On Economies of Scope

Why do companies create multiple products and services? How can consulting practices grow by developing new offerings while reducing risk? What are the limits or disadvantages of creating new consulting services?

I believe all of those questions can be better answered by understanding one key economic idea: Economies of scope. Let's start with the definition.

Economies of scope exist where an organization reduces the cost per unit sold by producing a bigger variety of products or services.

This idea was first explored by John Panzar and Robert Willig in a 1977 article entitled “Economies of Scale in Multi-Output Production”. When people hear about it, they often think about the much more popular idea of "economies of scale". They're related, but not the same.

Economies of scale are characterized by volume. The bigger your output (units produced or clients you sell to), the more you reduce your marginal cost. It's a key advantage for large companies such as Walmart, Amazon, Boeing, Toyota, Intel, and so on.

Economies of scope, on the other hand, are characterized by variety. Producing several different offerings is more cost-effective to a firm than producing fewer products and services. Or producing each one of them separately.

To benefit from economies of scope, you don't need scale. That's why it is a much more useful concept for boutique consulting firms that might not have access to, or the ability to serve, a large number of clients.

To keep this email brief, I want to quickly focus on answering three questions:

• What are the sources of economies of scope?
• What are their benefits?
• What are their limits?

Sources of Economies of Scope

Economies of scope can occur because the products or services are co-produced, they share the same processes, or they share the same resources:

1. Offerings Are Co-Produced: This happens when delivering one offering will automatically produce another product or service as a byproduct. Cream is a "side-effect" in the production of skim milk in a diary - to produce skim milk, all you need is to separate it from the cream. And it turns out a lot of people enjoy and are willing to buy cream by itself.
   
   It's easy to spot examples of this in the consulting industry. If you need to diagnose your clients before delivering larger engagements, you can start selling your assessments separately. If you use a framework or documented process to solve a specific problem, you can productize your IP and sell it as an asset.
   
   All of these examples would create an economy of scope since when you productize or package your projects into smaller engagements you also decrease the cost of delivering them.
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2. Offerings Share Business Processes: Economies of scope also come from sharing production processes. For boutique consulting businesses, the most important ones are business development (which includes marketing and sales) and operations or client delivery.
   
   Selling becomes much more effective when you provide prospects with a range of options, rather than one unique solution. And a variety of offerings allows you to cut down client acquisition costs - instead of looking for new clients, you can retain your current ones by continually serving them in different ways.
   
   From a delivery perspective, it's easy to see how delivering a sequence of services for the same client can increase results or improve client experience. But it also creates economies of scope since you and your team will likely need to invest less time to diagnose, earn trust, and deliver on your marketing promises.
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3. Offerings Share Business Resources: Since business inputs (people and assets) usually have more than one use, economies of scope can often come from common inputs to the production of two or more different offerings.
   
   People are a natural example in consulting. You can reduce costs by allocating your time and/or your staff's time to deliver more than one service, instead of hiring different people for different projects. That's why large firms obsess with maximizing their consultants' utilization rates - time is money.
   
   Sharing assets and overhead costs are also a source of economies of scope for boutique consultancies. If you own specialized software or equipment that adds to fixed costs, developing more services where you can put them into use will decrease your marginal costs. Your cost structure matters.

You might be thinking: "Got it, but why should I worry about decreasing my marginal costs when I take in just a dozen clients every year?"

Benefits From Economies Of Scope

This question can actually spark interesting discussions with consultancy partners, but let’s try to keep it short here. The concrete and direct benefits of economies of scope for boutique consultancies are two:

• Improving financial performance: As a firm increases the number of its offering (either by packaging co-produced products and services, or identifying new ones that share common processes or resources), the average cost of promoting and delivering each offering decreases. And this leads to a higher profit margin on each new engagement sold.
• Improving financial security: A stronger financial performance, when well-managed, naturally leads to stronger financial security. But there's also a direct effect here. By marketing and delivering a variety of offerings, a firm diversifies its sources of revenue. And this reduces the risk associated with product/service failure.

