What it means
Economies of scale are the reason large businesses exist: spreading fixed costs over more units, buying in bulk, specialising labour and equipment, and using large-scale technology all reduce the cost per unit as output grows. But the effect does not continue indefinitely.
At some scale the advantages are exhausted and new costs appear. The long-run average cost curve, which slopes down as scale increases, flattens at the minimum efficient scale and then, for most businesses, turns up.
The upward slope is diseconomies of scale, and the scale at which it begins varies enormously by industry: a car plant reaches minimum efficient scale at hundreds of thousands of vehicles a year, a restaurant at a few dozen tables, a consultancy at a few hundred people. Internal diseconomies arise within the business.
As it grows, it needs more layers of management to coordinate its activities, and each layer adds cost, slows decisions and filters information. Communication across a large organisation is slower and less accurate than within a small one, and the people making decisions are further from the customers and the work.
Employees in a large organisation may feel less connected to its purpose and results, and their productivity and care decline. Systems and procedures that were adequate at one scale break at another and must be replaced.
Large single sites face physical limits: congestion, longer internal transport, more complex scheduling. And the management of a very large enterprise is a scarce skill; the people who ran it well at half the size may not be able to run it at double.
External diseconomies arise in the markets the business operates in. A firm that grows large relative to its labour market bids up wages; one that grows large relative to its suppliers pushes up input prices; one that grows large relative to its customer base must win less profitable customers or cut prices to grow further.
Transport costs rise as the business serves customers further from its base. Regulatory and public scrutiny increase with size.
These effects are outside the business's control and can be the binding constraint even when its internal organisation is sound. Businesses respond to diseconomies in several ways.
The most direct is to stop growing the unit that has reached its limit and grow by replication instead: a second plant, a second region, a second brand, each run at its own efficient scale. Decentralisation gives divisions or sites the autonomy of a smaller business while keeping the purchasing and financing advantages of a large one.
Investment in systems and management information reduces the coordination cost of scale. Outsourcing removes activities where the business has no scale advantage.
And some businesses simply accept a scale beyond which they will not grow, or split themselves up, on the judgement that two efficient businesses are worth more than one inefficient one. For financial analysis, the practical test is the trend in unit cost, margin and return on capital as the business grows.
A business whose margins fall as it expands, whose overhead grows faster than its revenue, whose acquisitions fail to deliver the synergies promised, or whose return on capital declines with each expansion is showing diseconomies, whatever its size. The remedy is rarely more growth.
An investment appraisal for expansion should model the costs of coordination and complexity that the expansion will add, not only the spreading of fixed costs it promises, and a board should ask, before approving a larger plant or a bigger acquisition, where the business's minimum efficient scale actually lies.
In practice
Real-world examples.
Example
A software company that grew from 200 to 2,000 engineers finds that the time to ship a feature has tripled, because every change now requires coordination across dozens of teams, and it reorganises into autonomous product units.
Example
A supermarket chain that has opened stores in every town in its region finds that new stores take sales from existing ones, and its return on new capital falls below its cost of capital.
Example
A hospital that doubled in size finds that its administrative staff has tripled, its bed occupancy has fallen and its costs per patient are higher than smaller hospitals nearby.
Think of it
“Diseconomies of scale is when getting too big makes things more expensive-size becoming a disadvantage.
Formula
Calculation
Average cost per unit = Total cost / Output = (Fixed costs + Variable costs) / Output
Economies of scale: average cost falls as output rises
Diseconomies of scale: average cost rises as output rises, because fixed costs step up (new management layers, systems, sites) and variable cost per unit rises (overtime, longer logistics, higher input prices)
Minimum efficient scale = the output at which average cost is lowest
Worked example. A manufacturer's single plant has fixed costs of $10,000,000 and a variable cost of $50 a unit up to 400,000 units a year. Beyond that, additional management, congestion, overtime and longer-distance distribution raise both fixed and variable costs.
