Economies of Scale and Scope

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ECONOMIES OF SCALE AND SCOPE

Economies of scale and scope

Economies of scale

Economies of scale are factors that cause the average cost of producing something to fall as the volume of its output increases. Hence it might cost $3,000 to produce 100 copies of a magazine but only $4,000 to produce 1,000 copies. The average cost in this case has fallen from $30 to $4 a copy because the main elements of cost in producing a magazine (editorial and design) are unrelated to the number of magazines produced.

Economies of scale were the main drivers of corporate gigantism in the 20th century. They were fundamental to Henry Ford’s revolutionary assembly line (see Mass production, page 127), and they continue to be the spur to many mergers and acquisitions today.

There are two types of economies of scale:

� Internal. These are cost savings that accrue to a fi rm regardless of the industry, market or environment in which it operates.

� External. These are economies that benefi t a fi rm because of the way in which its industry is organised.

Internal economies of scale arise in a number of areas. For example, it is easier for large fi rms to carry the overheads of sophisticated research and development (r&d). In the pharmaceuticals industry r&d is crucial. Yet the cost of discovering the next blockbuster drug is enormous and increasing. Several of the mergers between pharmaceuticals companies in recent years have been driven by the companies’ desire to spread their r&d expenditure across a greater volume of sales.

Economies of scale, however, have a dark side, called diseconomies of scale. The larger an organisation becomes in order to reap economies of scale, the more complex it has to be to manage and run such scale. This complexity incurs a cost, and eventually this cost may come to outweigh the savings gained from greater scale. In other words, economies of scale cannot be gleaned for ever.

Frederick Herzberg, a distinguished professor of management, suggested a reason why companies should not aim blindly for economies of scale:

Numbers numb our feelings for what is being counted and lead

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ECONOMIES OF SCALE AND SCOPE

to adoration of the economies of scale. Passion is in feeling the quality of experience, not in trying to measure it.

T. Boone Pickens, a geologist turned oil magnate turned corporate raider, wrote about diseconomies of scale in his 1987 autobiography:

It’s unusual to fi nd a large corporation that’s effi cient. I know about economies of scale and all the other advantages that are supposed to come with size. But when you get an inside look, it’s easy to see how ineffi cient big business really is. Most corporate bureaucracies have more people than they have work.

Economies of scope

First cousins to economies of scale are economies of scope, factors that make it cheaper to produce a range of products together than to produce each one of them on its own. Such economies can come from businesses sharing centralised functions, such as fi nance or marketing. Or they can come from interrelationships elsewhere in the business process, such as cross-selling (see page 51) one product alongside another, or using the outputs of one business as the inputs of another.

Just as the theory of economies of scale has been the underpinning for all sorts of corporate behaviour, from mass production to mergers and acquisitions, so the idea of economies of scope has been the underpin- ning for other sorts of corporate behaviour, particularly diversifi cation (see page 65).

The desire to garner economies of scope was the driving force behind the vast international conglomerates built up in the 1970s and 1980s, including btr and Hanson in the UK and itt in the United States. The logic behind these amalgamations lay mostly in the scope for the companies to leverage their fi nancial skills across a diversifi ed range of industries.

A number of conglomerates put together in the 1990s relied on cross- selling, thus reaping economies of scope by using the same people and systems to market many different products. The combination of Travelers Group and Citicorp in 1998, for instance, was based on the logic of selling the fi nancial products of the one by using the sales teams of the other.