Economies of scope

As a business owner, needless to say, you want to bring your business forward, increase growth and increase sales. This is made possible by using economies of scope: you expand your product range with new products, thereby increasing sales, winning new customer groups and using already existing production processes. Such economies of scope help companies make cost savings. Economies of scope are therefore synergies in multi-product companies. In this respect, they differ from so-called economies of scale, which distinguish themselves through cost savings through an increase in output. Both effects serve to reduce costs during production. Let’s delve deeper into the term ‘economies of scope’.

Cost savings coupled with high sales volumes is the aim! This is most likely what most profit-oriented companies are looking for. One way to achieve this is to expand your own product range. But how exactly does that work? The idea behind economies of scope is to exploit synergies, so the products that you offer in addition to your existing portfolio should have a certain proximity to the products you already offer. This way you can rely on already existing processes for production, and costs are lower than with a completely different kind of product. There are two types of cost-saving effects: Bundling effects and integration effects.

Depending on whether you extend the product chain vertically or horizontally, you could be talking about either integration effects (expansion of depth) or bundling effects (expansion in the width).

When you vertically integrate your company, you increase your depth of service. This is the case, for example, when you manufacture the materials you need to make the product yourself or when you take over distribution channels. By taking over more and more stations in the value chain yourself, you usually achieve cost savings. In addition, you may also be able to make the additional production or distribution stations that you have established available to other companies in return for a fee. This way you can generate additional revenue.

With the bundling effect you broaden your offering range at the level of the value chain. So, you make a new product in addition to an existing one. Ideally, you should try to use as many of the existing resources as possible to make the new product: skilled workers, machinery, and storage facilities should at least be partially made available for the production or distribution of the item. As a result, you can usually save more money than producing a completely different product that requires different machinery and knowledge to that of your previous production. At the same time, the expansion of products or services usually increases the turnover of the company.

Within these two types of effects, you can again differentiate three types of the connection: They are of a functional, spatial or temporal nature.

The products are in a functional relationship to each other and are mutually dependent to a certain extent. This is the case, for example, when a byproduct is produced in the manufacture of a product, which can then also be used profitably in what is called a joint production. Using the same machines for the production of another product and therefore improving its utilization is also called a function effect.

When production processes can be bundled locally it is referred to as a spatial effect. This plays an important role in logistics, for example: if the transport of passengers is linked with that of freight, this is referred to as a spatial bundling effect. Even the merging of several branches of a company can lead to spatial economies of scope. With such synergies it can also be differentiated as to whether it relates to a customer-related or customer-unrelated connection, as well as a stationary or mobile connection.

Bundling or integration effects are of a temporal nature when they take place at the same time or at least very closely to each other. If you sell the customer two products (e.g. coupled subscriptions), for example, upon the conclusion of only one contract, it is referred to as a temporal bundling effect. A temporal integration effect is also present, for example, in the metalworking process when you pour the finished product directly after the raw material has melted, instead of carrying out an intermediate step with a preliminary cast (ingot), including the cooling process and storage.

The exact way that you expand your offerings is decisive in whether you can create positive economies of scope: An advantage only exists if the costs of expansion are lower than those of separate production. This means you have to successfully use existing factors in your company for additional production. Such factors can be found in many different areas and they offer different advantages:

• Logistics: Use existing means of transport and routes to deliver the new goods to their destination. For example, if you had previously used trucks that were not filled to their capacity, you can save costs for the extra cargo.
• Warehousing: Utilization is again crucial here. Completely stocking an existing warehouse is more cost efficient. This is additionally important for certain warehouse conditions (such as cooling chambers).
• Marketing: If you operate your own marketing department, it is easy for the employees to continue using established processes and to also use their existing know-how for the new product.
• Production facilities: Machines are often not just used for creating a single type of product. This way you can often produce, if not the complete new product, at least a part of it with existing equipment. This saves acquisition and maintenance costs.
• Purchasing: You probably partly use the same resources for old and new products. As this increases your purchasing power, you can expect better purchasing conditions.
• Technologies: If you have developed your own technologies, it makes sense to apply them to as many products as possible. But the secondary exploitation of technologies can also make sense as an integration effect - for example, if you also sell or license the new technology to other companies.
• Know-how: If you have acquired important know-how during the creation of a product or in researching new techniques, it makes sense to use it as widely as possible.
• Skilled workers: Even skilled workers and their knowledge can usually be used, not only for the production of a particular type of product, but also for the manufacture of similar products. Use this knowledge to create synergy effects.
• Distribution channels: Regardless of which sales model a company pursues, the use of existing channels ensures positive economies of scope. Employees in direct sales can sell the new product as well as intermediaries in the retail sale.

