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 assets Economies 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 acquisition Can 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 Centers JM Smuckers YUM! Brands 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 boundary 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. 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 Strategic role of products? 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 Diamond Foods case on this.