Economy of scale is a bedrock economics principle. Costs go down as production increases because you're able to purchase in greater bulk and achieve efficiency and flow. However, these cost reductions have their limits, and as companies grow, they can run into some inconvenient cost increases, also known as diseconomies of scale.
TL;DR (Too Long; Didn't Read)
Diseconomies of scale are caused by growth spurts that require new equipment and processes that cost extra money and disturb established production systems.
Causes of Economies of Scale
- Continuity. It takes less energy to keep an engine running than to start it once it's cold. Similarly, it takes fewer resources to keep your production line producing once it's up and running than to shut it down and start it up again to manufacture small batches.
- Leveraging overhead. If your rent is $1,000 per month and you only manufacture one unit, your rent cost per unit is $1,000. However, if you manufacture 10,000 units, your rent cost per unit is 10 cents. As your company grows, you will reap similar cost advantages in everything from human resources staffing to automobile expenses.
- Buying in bulk. Your company will enjoy volume discounts as you buy materials and supplies in greater bulk. This economy of scale can translate to higher margins or better prices for your customers, increasing sales volume.
Causes of Diseconomies of Scale
Business growth comes in spurts and plateaus. When your company is expanding rapidly, the systems and equipment that have served you well in the past may no longer prove as useful. You may have been using a payroll database that worked well with 15 employees but has grown cumbersome now that you're writing 50 paychecks. Aside from stretching the resources you've developed to the point where they malfunction or break down, growth may force you to invest heavily in new solutions.
The causes of managerial diseconomies of scale are linked to the difficulty of effectively knowing and understanding everyone on your staff as your business grows. In addition to the employee alienation that can grow out of not being known personally by supervisors and company decision makers, a growing business faces the challenge of not knowing how to leverage its employees' best qualities. A higher ratio of employees to managers means that supervisors may not know who works most efficiently and who works most thoroughly.
Inventory diseconomies of scale come from the difficulty of being able to predict what materials your company needs as you produce more volume and operations become more complex. In a smaller company, over-ordering may be a matter of a handful of items and a few hundred dollars. In a larger business, you may end up paying for pallets full of materials that go to waste, especially if these items are customized and your processes and products change.
Finding the Sweet Spot
Real-life examples of diseconomies of scale often show a business reaping advantages from growth until it reaches a point where these advantages turn into disadvantages. A company may reap economies of scale by using its equipment to the fullest rather than investing in new machines, but once this equipment is operating at full capacity, it is possible to lose business by not being able to produce more.
The solution may be to expand capacity by buying new equipment, but this introduces the diseconomy of major investments that you may not yet be able to utilize to their fullest. In a perfect world, a business would be able to find the ideal scale on which to operate and stay at that level indefinitely. In the real world, each company needs to explore these issues as they unfold and develop solutions appropriate to its current size and scope.
Devra Gartenstein founded her first food business in 1987. In 2013 she transformed her most recent venture, a farmers market concession and catering company, into a worker-owned cooperative. She does one-on-one mentoring and consulting focused on entrepreneurship and practical business skills.