It is also possible to exploit subtler economies of scope to a limited degree. This happens particularly in the marketing segment. This is the case, for example, when a newly launched product profits from the good reputation of another product (and therefore of the company). Market entry is easier in such a case than for a completely unknown company with a similar product.

If the above-mentioned factors are not used properly, negative economies of scope can also occur, also referred to as diseconomies of scope. For example, if you expand your portfolio so much that administration becomes too complex, it will have a negative impact on your profits.

There are several methods and resulting effects that can help a business achieve growth. In addition to the economies of scope described here, you may have also heard of economies of scale and economies of density. The former describes the effects increasing output has on manufacturing costs. The aim here is to increase the output disproportionately to the input, i.e. to generate more revenue than expenditure. You can achieve an increase of output by increasing productivity for example, but also by expanding the entire operation.

Economies of density can be classified as a subcategory of both economies of scope and economies of scale. Economies of density is a term that describes the impact of clustering multiple companies of the same industry in one location or the impact of a dense collection of many consumers. Economies of density play an important role, especially with regard to transport routes, which also confirms the extent to which economies of density are linked to the first-mentioned effects: If a supplier supplies a single raw material to several companies in the same location, it benefits from economies of scale. If a company can supply several customers in the same location with different products, then economies of scope come into play.

As described, economies of scope can result from a wide range of measures. These examples illustrate the mode of action.

A farmer keeps cows and sells both the freshly collected milk and the butter made from it directly on the market. For this reason, he also runs a small factory and several large refrigerated storage rooms. The market is already saturated with these products. In order to increase his sales, he also chooses to produce cheese. He has the raw material for this anyway, and he can also use the storage rooms for the new product in his range.

He also has his own stand at a market and can sell cheese there. The farmer can therefore establish an additional product on the market without having to bear the full cost of a completely independent product.

A shoemaker owns a small workshop where she makes high-quality, handmade shoes. She sells them to a local shoe retailer, who of course sells the shoes at a greatly increased price. To generate more revenue, the shoemaker decides to set up her own shop connected to her workshop. She therefore creates an integration effect: instead of making use of only one level in the value chain, she extends her portfolio vertically.

The shoemaker, however, is in danger of creating diseconomies of scope: while she can theoretically lower the cost per shoe, she cannot disregard the extra cost. In addition, there is the risk that her shoe shop will not be as attractive to customers as the larger, established retailer. She may try to reduce this risk by not only selling self-made shoes in the store, but also products from other manufacturers. She could therefore use the sales area more profitably in terms of economies of scope.

Let’s imagine a company that makes shampoo. It is mainly women that buy its product. In order to offer a male buyer group their own product, it decides to launch a customized product on the market, within the sense of gender marketing. The actual recipe of the product is not changed. The company only adds a different fragrance. The packaging is also completely different. It then takes other marketing measures, driven by the already experienced employees. The new product is distributed through the same drugstores as the old product.

The company can therefore benefit from several economies of scope: there is no need to buy new machinery and research for a new recipe is also unnecessary. Since the new product consists largely of raw materials which the company buys anyway, a better price can be achieved due to volume discounts. This way, the company enables a secondary exploitation of several factors, makes savings in purchasing at the same time and can strengthen sales through a new target group. In this example, the company makes excellent use of economies of scope.

Click here for important legal disclaimers.