Diseconomies of scope

What Is Diseconomies of Scope?

Diseconomies of scope refer to the economic inefficiencies that arise when producing a wider variety of goods or services actually increases the average total cost of production, rather than decreasing it. This concept falls under production economics and business strategy, highlighting a point where organizational complexity or unrelated diversification outweighs the benefits of shared resources. Instead of generating positive synergy, the firm experiences higher expenses and reduced productivity as it expands its range of activities.

This phenomenon occurs when managing multiple product lines or services becomes overly complex, leading to increased fixed costs and variable costs per unit across the different operations. It can manifest through coordination problems, diluted management focus, and a lack of specialization, ultimately hindering operational efficiency.

History and Origin

While the explicit term "diseconomies of scope" gained prominence with the evolution of modern economic and business management theories, the underlying concept of diminishing returns from excessive diversification or organizational sprawl has been observed for decades. The benefits of producing multiple goods together, known as economies of scope, were initially celebrated, particularly in the era of large industrial conglomerates. However, as these large, multi-faceted companies grew, the challenges of managing disparate businesses often led to inefficiencies.

The reversal of the conglomerate trend in recent decades serves as a practical illustration of diseconomies of scope. Many large corporations, after decades of expanding into diverse sectors, have chosen to divest non-core assets or break up entirely to streamline operations and enhance focus. For instance, General Electric (GE), once a sprawling industrial giant, underwent a multi-year transformation culminating in its breakup into three separate public companies focused on aviation, energy, and healthcare. This strategic move was designed to unlock greater value by allowing each unit to pursue its specialized goals without the complexities and inefficiencies associated with the broad scope of the original organizational structure.⁴,

Key Takeaways

• Diseconomies of scope occur when expanding the variety of products or services leads to increased average costs.
• They often arise from managerial inefficiencies, increased coordination costs, and a lack of focus.
• Symptoms include diluted management attention, conflicting corporate cultures, and difficulty achieving cost management.
• Companies facing diseconomies of scope may benefit from divestiture, spin-offs, or streamlining their product portfolios.
• This concept highlights the importance of aligning a company's scope with its core competencies and strategic focus.

Formula and Calculation

Unlike economies of scale, which can often be quantified through cost per unit as production volume increases, diseconomies of scope do not have a single, universal formula. They are typically observed when the joint production of two or more goods or services becomes more expensive than producing them separately.

The presence of diseconomies of scope can be inferred if:

Where:

• ( C(Q_1, Q_2) ) = The total cost of jointly producing quantities ( Q_1 ) of good 1 and ( Q_2 ) of good 2.
• ( C(Q_1, 0) ) = The total cost of producing quantity ( Q_1 ) of good 1 alone.
• ( C(0, Q_2) ) = The total cost of producing quantity ( Q_2 ) of good 2 alone.

If the cost of combined production exceeds the sum of producing each product individually, it indicates the presence of diseconomies of scope. This analysis relies on detailed cost accounting and the ability to accurately allocate expenses to specific product lines.

Interpreting the Diseconomies of Scope

Interpreting diseconomies of scope involves recognizing the financial and operational signals that suggest a company has overextended its reach. This might include a noticeable increase in administrative overhead, a decline in profit margins across diverse business units, or a struggle to innovate effectively across multiple product categories. For instance, if a technology company known for its software development diversifies into hardware manufacturing, and the associated management, supply chain, and production challenges lead to higher per-unit costs and delays compared to specialized hardware firms, it indicates diseconomies of scope.

Companies and analysts can identify this issue by carefully examining return on investment for different business segments and comparing their performance to more focused competitors. A decline in overall competitive advantage or a consistent underperformance of a broadly diversified firm relative to specialized rivals can also signal the presence of diseconomies of scope.

Hypothetical Example

Consider "AlphaTech," a successful software development company specializing in enterprise resource planning (ERP) solutions. AlphaTech decides to enter the highly competitive consumer electronics market, launching a new line of smart home devices.

Initially, AlphaTech hopes to leverage its brand recognition and existing sales channels. However, the move quickly reveals diseconomies of scope:

1. Increased Overhead: AlphaTech needs to hire completely new teams for hardware design, manufacturing, and consumer product marketing, significantly increasing its fixed costs.
2. Managerial Distraction: The CEO and senior management, previously focused solely on software, now spend considerable time addressing manufacturing issues, supply chain disruptions, and intense competition in consumer electronics. This dilutes their focus on the core ERP business.
3. Conflicting Cultures: The agile, iterative culture of software development clashes with the precise, large-scale production requirements of hardware, leading to internal conflicts and reduced productivity.
4. Higher Unit Costs: Due to a lack of experience and established supplier relationships in hardware, AlphaTech's cost per unit for its smart home devices is higher than that of established electronics manufacturers, leading to uncompetitive pricing or thin margins.

