Economies of Scope Exists if the firm achieves cost savings as it increases the variety of goods or services produced.

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)

Cost

$1,000,000

Firm 2 (producing 1000 units of product B only)

$2,000,000

Firm 3 (producing 1000 A and 1000 B together)

$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 assetsEconomies from distribution, promotion,

technology, management

Management Implications

Do we diversify? Focus?How? What products?Does diversification “dilute” our

advantages and/or profit?Diversification by direct expansion or

acquisitionCan we “manage” diverse products or

markets?

Does it make sense to diversify?

Hillenmeyer Nursery HM Architecture & Design

Ale-8-One soft drink Ale-8-One salsa

Purity Foods bulk organic

Packaged foods

ADM Chocolate

cattle grain

NFE CF eggs CF baked ingredients

Diversification

Walmart Super CentersClub Store formatNeighborhood Store formatWalMart Express?

JM SmuckersJif peanut butter

YUM! BrandsPizza 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 productsOften cited by management to justify

investment in growth (merger and acquisition)

Scope Economies Can Drive Mergers and AcquisitionsMonsanto and Dekalb Seed 1998Supermarket retailer consolidationDiamond Foods/Diamond Walnut Growers Coop

2005See recent mergers and acquisitions in the

processed dairy products sectorFood Industry News on The Food Institute

www.foodinstitute.comAEC 422 Fall only access

Login: timwoodsPassword: tracylw

Diversification

Horizontal boundary byVariety of productsVariety of market formatsMarket area (Pizza Hut goes Chinese; WalMart

urban centers)

Diversification as Risk Management

Input driven-limited sourcesSeasonalityGeographic marketsCompetitive responseOutputs (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.

Second, is Boston Consulting Group (BCG) Growth Share Matrix.

BCG Model

Developed in 1970’sConsidered 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 CowsDogsProblem 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

Strategic role of products?Connection between market share and cost

savings is cloudy

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.

Flaws in BCG Growth Share Matrix

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 Diamond Foods case on this.