If a service becomes outdated or less effective to generate results for clients, you can continue to promote other offerings while you work on making changes. You gain the ability to quickly identify any shifts in market demand. And with several services, a rejection of a new offering never puts your business at risk.

But too much medicine will overdose the patient. Keep increasing the number of offerings in your consultancy forever, and the benefits disappear. After a threshold, the more services you add, the more your marginal costs go up.

Diseconomies of Scope

The average cost falls until a certain point. A consultancy that offers too many products and services might begin to see an increase in the average cost of each offering. This is what John Panzar and Robert Willig called “diseconomies of scope”.

But why is that true? How does creating a service list longer than a Thai restaurant menu hurt boutique consultancies?

There are three main factors diseconomies of scope include:

1. Diluted competitive focus: If you do everything, for every kind of client, whenever they want... it's impossible to differentiate yourself in the market. And if your prospects and clients can't tell you apart from other consultancies, the only way to compete is by price. This is not a wise or feasible strategy for 99.99% of boutique consultancies.
2. Lack of management expertise: You may be willing to dilute your focus and promote 10 different services. Clients may be open to giving some of those a try. But do you actually have the expertise to deliver all of those? Bringing new offerings to market only to under-deliver your promises will cost your business a lot of trust and reputation.
3. Bottlenecks, shortages, and increased overhead costs: Creating a marketing strategy for a couple of service offerings is straightforward, for 10 different offerings it becomes a full-time job. Finding a contractor to help you with a few standardized engagements is doable, hiring a dozen different consultants for different skills and project sizes becomes a nightmare.

Having only one service offering sabotages your growth. Too many will hurt your margins and add unneeded complexity to your consulting business. The challenge is to reach the right balance.

How much is enough? Check the “One Question” section.

“Economies of scale and scope (...) are both types of learning.

Economies of scale are the advantages that can result when repeatable processes are used to deliver large volumes of identical products or service instances. Scaling relies on interchangeable parts either in the product itself, or in the delivery mechanisms, in the case of intangible services.

Economies of scope are the advantages that can result when similar processes are used to deliver a set of distinct products or services.

As a first approximation, you could say that economies of scale result from learning the engineering, while economies of scope result from learning the marketing. The first is primarily a one-front war between a business and nature. The second is primarily a two-front war where a business fights nature on one front, and market incumbents on another.”

Source: Venkatesh Rao, “Economies of Scale, Economies of Scope”

SPI’s latest research shows that new services were responsible for 25 to 30% of revenue among professional services firms. This includes projects sold to both existing and new clients.

Source: SPI, 2023 Professional Services Maturity Benchmark

When was the last time you reflected on how to package your expertise in multiple ways to help clients solve new problems and/or make them comfortable with the exchange of value?

I sometimes get asked by partners: “Do you have any data on what the ideal number of offerings for a boutique like mine (8 people, close to $1 mi/year rev) is? What's the sweet spot?”

My answer is always the same: No, I don't have data. And, as Venkatesh’s quote clarified, there's no sweet spot.

When I'm helping boutique consultancies rethink their offering mix, these are some questions that typically come up:

• What is the right level of diversification for our services?
• Which new market segment can we serve with the services we already have?
• What is the right way to bundle and price-related services?
• How much implementation support should we offer? Are there any clients who would actually pay for our consultancy to do everything for them?
• Which new offerings should we develop? Which services or IP should we acquire from or deliver through external collaborators?

These decisions can create economies of scope for your consulting business. They may reduce the average unit cost of serving a client and increase your margins. But they are, essentially, marketing questions.

This is why there's not a single solution to the question "how many offerings should you promote?" It's not an engineering problem, like the ones you have when scaling production inside a factory. The market changes, your clients' needs and preferences change, and you do your best to adapt.

As Venkatesh puts it, improving your offering mix is a learning problem. The more you learn, the better your services will be accepted in the market. If you haven’t asked yourself this question recently, invest some time into exploring it - feel free to drop me a line if you need help in the process.