Economies of Scope

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What does 'Economies of Scope' mean

Economies of scope is an economic theory stating that the average total cost of production decreases as a result of increasing the number of different goods produced. For example, McDonald's can produce both hamburgers and French fries at a lower average expense than what it would cost two separate firms to produce each of the goods separately. This is because McDonald's hamburgers and French fries are able to share the use of food storage, preparation facilities and so forth during production.

BREAKING DOWN 'Economies of Scope'

Specifically, economies of scope describe situations in which the long-run average and marginal cost of a company, organization or economy decreases, due to the production of similar complementary goods and services. The output of item A, therefore, reduces the price of producing item B.

Proctor & Gamble is another good example of a company that efficiently realizes economies of scope, since it produces hundreds of hygiene-related products, from razors to toothpaste. The company can afford to hire expensive graphic designers and marketing experts who can use their skills across all of the company's product lines, adding value to each one. If these team members are salaried, each additional product they work on increases the company's economies of scope, because the average cost per good decreases. Additionally, the company is able to consolidate and streamline its production process, making it easier to produce both a razor and a tube of toothpaste, further decreasing average unit costs.

Different Ways to Achieve Economies of Scope

Economies of scope are important for any large business, and a firm can go about achieving such scope in a variety of ways. First, and most common, is the idea that this operational efficiency is gained through related diversification. This is a similar strategy to that of McDonalds and Proctor & Gamble. Kleenex, using another example, has achieved economies of scope through the diversification of its simple tissue paper. The company expanded its product line to service numerous, unrelated end users, such as consumers and hospitals, all of which required a unique type of paper product.

Merging with or acquiring another company is another a way to achieve economies of scope. Two regional retail chains, for example, may merge with each other to combine different product lines and reduce average warehouse costs.

Finally, a company that wants to achieve economies of scope can link its supply chain through vertical integration. The ownership of a supply chain, from raw materials to the point of sale, allows many companies to consolidate the logistical process by combining multiple products into one production process, thus reducing costs.