Economy of Scope Explanation, Equation, and Calculation Methods
In the competitive business world, companies are constantly seeking ways to reduce costs and increase efficiency. Two key concepts that play a significant role in achieving these goals are economies of scale and economies of scope.
Economies of Scope: The Key to Diversification
Economies of scope offer cost advantages when companies produce a variety of goods using shared inputs or capabilities. This encourages diversification, as firms can leverage shared resources, technologies, or processes across different product lines, lowering aggregate costs and risk.
The formula for calculating economies of scope is: S = [(C(Qa) + C(Qb)) - C(Qa + Qb)] / C(Qa + Qb), where C(Qa) is the cost of producing product A separately, C(Qb) is the cost of producing product B separately, and C(Qa + Qb) is the cost of producing both products together.
For instance, a company with a machine that has a maximum capacity of 10 units can produce both 2 units and 5 units of product A, incurring less per unit fixed costs with an output of 5 units. This is an example of economies of scope.
Economies of Scale: The Focus on Expansion
In contrast, economies of scale focus on cost savings gained by increasing the volume of a single product, spreading fixed costs over more units and improving operational efficiency.
When firms increase production volume, they achieve economies of scale. For example, a company producing 1,000 units of a single product would have lower per-unit costs compared to producing 100 units of the same product.
The Difference Between Economies of Scope and Economies of Scale
The key difference is that economies of scope arise from producing a variety of goods jointly, while economies of scale stem from expanding production of a single good or service.
The Benefits of Economies of Scope
By understanding and leveraging economies of scope, businesses can reduce costs, increase efficiency, and diversify their product offerings to meet changing consumer needs. This is particularly beneficial for companies that produce different products, as they can use the same production facilities, raw materials, and other resources to manufacture multiple items.
Additionally, economies of scope provide benefits beyond cost reduction. They also allow companies to reduce the risk of weakening demand in one product line by offering a diverse range of products.
Achieving Economies of Scale and Economies of Scope
Ideally, companies aim to achieve both economies of scale and economies of scope simultaneously to reduce the cost per unit even further. A flexible manufacturing system can enable fast and inexpensive switching from one product line to another, achieving economies of scope.
Real-World Examples
Automakers can save on warehousing or inbound logistics costs by using one production facility to produce two products: passenger vehicles and commercial vehicles. This is an example of economies of scope, as the total cost of producing both together is 10% less than making the two separately.
Further Learning Resources
For those interested in delving deeper into this topic, further learning resources include topics on 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 a diverse product line can lead to economies of scope, allowing companies to share resources, lowering aggregate costs and risk. In this way, companies can become more efficient and increase their business.
By understanding and leveraging both economies of scale and economies of scope, a company can efficiently enhance its competitive advantage in the finance and investing sectors. This can translate to higher net profits and better overall business performance.
