Understanding economies of scope
Economies of scope are benefits that come from operating across different areas. When firms diversify into different areas, there may be some cost-savings that come from operating in different industries. These are scope economies – the cost advantages from diversifying.
Types of diversification that can result in economies of scope
For companies to derive economies of scope from diversification, there needs to be some resource sharing or supply aggregation from operating in the different areas. For example, if back-end functions of the firm can be shared, this sharing of resources may allow the firm to be more effective than a company operating only in one area. Similarly, if there is greater purchasing volumes across shared inputs (i.e., those inputs that are used in different areas), this can allow the firm to get economies of scope relative to firms operating in only one industry.
Not all diversification however is likely to result in such benefits. There needs to be direct opportunities to either share resources or opportunities for greater purchasing volumes. Related diversification is most likely to result in such benefits – areas that are closely connected to the firm’s operations, and this is more likely to share resources or have similar inputs in order to increase purchasing volumes.
The importance of integration to achieve economies of scope
Economies of scope benefits do not come by themselves – it is important that there is at least some level of integration between the different areas of the firm in order to achieve the benefit of scope. For example, in order to achieve savings from increased purchasing volumes, it may be necessary to have purchasing made centrally, rather than the separate areas of the firm purchasing inputs separately.
Similarly, to see scope benefits from shared resources, it is important for the firm to integrate the various separate parts of the business in order to be able to share these resources across the areas.
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