Published On:Tuesday, 3 January 2012
Posted by Muhammad Atif Saeed
Economies of Scale vs. Economies of Scope
Generally speaking, economies of scale is about the benefits gained by the production of large volume of a product, while economies of scope is linked to benefits gained by producing a wide variety of products by efficiently utilising the same Operations. Each of these business strategies, their strengths and weaknesses, will be discussed in details in this paper.
"Economies of scale" has been known for long time as a major factor in increasing profitability and contributing to a firm's other financial and operational ratios. Mass production of a mature, standardised product can apply the most efficient line-flow process and standard inputs for reducing the manufacturing cost (per unit). Mass manufacturing is also associated with a significant market-share, and a tight supply-chain management (up to vertical integration with suppliers and retailers). To maintain the market-share, the market leader should come with continuous product improvements, so to sustain demand and avoid its dropping, following the product's maturity in the Product Life-Cycle (PLC).
"Economies of scope" is relatively a new approach to business strategy, and is heavily based on the development of high technology. Economies of scope, as defined by using same processes for producing similar products, can fit the batch-flow or group-technology processes; nevertheless, for best results the flexible-manufacturing should be adopted. Computer Integrated Manufacturing (CIM) allows lowering the setup-time and required tuning between products, so to be economically efficient for small batches of non-standardised products. In other words, companies can compete on product customisation and short lead-time.
A case study at GM shows that new competition can reduce firm's market share and its benefits from economies of scale (Howell, 2003). The author argues that the main problem was the neglect of innovation, as a side-effect of GM's strategy (until the Japanese cars entered the US market, in the late 1970s). Cachon and Harker (2002) found that scale economies are so powerful that to provide a strong motivation for outsourcing, too; even though the outsourcing contractors are not allowed reaching the same scale as the outsourcer. Dobson and Yano's (2002) article is an in-dept scholarly analysis of the factors associated with economies (and diseconomies) of scale and economies (and diseconomies) of scope. The authors argue that mass-customisation, which means broader product lines, "may help to increase market share and may allow higher prices to be charged, but they also cause challenges associated with diseconomies of scope" such as setup time.
Ang and Lin (2001) bring a case study from the financial industry, and the ways economies of scope and economies of scale work for mutual fund offerings. At Fidelity, an example of economies of scope at work, investors had the option for high diversified portfolio at the same institution. But aiming at cost reduction (which is of interest to clients and investors), the economies of scope did not provide the desired objectives, while economies of scale did, in the case of mutual funds. Trying to find the ideal conditions for economies of scale and economies of scope, the authors say that a single-product firm should pursue the economies of scale. However, economies of scope for a two-product firm is said to exist "if the cost of producing the two products jointly is less than producing the same products separately". When it comes to three or more products, the number of production combinations increases, so evaluation of the economies of scope becomes more complicated and requires more data to analyse.
Advocating for a different view of the economies of scope and scale, Peppers and Rogers (1995) put the customers under the spotlight. They argue that market share can be seen as share of customer, pursuing customer differentiation rather than product differentiation, managing customers and not only products and more emphasis on economies of scope at the expense of scale.
As expected, between these two approaches there is a "grey area", in which firms found a way to enjoy both worlds of economies of scale and scope. Mass-customisation, I believe, provides few similar customised products (the concept behind economies of scope) along with operating mass-production and controlling large market-share for each of these products.
"Economies of scale" has been known for long time as a major factor in increasing profitability and contributing to a firm's other financial and operational ratios. Mass production of a mature, standardised product can apply the most efficient line-flow process and standard inputs for reducing the manufacturing cost (per unit). Mass manufacturing is also associated with a significant market-share, and a tight supply-chain management (up to vertical integration with suppliers and retailers). To maintain the market-share, the market leader should come with continuous product improvements, so to sustain demand and avoid its dropping, following the product's maturity in the Product Life-Cycle (PLC).
"Economies of scope" is relatively a new approach to business strategy, and is heavily based on the development of high technology. Economies of scope, as defined by using same processes for producing similar products, can fit the batch-flow or group-technology processes; nevertheless, for best results the flexible-manufacturing should be adopted. Computer Integrated Manufacturing (CIM) allows lowering the setup-time and required tuning between products, so to be economically efficient for small batches of non-standardised products. In other words, companies can compete on product customisation and short lead-time.
A case study at GM shows that new competition can reduce firm's market share and its benefits from economies of scale (Howell, 2003). The author argues that the main problem was the neglect of innovation, as a side-effect of GM's strategy (until the Japanese cars entered the US market, in the late 1970s). Cachon and Harker (2002) found that scale economies are so powerful that to provide a strong motivation for outsourcing, too; even though the outsourcing contractors are not allowed reaching the same scale as the outsourcer. Dobson and Yano's (2002) article is an in-dept scholarly analysis of the factors associated with economies (and diseconomies) of scale and economies (and diseconomies) of scope. The authors argue that mass-customisation, which means broader product lines, "may help to increase market share and may allow higher prices to be charged, but they also cause challenges associated with diseconomies of scope" such as setup time.
Ang and Lin (2001) bring a case study from the financial industry, and the ways economies of scope and economies of scale work for mutual fund offerings. At Fidelity, an example of economies of scope at work, investors had the option for high diversified portfolio at the same institution. But aiming at cost reduction (which is of interest to clients and investors), the economies of scope did not provide the desired objectives, while economies of scale did, in the case of mutual funds. Trying to find the ideal conditions for economies of scale and economies of scope, the authors say that a single-product firm should pursue the economies of scale. However, economies of scope for a two-product firm is said to exist "if the cost of producing the two products jointly is less than producing the same products separately". When it comes to three or more products, the number of production combinations increases, so evaluation of the economies of scope becomes more complicated and requires more data to analyse.
Advocating for a different view of the economies of scope and scale, Peppers and Rogers (1995) put the customers under the spotlight. They argue that market share can be seen as share of customer, pursuing customer differentiation rather than product differentiation, managing customers and not only products and more emphasis on economies of scope at the expense of scale.
As expected, between these two approaches there is a "grey area", in which firms found a way to enjoy both worlds of economies of scale and scope. Mass-customisation, I believe, provides few similar customised products (the concept behind economies of scope) along with operating mass-production and controlling large market-share for each of these products.
Economies of scale - a quick explanation:
