Running a business is a costly affair. For a company to be profitable they will need to produce more revenue than their average cost. This is why businesses seek methods to cut costs and make reductions wherever possible. Two strategies to make cost reductions in company proceedings are economies of scale and economies of scope.
Economies of scale is a method that aims to reduce cost by increasing production efficiency. Economies of cost aim to reduce average cost by diversifying the resources. That is, using the same resources and operations to produce varied products.
This article explains how both methods work. It also explains the differences between the two.
Economies of Scale vs Economies of Scope
Economies of scale are a cost-reduction strategy. Companies reduce costs by increasing their production efficiency and outputs. It is a product standardization method. The hypothesis behind the strategy is that there is a negative relationship between an increase in the volume of production and fixed costs per unit. Therefore, companies seek to increase their production by purchasing resources in bulk, using automated production lines, division of labour, etc. The method also requires investment in production facilities, distribution networks, technology, etc. Companies increase the production of only one product following economies of scale.
Economies of scope is a cost reduction method, where companies reduce their average cost by producing different products using the same resources. It is a product diversification method. Companies seek to share their resources for producing different goods and services. Many products share base components; hence companies can use the same components to produce a variety of products, instead of ordering different components for each. The method requires investment in research and development, marketing, etc. Companies increase the production of a variety of goods and services in economies of scope.
Difference Between Economies of Scale and Economies of Scope in Tabular Form
|Parameters of Comparison
|Economies of Scale
|Economies of Scope
|Method of reducing cost by increasing production
|Using the same operations to produce different products
|The method helps to reduce the average cost of producing one product
|The method helps to reduce the average cost of production of multiple products
|By increasing the volume of production and expanding the size of operations companies benefit from the cost reductions
|By increasing the variety of products and services produced and using shared resources, companies achieve economies of scope
|Range of products
|Does not produce a variety of products, instead it aims at producing large quantities of a single product
|Aims at producing multiple products
|Requires investment in production facilities, distribution networks, technology, etc.
|May require investment in research and development, marketing, etc.
|Provides a competitive advantage by helping companies lower their product prices
|Provides a competitive advantage by helping companies offer a variety of products and services
|The method involves product standardization
|The method involves product diversification
|Uses large amounts of resources
|Use common resources
|Bulk purchasing, automated production lines, division of labour, etc
|A company uses the same resources to produce refrigerators and washing machines, companies producing mobiles and laptops, etc.
What is Economies of Scale?
Economies of scale are a cost-saving method. It focuses on making production more efficient to reduce the overall cost. Companies use methods to make their production more efficient and increase production output. The logic behind this method is that there is a negative relationship between an increase in the volume of production and fixed costs per unit. Fixed cost is the cost companies will incur no matter the amount of production. Whether a company produces a hundred products or five hundred products, they will still have to pay the same fixed cost. Hence, it is wise to produce more products to reduce the per-unit cost of production.
Companies can employ the strategy of economies of scale by purchasing items in bulk, using automated production lines, using division of labour, etc.
An example of how economies of scale work-
A company XYZ wants to make a purchase order for electronic chips. The seller asks for a price of 1000 rupees for 100 chips and 3000 rupees for 500 chips. If the company were to purchase only 100 chips, the per unit cost will be 10 rupees. However, if they purchase 500 chips, the per unit cost will be 6 rupees. Hence, buying in bulk is an efficient method to reduce costs.
Increased production with less cost helps businesses gain a competitive advantage in their industry. When there are more products, companies can reduce the price of the goods and services. By reducing the price, companies gain more customers.
Features of Economies of Scale
Following economies of scale, businesses can reduce their overall cost. The fixed cost of companies remains the same irrespective of the number of production outcomes. Companies distribute their fixed cost evenly over larger production output. In this manner, when they produce additional outputs, the cost of production goes down.
To increase production businesses will have to use specialised pieces of equipment, buy resources in bulk, and use efficient methods of production. All these steps help to increase production efficiency and reduce costs.
When businesses reduce their costs using economies of scale, they gain a competitive advantage. Lowering costs for companies means they can lower the price of their products. Lower product prices lead to more customers.
Causes Of Economies Of Scale
Companies can achieve economies of scale in two ways, internal economies of scale and external economies of scale.
Internal Economies Of Scale
When companies reduce their overall cost by making changes in their internal function, it is internal economies of scale. Different companies have different ways of executing their cost-cutting procedures. Therefore, each company's internal economies of scale are unique to its own.
Internal economies of scale have different types. They are as follows,
- Technical: The method involves making changes in the technical procedures. Companies can cut costs by using large-scale machines to increase their production output.
- Purchasing: companies can cut costs by purchasing resources in bulk.
- Managerial: Companies can make changes on the managerial level to increase efficiency. They can hire specialists with experience in improving the production process.
- Risk Bearing: using different investors to reduce the effect of risk.
- Financial: cutting costs helps increase the creditworthiness of the company. If a company has good creditworthiness, it helps them receive loans with ease. This benefit helps companies to have access to necessary capital.
External Economies Of Scale
When companies experience a reduction in overall costs and increase efficiency because of changes external to the company, it is external economies of scale. Such factors can affect the production of an entire industry. A single company does not control its cost reductions. External economies of scale occur because of factors like a highly skilled labour pool, tax reductions, joint ventures, etc.
What is Economies of Scope?
When companies reduce their average cost by using the same operations to produce a variety of goods, it is economies of scope. Using the same resources to produce multiple products, decrease the overall cost of production for the company. Here the production of one good helps decrease the production costs of another product. According to this method, the cost of producing two products is less than the cost of producing the items one by one.
If a company were to use unique items to create each of its products, it will increase their expenses. They will have to purchase different items for each product and the pieces of equipment needed for them, which is an expensive approach. Hence, it is better to use the same resources whenever possible.
Many products use the same equipment for their production, or the same resources to create the final product. Following economies of scope, a company decides to use the resource for the production of one product for producing others. For example, restaurants can create many different dishes using the same food items; Electronics Companies can create many devices using the same parts.
Features Of Economies Of Scope
Instead of purchasing and using different resources for different products, businesses can reduce costs by sharing the resources. If the same facilities and distribution networks can work for producing more than one type of product, it is better to share the resources. For example, companies can produce refrigerators and washing machines by sharing some resources. These two pieces of equipment contain certain parts, which are similar and hence can work for both.
Using a combination of resources produces synergy; that is, a combined effect is greater than the sum of individual effects. In economies of scope, the cost of producing different products is lower than the cost of producing them individually.
Economies of scope focus on producing a variety of products. Hence, they open up new markets for the company. Companies can gain a broader range of customers.
Causes of Economies of Scope
Economies of scope involve producing a variety of products. Companies can produce a variety of products by the following methods,
When the production of one good automatically leads to the generation of another good, like a by-product, it is a co-product or complement. If companies can find a market for these co-products or use them in the production of another good, they can save resources and decrease costs.
For example, dairy farmers make whey, and curd from milk. Here, whey and curd are a by-product of the main product, milk. When the curd is the main product, farmers can create cheese as the by-product.
Complementary Production Process
When the production processes of two or more goods or services interact, it is a complementary production process. Here, producing two goods together instead of separately helps reduce the average cost.
An example is internship programs. Colleges often outsource internships to other institutions or companies. Colleges benefit from not having to provide internships at their expense and companies benefit by getting free labour. Hence, colleges produce their outcome, a college degree at a reduced cost and external institutions produce their goods with less cost.
Productive resources like land, capital, and labour have more than one purpose and they serve the production of more than one product.
An example is a technology firm producing phones, laptops, and tablets together using the same resources. This method is more cost-effective than one company producing phones, another producing laptops, and yet another producing tablets.
Main Differences Between Economies of Scale and Economies of Scope (in Points)
- Economies of scale is a method of cost reduction, in which companies reduce their average cost by increasing production efficiency. Economies of scope is a method through which companies reduce their average cost by using the same operations and resources to produce a variety of products.
- Concerning products, economies of scale simply increase the production of the same product. Economies of scope increase the production of different products.
- Economies of scale are the better method for companies that have a high fixed cost. Economies of scope are better suited for companies that produce similar products.
- Economies of scale help companies increase their production, which lets them lower their prices and gain more customers. Economies of scope help companies gain more consumers by offering a wide variety of products.
- Economies of scale focus on product standardisation while economies of scope focus on product diversification.
- There are two ways to achieve economies of scale; they are internal economies of scale and external economies of scale. Methods to achieve economies of scope include co-products, complementary production processes, and shared inputs.
- Companies can employ the strategy of economies of scale by purchasing items in bulk, using automated production lines, using division of labour, etc. Companies can achieve economies of scope by sharing their resources and personnel.
To sum up, economies of scale and economies of scope are two strategies to reduce the average costs for a business. Economies of scale involve producing more of the same product to reduce costs. Economies of scope involve using the same resources to produce a variety of products. Economies of scale are better suited when the production of a particular good or service has a high fixed cost. Economies of scope are the better option when production or consumption is complimentary.