Economies of Scope  Exists if the firm achieves cost savings as

Economies of Scope
Exists if the firm achieves cost savings as
it increases the variety of goods or
services produced.
Economies of Scope
Economies of scale defined in terms of
declining AC functions – for a specific
product. $/homogenous unit
Economies of scope defined in terms of
the relative total cost of producing a
variety of goods and services together in
one firm versus separately in two or more
firms.
Economies of Scope
 Exist if the firm achieves savings as it adds the
production of a good or service
 EXAMPLE:
Firm 1 (producing 1000
units of product A only)
Firm 2 (producing 1000
units of product B only)
Firm 3 (producing 1000
A and 1000 B together)
Cost
$1,000,000
$2,000,000
$2,500,000
Economies of Scope
The basic idea is that a firm has
economies of scope if it is cheaper for a
single firm to produce both goods than for
one firm to produce good A and another
firm to produce good B
Where do these economies come from?
Sharing fixed assets
Economies from distribution, promotion,
technology, management
Management Implications
Do we diversify?
How? What products?
Does diversification “dilute” our
advantages and/or profit?
Diversification by direct expansion or
acquisition
Can we “manage” diverse products or
markets?
Does it make sense to diversify?
Hillenmeyer Nursery
Ale-8-One soft drink
HM Architecture &
Design
Ale-8-One salsa
Purity Foods bulk
organic
Toyota petrol cars
Packaged foods
cattle
grain
soybeans
Organic soybeans
Hybrid cars
Diversification
Walmart Super Centers
Club Store format
Neighborhood Store format
WalMart Express?
JM Smuckers
Jif peanut butter
YUM! Brands
Pizza Hut, KFC, Taco Bell, Long John Silvers, A&W
Economies of Scope
Common expressions that describe
strategies that exploit the economies of
scope
“Leveraging core competences”
“Competing on capabilities”
“Mobilizing invisible assets”
Diversification into related products
Often cited by management to justify
investment in growth (merger and acquisition)
Scope Economies Can Drive Mergers
and Acquisitions
 Monsanto and Dekalb Seed 1998
 Supermarket retailer consolidation
 Diamond Foods/Diamond Walnut Growers Coop
2005
 See recent mergers and acquisitions in the
processed dairy products sector
Food Industry News on The Food Institute
 www.foodinstitute.com
AEC 422 Fall only access
 Login: timwoods
 Password: tracylw
Diversification
Horizontal boundry by
Variety of products
Variety of market formats
Market area (Pizza Hut goes Chinese; WalMart
urban centers)
Diversification as Risk Management
Input driven-limited sources
Seasonality
Geographic markets
Competitive response
Outputs (vegetables, grape varieties,
cattle/grain)
Diversified portfolio lowers our “risk”
exposure for key aspects of the business
Diversification
 Diversification strategy implied as necessary
when there are scope economies
 Note that firms may expand their horizontal
boundaries to capture economies of scale and
scope in production, marketing and distribution.
 Question is, “How do you decide in which
markets you want to operate or which firms with
whom you wish to horizontally merge?
Diversification
We have two tools to help answer these
questions.
First is Economic Value Added (EVA) which is
used to address acquisition/divesture issues. (to
be covered in a later lecture)
Second, is Boston Consulting Group (BCG)
Growth Share Matrix.
BCG Model
Developed in 1970’s
Considered to be a “portfolio technique” in
that it helps companies visualize their
portfolio (or combination) of product lines
or brands.
BCG’s Growth/Share Paradigm
Product life cycle model combined with an
internal capital market, with the firm
serving as a banker
Use the cash generated by “cash cows” to
exploit the learning economies of “rising
stars” and dealing with “problem children”
BCG’s Growth/Share Matrix
Source: http://www.valuebasedmanagement.net/methods_bcgmatrix.html
BCG Growth Share Matrix
Vertical axis is Product Life Cycle
Remember Product Life cycle suggests
that products go through four distinct
stages with respect to sales over time:
“Introduction” with low sales and growth
“Growth” with rapid sales increases
“Maturity” with sales leveling off and industry
maturing
“Decline” with demand declining as superior
technology and products are introduced
BCG Growth Share Matrix
Horizontal axis represents relative market
share.
Or better - It is the ratio of the firm’s
market share to the market share held by
the largest rival firm in the industry.
ConAgra Foods, Inc.
BCG Growth Share Matrix
Product Lines can then be classified into
one of the four categories noted in the
matrix:
Cash Cows
Dogs
Problem Child or “?”
Rising Star
BCG Growth Share Matrix
 Cash Cows: High relative market share but in a
low growth rate of industry demand.
 Competitive strength comes from experience,
cost leadership, entry barriers, differentiated
products, etc.
 Recommended that the firm “milks” the cash
cow for working capital to help other product
lines.
 Action: sustain these as long as possible
BCG Growth Matrix
 Dogs: Low relative market share and low rate of
industry growth.
 This is a weak and unattractive competitive
position due to poor management or a poor
market opportunity (or both).
 Dogs are net users of scare capital resources.
 Action: Divest
BCG Growth Share Matrix
 Problem Child: Characterized by low relative
market share but in a high growth rate industry
demand situation.
 Puzzling situation in that the product line might
evolve into a “rising star” or it may devolve into a
“cat/dog.”
 Weak competitive position.
 Action: further analysis is required whether to
divest or invest?
BCG Growth Share Matrix
 Rising Stars: High relative market share in a
high growth rate of industry demand.
 Obviously a good situation to be in—high share
of the market and the market is high performing
(demand growth rate is high).
 Action: Sustain this competitive advantage
Flaws in BCG Growth Share Matrix
 Model is simplistic with two dimensions.
Probably would want to combine this portfolio
approach with EVA, profitability, liquidity and
other market based performance measures to
evaluate diversification
 Connection between market share and cost
savings is cloudy
Flaws in BCG Growth Share Matrix
Cash cow position may not necessarily
result in surplus working capital
It ignores sources of value creation. Next
section on vertical boundaries we’ll
consider value chain analysis to help
identify sources of value creation.
One Final Comment
The further a firm gets from it’s core
competencies, the more risk it takes on.
Diversification has benefits, but it can
result in “mission creep.”
See Examples 5.3 and 5.4 (Pepsi and
Philip Morris) in the textbook for examples
of diversification strategies that didn’t work
as planned