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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 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