Recent research from the University of Surrey has unearthed that numerous businesses are labouring under the erroneous belief that diversifying their product lines will inherently result in cost reductions. This prevailing misapprehension may lead to annual financial losses amounting to millions for companies, as the study highlights the fundamental flaws in the traditional approaches used to gauge economies of scope.
The study, published in the Annals of Operations Research, critiques the conventional methods used to assess cost savings through diversification, commonly called “economies of scope.” These traditional techniques typically evaluate the costs associated with producing multiple products in tandem rather than independently, yet they overlook the crucial efficiencies derived from shared resources. The research advocates for a departure from simplistic calculations, which frequently result in overstated and erroneous cost estimates, proposing a more precise methodology for evaluating production costs instead.
The researchers illustrated their point by considering the scenario of companies looking to expand into new markets by manufacturing both smartphones and tablets. They suggested that companies should move past basic assumptions of cost-sharing and consider the complexities involved in managing supply chains, allocating resources, and navigating production bottlenecks. This is crucial to avoid the dissipation of anticipated cost savings into unforeseen expenses, such as inefficiencies and quality issues.
To substantiate their methodology, the researchers simulated two virtual companies specialising in different products, using data from existing diversified enterprises. By comparing the costs associated with these specialised firms to those incurred through joint production, they provided a more transparent view of when diversification genuinely leads to cost savings.
Dr Mehdi Toloo, co-author of the study and Reader in Business Analytics at the University of Surrey commented on the findings, stating, “Many businesses are entrenched in antiquated notions of cost efficiency. Our research challenges these outdated beliefs and offers actionable insights for companies to make more informed decisions about their operations and strategic directions.” He further explained, “We examined the cost implications for companies that produce varying products by assessing whether producing them collectively is more economical than doing so separately. Our innovative approach revealed that while some companies indeed benefit financially from combined production efforts, others may incur higher expenses.”
The study demonstrates that firms relying on obsolete methods might be squandering resources and overlooking opportunities to reduce expenditures. By adopting this revised strategy, businesses can more accurately determine the cost-effectiveness of producing multiple products conjointly, moving away from unquestioningly adhering to archaic practices. Additionally, the research underscores companies’ need to re-evaluate their mergers and multi-product production decisions. It offers explicit recommendations on how businesses can sidestep inefficiencies and enhance profitability amidst the fiercely competitive landscape of today’s market.
More information: Jafar Sadeghi et al, Evaluating economies of scope and potential merger: an alternative approach, Annals of Operations Research. DOI: 10.1007/s10479-024-06418-2
Journal information: Annals of Operations Research Provided by University of Surrey