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Economies of Scope

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

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Economies of Scope

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

  2. 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.

  3. Economies of Scope • Exist if the firm achieves savings as it adds the production of a good or service • EXAMPLE:

  4. 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

  5. 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?

  6. Does it make sense to diversify?

  7. 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

  8. 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)

  9. 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

  10. Diversification • Horizontal boundry by • Variety of products • Variety of market formats • Market area (Pizza Hut goes Chinese; WalMart urban centers)

  11. 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

  12. 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?

  13. 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.

  14. 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.

  15. 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”

  16. BCG’s Growth/Share Matrix Source: http://www.valuebasedmanagement.net/methods_bcgmatrix.html

  17. 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

  18. 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.

  19. 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

  20. 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

  21. 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

  22. 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?

  23. 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

  24. 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

  25. 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.

  26. 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

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