Diseconomies of Scale

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Definition of Diseconomies of Scale:

Diseconomies of scale exist when increasing output results in an increase in the average cost to produce a good or service. 

Detailed Explanation:

There are limits to how much a large a company can grow and take advantage of its economies of scale. Initially increasing output and sales improve profit margins because economies of scale result in a drop in the average cost to produce a good or service. But eventually, the cost to produce each unit will begin to increase. At this point the company has diseconomies of scale.

For example, assume a landscaping company decides to expand rapidly. It invests in state of the art mowers, chain saws, and excavating equipment. Initially much of the equipment is only used a few days each week because the company lacks the workers and jobs to operate all the equipment every day. Eventually it hires more workers and secures additional work on jobs where the equipment is used more frequently. Increasing the equipment usage has increased productivity and decreased the average cost per job. The company is experiencing economies of scale. Profits continue to increase, and management continues to hire more workers until a point is reached when some of the workers may sit idly while the others complete their chore. The new workers require more training. Absenteeism becomes a larger problem. The company’s average cost per lawn begins to increase. It has reached the point of diseconomies of scale.

The graph below illustrates economies and diseconomies of scale. Up to output Q, there are economies of scale because the company’s average total cost is falling. Diseconomies of scale exist when output exceeds Q. 



Diseconomies of scale are caused by inefficiencies resulting from too much growth. Examples of challenges that could result in diseconomies of scale include:

  • Difficulty in coordination – In our example it may be difficult to coordinate all the workers at a job site to complete a job at the same time, so once a chore is completed a worker may spend time waiting for others to complete their tasks. Larger companies may have difficulty coordinating their supply chain if hundreds of suppliers are involved.  

  • Control – Monitoring the work of thousands of employees and several plants becomes more challenging as output increases. 

  • Bureaucracy – Decisions may have to sift through more layers as a company grows, resulting in more managerial time being used to reach a decision.
     
  • Communication – Language and cultural barriers can add difficulties in communicating with employees. There is a greater possibility that managers may receive the wrong or conflicting messages in larger companies. 

  • Employee morale – Getting all employees to “buy into” a policy or idea is an added challenge in large companies. Employees may feel unappreciated if they are one of thousands. Absenteeism may become a larger problem if workers believe they would not be missed if they sat out a day. 
An external diseconomy of scale occurs if something outside the business causes an increase in the total average production cost as output is increased. An example is when growth stretches an area’s infrastructure beyond its capacity. An overcrowded port can result in costly delays in receiving supplies or transporting goods.
 

Many larger companies have addressed diseconomies of scale by creating a more entrepreneurial environment where ideas are rewarded. Importance and appreciation can be enhanced when human resource departments conduct team building exercises or smaller production teams are used.

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