What Are Economies of Scope?
An economy of scope is a business that has reduced costs by producing multiple products or services in one production process. In an economy of scope, the cost of producing new products does not significantly raise the total cost of running the business. Economies of scope are possible because the business becomes more cost-efficient as the costs are spread across multiple products.
For example, a dine-in restaurant that adds a take-home bakery section is using an economies of scope strategy. Overhead costs won’t rise because the restaurant can use the same kitchen space, employees, and processes to produce the additional bakery items. This makes the restaurant more cost-efficient and ultimately more profitable.
In this article, learn how economies of scope could be the key to higher profits and quicker growth for your business.
- Economies of scope allow business owners to reduce expenses by expanding their product offerings, allowing them to split overhead costs between a greater number of products.
- Creating a multi-use production process, simplifying the supply chain, centralizing key departments in your company, and merging or acquiring similar companies can create economies of scope in your business.
- An economy of scale works through the increased output of the same product, while an economy of scope is created by expanding the variety of products rather than the volume.
How to Achieve Economies of Scope
There are a few strategies you can pursue to achieve economies of scope. Some business owners implement just one of these strategies, while others implement a combination or all of them. The right strategy for you depends on your business, products, and goals.
1. Create a Multi-Use Production Process
The easiest way to achieve economies of scope is to create products that require similar materials, equipment, and facilities for production. For example, a vitamins and supplements company can use similar containers for a variety of products. They can buy these containers in bulk to receive discounts and reduce waste.
Each different product can likely be manufactured using the same equipment, and employees will need little to no additional training to create the end product. This allows the company to introduce new products without introducing significant excess costs.
2. Maximize Supply Chain Efficiency
Many businesses, especially young brands, do not utilize the total capacity of their supply chain. While only offering a small range of products, you may have unused capacity in your warehouses. Or perhaps you’re paying shipping costs but not taking full advantage of your allotted capacity. Adding products allows you to eliminate these inefficiencies and maximize revenue without increasing costs.
3. Look for Merger and Acquisition Opportunities
Mergers and acquisitions are one of the most common strategies for achieving economies of scope. When similar brands merge, they are able to continue offering a full range of products while operating under centralized marketing, accounting, human resources, and other major operational departments. This cuts operational costs nearly in half while retaining customers from both companies.
Example of a Successful Economy of Scope
The world-famous Starbucks coffee company utilized economies of scope to reach its massive success. Today, the $114 billion dollar company with 48 drinks on its menu is known for its various sweet lattes, fancy frappuccinos, and themed holiday drinks, but the first Starbucks menus sold only plain brewed coffee.
Starbucks profits by selling a variety of products that use similar ingredients and a similar production process. This means the coffee company can utilize bulk discounts, a simple employee training process, and quick transactions.
Additionally, Starbucks has acquired multiple profitable brands that sell tea, bakery items, and bottled water. These acquisitions allow the coffee company to sell the additional products out of its own stores. They are still able to maintain similar revenue levels the acquired brands had previously achieved but reduce costs by eliminating the expense of operating multiple brick-and-mortar stores.
Be Cautious of These Issues When Pursuing an Economy of Scope Strategy
While economies of scope have the potential to improve your profits, this strategy can set you back on your business goals if it’s implemented poorly. Here are some problems to be aware of while building economies of scope:
If your expansion of product offerings causes the quality of your products to suffer, you may lose customers. An economies of scope strategy became common in the finance industry when banking mergers surged in popularity in the 80s and 90s, a trend that lasted for decades. A 2013 study surveyed consumers who had recently experienced a merger or acquisition at their bank. 15% of those surveyed left their bank after the merger. Additionally, 42% of those who left reported the customer experience had declined in quality.
Brand dilution occurs when a new product negatively alters consumers’ perception of a brand. For example, in the early 1960s, Cadbury had a reputation for being a high-end chocolate brand. When it introduced instant mashed potatoes to its product offerings, the company’s chocolate sales suffered. Although consumers bought the mashed potatoes, because it was a low-end food product, it changed the perception of Cadbury as a premium food brand.
As a company grows, it can become more difficult for leaders of the business to manage the added complexity. With increasing product offerings, managers may be unaware of the unique issues of each product. This can lead to uninformed business decisions that can impact the company’s long-term success.
To avoid these problems while adding new products to your company, be sure to:
- Launch products that align with your brand image.
- Practice quality control of all products and services.
- Implement strong management systems that allow for thorough communication across all levels of the company.
Economies of Scale vs. Economies of Scope
Similar to economies of scope, economies of scale is an economic principle that refers to an increase in cost efficiency. Economies of scale occur when the average cost per unit decreases as the scale of production increases. The production costs are spread over a larger number of units, so the more units that are produced, the lower the cost per unit becomes.
Businesses can achieve economies of scale by purchasing materials with bulk discounts, hiring employees that specialize in one part of the production process, and utilizing systems, equipment, and infrastructure already in place to increase output without increasing costs.
The key difference between economies of scale and economies of scope is that economies of scale improve cost efficiency by increasing the production volume of a single product. However, economies of scope increase cost efficiency by producing a wider variety of products.
How to Choose the Right Strategy for Your Company
Before making any business decisions, it’s critical to do research rather than follow your gut. If you’re not sure whether to grow your business with an economy of scope strategy by diversifying your product line or to pursue an economy of scale strategy by increasing the volume of your current product offerings, it’s time to do some analysis.
To determine if an economy of scope is right for you, follow these steps:
- Identify new products that require similar materials and equipment to your current products.
- Research your customer base to determine whether a new product would be well-received.
- Calculate your current overhead costs and the amount (if any) a new product would increase them.
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