In this scenario, AlphaTech's expansion into a new, unrelated scope of business has not yielded anticipated synergies but instead led to rising average costs and organizational strain, illustrating diseconomies of scope. The company's profitability suffers as a direct result of this over-diversification.

Practical Applications

Diseconomies of scope play a critical role in strategic planning and corporate finance, influencing decisions related to corporate structure, product portfolio management, and mergers and acquisitions.

• Corporate Restructuring: Recognition of diseconomies of scope often prompts companies to undergo significant restructuring, including divestitures, spin-offs, or breakups. The recent trend of de-conglomeration, as exemplified by the breakup of General Electric, highlights how companies seek to shed non-core assets to improve focus and efficiency, countering the negative effects of overly broad operations.³
• Investment Analysis: Investors and analysts consider diseconomies of scope when evaluating the long-term viability and profitability of highly diversified companies. A firm experiencing these inefficiencies may trade at a "conglomerate discount," where its total market capitalization is less than the sum of its individual business units if they were valued separately.
• Merger and Acquisition Strategy: Understanding diseconomies of scope is crucial in M&A. Acquirers must assess whether combining businesses will truly create value through synergy or introduce new complexities and inefficiencies that lead to diseconomies.
• Resource Allocation: Companies must prudently allocate resources, including capital and managerial attention, to ensure they are supporting areas where they have a genuine competitive advantage. Spreading resources too thinly across disparate business lines can exacerbate diseconomies of scope. The Federal Reserve Bank of St. Louis provides extensive economic data that can be used by analysts to study industry trends and the impact of corporate structures on overall economic efficiency.²

Limitations and Criticisms

While the concept of diseconomies of scope provides a valuable framework for understanding corporate inefficiencies, its application has limitations and faces certain criticisms. One challenge is the difficulty in precisely measuring the costs attributable solely to "scope" rather than other factors like poor management, market shifts, or general organizational inefficiencies. Isolating the impact of scope alone can be complex, as many variables affect a company's overall cost structure.

Furthermore, defining what constitutes "related" versus "unrelated" diversification can be subjective. What appears to be unrelated on the surface might have hidden synergies or strategic benefits that are not immediately apparent in cost accounting. Critics might argue that some apparent diseconomies of scope are merely temporary growing pains or reflect a failure in strategic planning and execution rather than an inherent flaw in the diversified model itself.

Moreover, a company's ability to manage complexity varies. What leads to diseconomies of scope for one firm might be successfully managed by another with superior governance or technology. Harvard Business Review highlights that "growth stalls" often stem from management choices about strategy or organizational design, rather than solely external factors, implying that inefficiencies can be mitigated through effective leadership.¹

Diseconomies of Scope vs. Economies of Scale

Diseconomies of scope and economies of scale are distinct but related concepts within cost theory. They both describe how changes in production affect costs, but they focus on different aspects:

While economies of scale relate to producing more of the same thing cheaper, diseconomies of scope arise when producing different things together becomes more expensive than producing them separately. A company can experience economies of scale in one product line while simultaneously suffering from diseconomies of scope due to its overall, overly broad portfolio.

FAQs

What causes diseconomies of scope?

Diseconomies of scope are primarily caused by increased organizational complexity, coordination costs, and diminished managerial focus that arise when a company expands into too many diverse and often unrelated product lines or services. It can also stem from conflicting corporate cultures, inefficient resource allocation, and a lack of specialized expertise across different business segments.

How can a company overcome diseconomies of scope?

To overcome diseconomies of scope, a company might consider strategic divestitures, where non-core business units are sold off. They could also pursue spin-offs to create independent, more focused entities, as seen with large conglomerates. Additionally, streamlining internal processes, improving cost management systems, and re-focusing on core competencies can help mitigate these inefficiencies.

Is diseconomies of scope the opposite of economies of scope?

Yes, diseconomies of scope are the opposite of economies of scope. Economies of scope occur when it is more cost-effective for a single firm to produce two or more products jointly rather than for separate firms to produce them individually. Diseconomies of scope occur when the opposite is true, and joint production actually increases costs.