- At 200,000 units: average cost = $10,000,000 / 200,000 + $50 = $100
- At 400,000 units: average cost = $10,000,000 / 400,000 + $50 = $75
- At 600,000 units: fixed costs rise to $16,000,000 (a second shift structure, additional management and a warehouse extension) and variable cost to $54 (overtime and longer distribution); average cost = $16,000,000 / 600,000 + $54 = $80.67
- At 800,000 units: fixed costs $24,000,000 and variable cost $58; average cost = $24,000,000 / 800,000 + $58 = $88
- The minimum efficient scale of the plant is around 400,000 units; beyond it, every additional unit costs more than the average
Replication alternative. To produce 800,000 units, two plants of 400,000 each would cost 2 x ($10,000,000 + 400,000 x $50) = $60,000,000, an average of $75 a unit, against $88 from one overstretched plant: a saving of $13 a unit, $10,400,000 a year, which comfortably justifies the second plant's capital cost.Case study
Seen in the real world.
A restaurant group grew from 30 to 120 sites in four years, using the same model and the same central team that had built the first 30. At 30 sites the founder and three operations managers knew every restaurant, every manager and most of the staff; menus were adjusted quickly, problems were fixed the same week, and the average site made an operating profit of $180,000 on revenue of $1,500,000, a 12% margin. Central costs were $2,400,000, 5% of revenue.
At 120 sites the model had broken. The central team had grown to 60 people across operations, property, marketing, purchasing, training and finance, and central costs were $10,800,000, 6% of the $180,000,000 revenue. Restaurant managers reported to area managers who reported to regional directors, and a problem at a site took a month to reach anyone who could decide.
Menu changes were tested centrally and rolled out uniformly, which suited some regions and not others. Staff turnover had risen from 40% to 70% a year, and mystery shopper scores had fallen.
Average site profit had fallen to $120,000, an 8% margin, and the group's total operating profit, at $3,600,000 after central costs (120 sites x $120,000 less $10,800,000), was barely more than the $3,000,000 it had made at a quarter of the size. The return on the capital invested in the 90 new sites was a fraction of the group's 9% cost of capital: the expansion had destroyed value.
The board's response was to reorganise rather than to retreat. The group was split into four regional companies of about 30 sites each, the scale at which the original model had worked, each with its own operations director, its own menu authority within brand guidelines and its own profit responsibility. The central team was cut to 25, retaining purchasing, finance, property and brand, and central costs fell to $7,000,000.
Within two years average site margin had recovered to 10.5%, staff turnover had fallen to 50%, and group operating profit had risen to $11,900,000 (120 sites x $157,500 less $7,000,000 central). The finance director's analysis for the board showed the original expansion plan's assumption that central costs would fall as a percentage of revenue, spreading a fixed overhead, had been the wrong model: past 40 or 50 sites, the cost of coordinating the group had grown faster than the group itself, and the fix had been to recreate the scale at which the business had actually been efficient.
Watch out
Common mistakes.
- Assuming economies of scale continue indefinitely, so that expansion plans model only the spreading of fixed costs and not the coordination, management and logistics costs that growth adds.
- Growing a single unit past its efficient scale when replication, a second plant, region or division, would deliver the volume at lower cost.
- Responding to falling margins with more growth, on the theory that scale will fix them, when the falling margins are the symptom of too much scale already.
Questions
People also ask.
What is the difference between economies and diseconomies of scale?
Economies of scale reduce unit cost as output grows, through spreading fixed costs, bulk buying, specialisation and large-scale technology. Diseconomies raise unit cost as output grows further, through coordination costs, slower decisions, lower motivation, congestion and pressure on input markets. Most businesses experience economies up to a point and diseconomies beyond it.
How can a business tell it has reached diseconomies?
When unit costs, margins or return on capital deteriorate as it grows; when overhead grows faster than revenue; when decisions slow, quality falls and staff turnover rises with size. The trend in average cost against output is the direct test.
Can diseconomies of scale be avoided?
Reduced, through decentralisation, replication of efficient-scale units, better systems and information, and outsourcing of activities with no scale advantage. But every organisation has a scale beyond which coordination costs rise, and the practical question is where it lies and how to structure the business around it.
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