A company can outgrow itself through expansion. At times, business expansion comes with drawbacks like diseconomies of scale. A company that keeps its production cost in check will avoid overproduction. Such a company avoids the high cost of storing surplus finished goods. It also allows such copay to have enough money to spend on other business functions, which equally affects revenues. The best visual impression of production costs Vis-a-vis output volume is through the diseconomies of scale graph.
Table of Contents
- Diseconomies of Scale Definition
- Diseconomies of Scale Graph Examples
- How Do Diseconomies of Scale Occur?
- Reasons for Diseconomies of Scale
- Positive Effects
- Negative Effects
- Is Diseconomies of Scale Bad?
Diseconomies of Scale Definition
Diseconomies of scale occur when the per unit cost of production increases due to company’s expansion. This happens when the company grows to become very large, such that the cost of production increases with increased output.
In simple terms, the marginal cost of production increases with the production of every additional unit. This, in turn, causes a decrease in profits. Diseconomies of scale are the complete opposite of economies of scale. On the other hand, this is a situation where companies reap by increasing production levels and lowering costs while maximizing profits.
Diseconomies of Scale Graph Examples
Considering the above diseconomies of scale graph, any increase in output beyond output 3 will lead to a rise in the average cost of production. Many businesses are faced with this challenge in their expansion process since workload and clients increase simultaneously.
How Do Diseconomies of Scale Occur?
It is often economically believed that when companies grow steadily, they experience economies of scale. At an optimal point, they can maximize their profits and minimize their cost. However, once these companies surpass their optimal point by adding additional units to production, they will start experiencing diseconomies of scale.
Reasons for Diseconomies of Scale
Often, they require new channels of authority and communication. A quick insertion of these channels might lead to mismanagement.
2. Slow coordination
Take, for instance, larger companies; it becomes a challenge to coordinate them. The slow coordination results in production slowing down.
3. Unfamiliarity with new business circumstances
Diseconomies of scale examples are when growing companies ventures into a new industry. A new venture demands acquiring new tools and equipment, hiring new staff, and establishing a new supply chain system. Cost expenditure in such areas results in the inefficiency of a company producing diseconomies of scale.
4. Inability of a company to adapt to business growth
Take an example of a bakery. It has its fair share of customers, and then more customers begin streaming in. To keep up with the new customers streaming in, they will have to hire new staff to keep up with the orders. This may seem wise, but it has a few limitations. New staff not in sync with the bakery may not produce the cakes and bread to the same standard as before.
5. Disputes over job roles
Employees are likely to collide with each other anyway. Such conflicts make it harder to produce the expected output.
6. Insufficiency of factor inputs
Take the bakery case; it will need new ovens, baking utensils, computers, chairs, and tables, which are new resources. In adjusting to this new situation, there will be a reduction in profits.
Internal and External diseconomies of scale are the two major types of scale. Technical and organizational diseconomies of scale are subtypes of internal diseconomies of scale.
1. Internal Diseconomies of Scale
Internal diseconomies of scale are these factors that are directly involved in the company. This includes either the technical challenges in the production or the organization’s mismanagement. Any of these would increase the cost or result in mismanagement of resources without significant changes in the production process.
1.1. Technical diseconomies of scale
Technical diseconomies of scale often occur in the production stage. A firm may assume employing more workers will lead to the production of more goods and services. This, however, may not be the case as more workers will lead to overcrowding. Excess employees may lead to a reduction in morale, probably due to more conflicts of interest.
Technical diseconomies of scale may also happen when a firm is doing well financially and then decide to open new branches and invest in new machinery. The existing branches may have been doing good, but these new ones won’t necessarily be as efficient as the existing ones.
Impacts of technical diseconomies of scale
While expanding, firms may increase their production beyond their capacity. And while hiring new workers may seem the right approach, they will get in each other’s way.
- Scalability challenges
Opening new branches may not be an efficient way to expand.
1.2. Organizational diseconomies of scale
Organizational diseconomies of scale could happen for several reasons, but they mainly arise due to challenges in managing a larger workforce.
Impacts of organizational diseconomies of scale
Organizational diseconomies of scale inhibit effective communication, motivation, and effective coordination.
- Communication breakdown
As a firm expands and new employees are employed, employees may go through several departments to get things done. This may cause a slowdown in the growth of the firm. Furthermore, big firms often prefer written communication over oral communication. This, however, would lead to less interaction.
- Reduced motivation
As a firm expands, more and more employees are taken in. Being one of many employees may create a feeling of insignificance. This, unfortunately, creates the factor of no motivation among employees leading to them being inefficient in their work.
- Unavailability of effective coordination
Lack of coordination may also be another effect of the expansion of companies. Managers and supervisors find it difficult to lead a large team and ensure everybody is playing their part. The firm may be forced to hire more managers, which will result in increased costs.
2. External Diseconomies of Scale
The external diseconomies of scale result from challenges due to factors outside the firm but affect the whole industry.
Challenges of external diseconomies of scale
- Environmental pollution
As industries grow larger, several factories may open up nearby to benefit from resources that the government may have distributed. This, however, may cause additional problems in the form of pollution. The surrounding local community will suffer most from either respiratory diseases or other skin diseases.
- Scarcity of natural resources
As industries expand, they will require additional natural resources for more production. This will cause competition since the available resources will become scarce and expensive.
1. Better infrastructure
As more and more companies grow more prominent, the areas they are located will benefit from better infrastructure.
This, however, has a negative effect as well. As infrastructure becomes better, cities develop, and existing cities become bigger. This means that the cities will become more congested and susceptible to pollution. This will impact the health of the locals living in the area.
1. Increase in costs
As firms expand, they are willing to pay more to expand their production. This may lead to them overpaying for goods and services, which will affect them in the long run.
2. Mismanagement and waste
As the firm expands, it will require more resources and money. Because they are not used to managing such a large amount of resources, they might end up mismanaging, which will affect the firm in the long run.
3. Increased production costs
In the case of limited resources, the scarcer and limited they become, the more expensive the output becomes. This will affect the consumer who will have to deal with high prices.
Is Diseconomies of Scale Bad?
Not really. Inefficient allocation of resources causes an increase in the cost of production. This is just an indicator that the firms should think of alternative ways to fund their firms and manage the resources.