Definition
Diseconomies of scale refer to a situation in business where an increased output leads to an increase in long-term average cost per unit. In other words, a company or business operation becomes less efficient as it continues to scale up. This can often happen because of management challenges, over-utilization of resources, or logistical complexities.
Key Takeaways
- Diseconomies of scale occur when a business expands production and inefficiencies result, leading to an increase in average cost per unit output.
- This term contrasts with economies of scale which occur when a company increases production and sees a decrease in long-term average costs, gaining efficiency.
- Diseconomies of scale can be due to factors such as increased bureaucracy, inefficiency of resource allocation, or communication issues within a larger organization.
Importance
The term “Diseconomies of Scale” is important in finance because it describes a situation where a company or business’s production costs start to increase as the output volume begins to rise, which consequently eats into profitability.
This typically occurs when a firm has expanded too much, too quickly.
It might result from increased bureaucracy, communication difficulties, over-crowding, or logistical issues which all contribute to inefficiencies.
A proper understanding of this concept helps businesses in deciding when to cease expansion, as continuous growth could lead to a detrimental point where additional production may increase per-unit costs, rather than decreasing them, undermining one of the main advantages of a larger scale of operation.
Explanation
Diseconomies of Scale refer to a situation where the per unit cost of producing goods or services starts to increase as a company scales up production or grows bigger. The concept serves to highlight the financial inefficiencies that can unfold when an organization increases its size beyond an optimal level.
This is contrary to the expectation that efficiencies and cost advantages would naturally emerge with growth, which is the essence of economies of scale. To put it concisely, diseconomies of scale serve as a crucial litmus test for businesses in deciding whether or not to expand, by illustrating the potential pitfalls of excessive expansion.
The utilization of diseconomies of scale is strategically vital for firms as it aids in identifying the points at which their expansion may lead to less efficiency and higher costs, thus negatively affecting profits. Understanding the existence and potential impact of diseconomies of scale can prompt companies to evaluate their business models critically, modify their operational processes, or reconsider their strategies of expansion.
In diversely segmented industries, identifying diseconomies of scale can also help businesses to decide to focus on specialization rather than unwieldy growth, as over-expansion might lead to managerial inefficiencies, higher input prices, or logistical complications, negating any prospective benefits of large-scale production.
Examples of Diseconomies of Scale
Automobile Manufacturing: Large automobile companies can reach a point where they become too large and inefficient. For example, if a company is managing too many car models with numerous assembly lines across the globe, communication issues among teams, quality control issues, and rise in average costs may be encountered. A good example is General Motors. They faced such issues during the recession in 2008, and couldn’t keep up with the production costs and quality, resulting in significant financial difficulties.
Airlines: Airlines often encounter diseconomies of scale when they over-extend their routes and fleet. American Airlines, for example, faced significant challenges during the early part of 21st century due to overexpansion. The efforts to coordinate schedules, flights, and manage its fleet across the globe led to increasing costs and complexity, ultimately reducing their efficiency and leading to bankruptcy in
Fast Food Chains: If a fast food chain expands too rapidly by opening locations in several new markets at once, it can experience diseconomies of scale. They might face an increase in average total costs due to the increased expenditure on personnel training, supply chain management, and quality control. A prime example is Starbucks, which in 2007/2008 faced huge losses. They ended up closing hundreds of stores because rapid expansion led to oversaturation of markets, dilution of the Starbucks brand and eventually rising costs.
FAQs about Diseconomies of Scale
What are Diseconomies of Scale?
Diseconomies of Scale occur when a business expands so much that the costs per unit increase. It takes place when economies of scale no longer function for a business. With this phenomenon, as the quantity of output increases, the cost per unit also does the same.
What causes Diseconomies of Scale?
Diseconomies of Scale can occur due to a variety of reasons. Common causes include management problems, over-utilization of resources, inefficient operations, and increased costs of production. It can also occur when a company grows so large that the level of bureaucracy increases, resulting in a decrease of innovation and productivity and an increase in the time taken by the management to make decisions.
How do Diseconomies of Scale affect a business?
When Diseconomies of Scale occur, the cost of each unit of output increases, which can decrease profit margins. This means that even though a business may be producing more, they may be making less profit per unit because their costs are increasing at a rate that exceeds their production growth.
How can a company avoid Diseconomies of Scale?
Avoiding Diseconomies of Scale often involves improving efficiency, both in production and management. Companies need to ensure their growth is sustainable and well-managed. Decentralization can sometimes help to mitigate the effects of Diseconomies of Scale by allowing decisions to be made more quickly and efficiently.
Is there a correlation between Diseconomies of Scale and the size of a company?
Yes. Typically, very large companies are more likely to experience Diseconomies of Scale. This is because as companies grow in size, many of the issues leading to Diseconomies of Scale, such as management problems can become more likely.
Related Entrepreneurship Terms
- Decreasing Returns to Scale
- Cost Inefficiency
- Management Inefficiency
- Overproduction
- Increased Operational Costs
Sources for More Information
- Investopedia: Comprehensive resource for finance and investment terms and explanations.
- Economics Online: An educational website solely dedicated to explaining economics theories and terms.
- Corporate Finance Institute (CFI): A professional training institute that provides detailed information on financial terms.
- Tutor2u: A learning platform offering detailed educational resources on a variety of finance and economics topics.
