5.1.2 - Diseconomies of scale and growth limits

Rising average cost

A business experiences diseconomies of scale when expansion creates disadvantages that raise its average total cost.

To judge costs, compare total cost with output for the same period. Average total cost is total costs divided by output. A rise in total costs alone does not show diseconomies: an expanding business can spend more overall while producing each item more cheaply.

In an illustrative Mexican furniture business, a factory makes 1,000 chairs per month at total costs of US$50,000. Its average total cost is US$50,000 ÷ 1,000 = US$50 per chair. After expanding into several factories, it makes 1,500 chairs per month at total costs of US$84,000. Its average total cost is US$84,000 ÷ 1,500 = US$56 per chair. The increase is US$6 per chair. Total costs grew faster than output, so the cost of each chair rose.

The figures establish a rise in average cost; the cause needs investigation. If managers duplicate orders or factories wait for delayed instructions because the larger organisation is difficult to coordinate, that is evidence of diseconomies of scale. If timber prices rise for every producer regardless of size, the business's higher costs cannot simply be blamed on its growth.

Economies and diseconomies can occur together. Bulk-buying savings may continue while management problems grow. Average cost falls when the savings outweigh the additional costs, then may rise when organisational disadvantages become greater. There is no single output level at which every business reaches this limit.

Communication and control

Information can travel more slowly or become less accurate when a growing business adds people, locations and management layers.

Communication diseconomies arise when messages become difficult to transmit effectively. A decision may pass through several managers, increasing delay or distortion. In an illustrative international parcel business, a customer's changed delivery instruction must pass through head office, a regional manager and a depot supervisor. If the change arrives too late, the driver makes an unnecessary journey. Extra fuel and labour time increase the cost of each successful delivery.

Growth can also weaken control. Senior managers may know less about distant branches and find it harder to monitor inventory, service or spending. In an illustrative café chain, two branches may order excessive ingredients because each uses a different stock record. Spoiled ingredients raise waste and cost per meal. Control problems describe the difficulty of ensuring that decisions and standards are followed; they are related to communication but are not identical to it.

Possible responses include clearer reporting responsibilities, reliable shared information systems and shorter decision routes. Delegating decisions to local managers may reduce delays because they know local circumstances. However, those managers need training and agreed limits, or different branches may make inconsistent decisions. An information system can make stock visible, but inaccurate entries still produce inaccurate decisions.

A useful explanation follows the business consequence: a longer message route causes late instructions; late instructions cause repeat work; repeat work uses extra resources per completed order. A claim that a large business has “bad communication” needs this mechanism to explain why average costs rise.

Coordination and motivation

Larger operations need people and departments to work together, and expansion can weaken that cooperation.