Forget Economies of Scale. I Want Economies of Scope.

Wednesday, August 1, 2018

What are economies of scale?

Every student of economics knows what economies of scale are. They're the factors that allow big companies that specialize in a single product category to produce their offerings for pennies, even though it costs smaller first much more. Firms that spend significant sums on fixed costs like factories and computer systems are able to gain massive increases in efficiency that lower their per-unit production costs.

Economies of scale sound fantastic, but they aren't without their downsides. What happens when consumer demand goes down, preferences change, or new challengers adopt innovations that make all of those wondrous investments obsolete?

If only there were a way to achieve some of the benefits of economies of scale while keeping risks relatively low.

Enter economies of scope

Whereas economies of scale require a very narrow business focus (producing a lot of just one thing), firms focusing on economies of scope create a small number of closely related offerings. Because their products share a subset of production inputs, customer market segments, and managerial requirements, firms aiming for economies of scope have the potential to keep their costs low.

Examples of economies of scope and economies of scale

Before getting into the pluses and minuses of each, let's take a look at them in action.

The snack shop

Imagine a man name Theo lives along a busy street. He decides that he can earn quite a bit of money by selling snacks to passers-by. As a test, he takes all of the food from his kitchen and begins to sell to the hungry masses.

He soon discovers that his suspicions were correct! People are buying his wares and soon his pantry is completely emptied. Unfortunately, Theo makes little in the way of profit. Buying food at retail prices is just too expensive, so Theo investigates possible changes to his business model.

Creating an economy of scale

Fortunately, Theo studied economics and knows about the economics of scale. He takes what little money he has from his bank account and invests it into a pile of potatoes, a deep fryer, some peanut oil, and a big sign advertising "Theo's Magnificent French Fries." The deep fryer was rather expensive, but it allows him to cook his fries evenly, quickly, and with a minimum of oil. His flashy sign attracts many passers-by who love to eat french fries. His investments, though expensive at first, make the cooking process quick, easy, and cheap. As a result, he soon finds himself flush with cash.

One day, a new study comes out that links potato consumption to the onset of migraines. The research spreads like wildfire, and now nobody wants to buy his products. Drivers see his sign that advertises his "magnificent french fries," but not only do they not stop to make a purchase, but they actually speed up. Nobody wants french fries anymore, because no one wants migraines.

As a result, Theo goes bankrupt, his wife leaves him, his house goes into foreclosure, and his life is effectively ruined. Also, his son cries himself to sleep for the remainder of his life.

How his life would have turned out with an economy of scope?

Theo buys a deep fryer, some peanut oil, and a collection of meats, fish, and vegetables from a wholesale restaurant supplier. He also buys a big sign that reads "Theo's Magnificent Fried Food." When customers step up to his ordering window, he lets them pick an item from a menu and dumps the relevant ingredient items into the deep fryer. Some people order french fries, others ask for fried chicken, and the fried fish is quite a popular choice too.

Sometimes Theo wonders if he should have specialized, because the variety of foods that he offers means that he has to change his cooking oil more frequently (nobody likes chicken that tastes like fish), maintain a more complicated inventory system, and set his kitchen timers for different lengths of time when cooking different foods. Nevertheless, he continues on. It wasn't that bad really; everything he sells is some variation of "chop it up, stick it in oil, and then serve it on a plate."

Then, one day, a new study comes out that links potato consumption to the onset of migraines. The research spreads like wildfire.

As a result, Theo decides to stop serving potatoes. He takes a small loss on his inventory of spuds, but there are fortunately, plenty of other things he can sell. Drivers see his sign advertising "Magnificent Fried Food" and stop quite frequently. Sales of fried chicken practically double overnight.

As time passes, his son decides to go to medical school and is awarded a billion-dollar patent for a pill that prevents migraines from potato consumption. They all retire to Hawaii and get a puppy.

Benefits of economies of scope

There are many benefits to pursuing economies of scope. Here are a few of the most important:

Broadening a customer base - By appealing to a wider market, firms can reduce the chance that their dependence upon a small market segment. If that group goes bankrupt, or changes its preferences, the firm can still appeal to many others.
Cross-pollination - Lessons learned, knowledge, and experience from one product line can be used to improve another.
Cross-promotion - If a firm sells multiple products, it can promote each to buyers of the other. For instance, if a vendor sold books and consulting services, then people who read books might buy consulting and vice versa.
Cross-subsidization - Offerings that don't bring in enough income to pay for fixed-cost investments and pool their resources in order to afford them.

Downsides of Economies of Scope

Economies of scope are not just rainbows and roses. There are some very real drawback that should be noted. Here are some of the most common drawbacks:

Increased management overhead - The more products that are offered by a business, the more difficult management becomes. Inventory management, training, and coordination require more staff, more oversight, and more risk analysis.
Complexity of messaging - Sometimes products can't share fixed costs. For instance, a company that uses the same factories to produce both baby formula and rat poison would harm sales of each, if sold under the same brand name.
Difficulty in creating authority - A firm that makes several related things may not be seen as an expert in any of them.
Fear of cannibalization - Firms with several product lines in a given field will often create artificial barriers to prevent intracompany competition. This will necessarily decrease the value offered to consumers, as well as the potential of profit for the parent organization.
Inevitable march toward full generalization - A firm with a broader focus will have a tendency to increase its scope in order to increase income. Without a constant focus on maintaining a limited scope, it will lose its economies of scope.

Conclusion

Everyone focuses on economies of scale, but in many industries, economies of scope represent a safer alternative.

Which one is right for your business? That's tough to say. Whether you're better off with economies of scale or economies of scope will depend upon what you do, your goals, and who your customers are.

Of course, if you need help figuring all of that out, I'm sure you know exactly who to contact.