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