Thursday, 21 June 2018

Investopedia/Steven Nicholas: How do Economies of Scope and Economies of Scale Differ?

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How do Economies of Scope and Economies of Scale Differ?
By Steven Nickolas | Updated February 14, 2018 — 4:35 PM EST
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Economy of scope and economy of scale are two different concepts used to help cut a company's costs. Economies of scope focuses on the average total cost of production of a variety of goods, whereas economies of scale focuses on the cost advantage that arises when there is a higher level of production of one good.
Economies of Scope

The theory of an economy of scope states the average total cost of a company's production decreases when there is an increasing variety of goods produced. Economy of scope gives a cost advantage to a company when it produces a complementary range of products while focusing on its core competencies. Economy of scope is an easily misunderstood concept, especially since it appears to run counter to the concepts of specialization and scale economies. One simple way to think about economy of scope is to imagine that it's cheaper for two products to share the same resource inputs (if possible) than for each of them to have separate inputs.

An easy way to illustrate economy of scope is with rail transportation. A single train can carry both passengers and freight more cheaply than having separate trains, one for passengers and another for freight. In this case, joint production reduces total input costs. (In economic terminology, this means that one input factor's net marginal benefit increases after product diversification.)

For example, company ABC is the leading desktop computer producer in the industry. Company ABC wants to increase its product line and remodels its manufacturing building to produce a variety of electronic devices, such as laptops, tablets and phones. Since the cost of operating the manufacturing building is spread out across a variety of products, the average total cost of production decreases. The costs of producing each electronic device in another building would be greater than just using a single manufacturing building to produce multiple products.

Real-world examples of the economy of scope can be seen in mergers and acquisitions (M&A), newly discovered uses of resource byproducts (such as crude petroleum) and when two producers agree to share the same factors of production.
Economies of Scale

Conversely, an economy of scale is the cost advantage a company has with the increased output of a good or service. There is an inverse relationship between the volume of output of goods and services and the fixed costs per unit to a company.

For example, suppose company ABC, a seller of computer processors, is considering purchasing processors in bulk. The producer of the computer processors, company DEF, quotes a price of $10,000 for 100 processors. However, if company ABC buys 500 computer processors, the producer quotes a price of $37,500. If company ABC decides to purchase 100 processors from company DEF, ABC's per unit cost is $100. However, if ABC purchases 500 processors, its per unit cost is $75.

In this example, the producer is passing on the cost advantage of producing a larger number of computer processors onto company ABC. This cost advantage arises because the fixed cost of producing the processors has the same fixed cost whether it produces 100 or 500 processors. Generally, when the fixed costs are covered, the marginal cost of production for each additional computer processor decreases. At lower marginal costs, additional units represent increasing profit margins. It offers companies the ability to drop prices if need be, improving the competitiveness of their products. Large, warehouse-style retailers such as Costco and Sam's Club package and sell large items in bulk due in part to realized economy of scale.

Although an economy of scale may seem beneficial to a company, it has some limits. Marginal costs never decrease perpetually. At some point, operations become too large to keep experiencing economies of scale. This forces companies to innovate, improve their working capital or remain at their present optimal level of production. For example, if the company that produces the computer processors surpasses its optimal production point, the cost of each additional unit may begin to increase instead of continuing to decrease. (For related reading, see: What are some examples of economies of scale?)
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