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Diseconomies of Scale

Forces that increase the per-unit cost of goods and services

What are Diseconomies of Scale?

Diseconomies of scale occur when an additional production unit of output increases marginal costs, which results in reduced profitability. Instead of production costs declining as more units are produced (which is the case with economies of scale), the opposite happens, and costs increase with the production of each additional unit.

Diseconomies of Scale diagram

 

Consider the graph shown above. Any increase in output beyond Q2 leads to a rise in average costs. This is an example of diseconomies of scale – a rise in average costs due to an increase in the scale of production.

Many businesses face challenges when undergoing an expansion, as there are increases in workload and clients to serve. Effective cost control under changing business circumstances is difficult and may mean a reduction in profitability if production is increased.

 

Causes of Diseconomies of Scale

Diseconomies of scale may result from several factors, including communication breakdown, lack of motivation, lack of coordination, and loss of focus by the management and employees.

 

1. Communication Breakdown

Communication is important in any organization, especially in managing economies of scale. A communication breakdown could be the beginning of diseconomies of scale and have far-reaching adverse effects on the business. During the growth process in any entity, an efficient communication channel is vital in the proper running of the business.

Growth poses more challenges in communication as hierarchies change and increase. Increased layers of command can also distort a message as it travels upwards, downwards, or laterally. Where an organization relies more on written forms of communication such as notice boards, newsletters, and memos, there will be a weakened communication system since such communication may not allow feedback.

 

2. Reduced Motivation

As the business grows, the employee base increases, which can make them feel isolated and thus less motivated. A small business employs a few individuals with a personal connection to the business and a close working relationship with the owner and management. A large workforce with less interaction with the top management can easily lose focus, leading to reduced profitability and diseconomies of scale. Diminishing employee motivation and loyalty often leads to decreased productivity levels and an influx of marginal costs.

Solutions to low motivation can be resolved by improving empowerment, teamwork, and job enrichment. Empowerment involves delegation in making decisions, which makes lower-ranked employees feel a sense of belonging. If an opinion of an employee counts in the daily running of a company, their motivation could increase and engagement could significantly increase. Job enrichment involves making professions more interesting and less boring.

Many professions involve routine work, which makes an employee do the same thing year in year out in an 8-5 daily routine. The routine is boring, and one becomes used to the routine and can thus lose creativity. Making a job interesting could involve a rotation of roles once in a while, bringing fresh enthusiasm. Job enrichment can make roles more challenging and fulfilling if people are allowed to challenge themselves in their roles and, hence, improve the efficiency of operations.

Teamwork involves the grouping of employees into teams with the goal of improving interaction at the workplace. Team members can bring cross-functional perspectives on how to perform different tasks, and it brings fresh ideas into the team. Deliberation within teams on the best ways to undertake certain tasks can significantly improve operations.

A close link also exists between motivation and communication; when communication breaks down, an individual’s motivation plummets. Communication breakdowns can be reduced by management through implementing training and policies.

 

3. Lack of Coordination and Loss of Direction

As an entity grows in size, it becomes harder to coordinate the employees who, in turn, lose direction and motivation. Many employees are used to a routine, and face the risk of losing motivation and interest in improving the profitability of the business. Managers and supervisors also experience a hard time organizing operations and ensuring that everyone is playing their part effectively.

Businesses will be forced to hire or promote more supervisors to oversee the increased operations and monitor the performance of employees. The move will result in increased costs as the company gears towards optimizing its operations.

The ideal solution to the loss of direction and lack of coordination is to delegate tasks and decision-making to the junior levels in the organizational chart. Delegating tasks and responsibility not only saves time but also equips lower-level employees with better skills, rather than waiting for the higher levels of management to give direction on every task. Furthermore, delegation motivates junior employees to be innovative and creative since they move from being just executors of functions to owners of specific tasks.

 

Diseconomies of Scale and Mechanization

The initial introduction of machines in a largely manual system can also lead to increased costs. If a company plans to mechanize its operations, such exercises should be effectively managed to reduce the impacts of diseconomies of scale.

The machine operators and other employees should undergo training and take time to familiarize themselves with the new systems before the implementation date of mechanization. While transitioning a manual system to a mechanized system may not be an easy task, this expansion and growth should be thought out by all stakeholders to identify all potential loopholes. Involving the stakeholders in the mechanization process helps reduce the effects of diseconomies of scale.

 

Diseconomies of Scale example

 

Other Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

  • Economies of Scale
  • Economies of Scope
  • Law of Supply
  • Market Economy

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!