, but its number of products sold will increase. The cost of producing multiple products simultaneously is often less than the costs associated with producing each product line independently. Therefore, because the firm has managed to reduce its total costs per unit produced, XYZ could become more profitable.

Why it Matters:

Similar to economies of scale, economies of scope provide companies with a means to generate operational efficiencies. However, economies of scope are often obtained by producing small batches of many items (as opposed to producing large batches of just a few items). Because they frequently involve marketing and distribution efficiencies, economies of scope are more dependent upon demand than economies of scale. This is often what motivates manufacturers to bundle products or to create a whole line of products under one brand.

Although economies of scope are often an incentive to expand product lines, the creation of new products is often less efficient than expected. The need for additional managerial expertise or personnel, higher raw materials costs, a reduction in competitive focus, and the need for additional facilities can actually increase a company's per-unit costs. When this happens, it is often referred to as diseconomies of scope.

Nevertheless, when done correctly, economies of scope can help companies gain a significant competitive advantage. Not only do they trim expenses on a per-unit basis and improve profitability, but they can also force less cost-efficient competitors out of the industry or discourage would-be rivals from even entering the market.

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