Diseconomies of Scale

What Are Diseconomies of Scale?

Diseconomies of Scale refer to the negative effects that an organization experiences as a result of expansion, which leads to inefficiencies.

Diseconomies of scale occur when a corporation or firm grows and its marginal costs per unit increase with increased production of one more unit. They occur when a company's economies of scale fail.

Diseconomies of scale refer to the point at which a company's expansion leads to higher production costs per unit and diminishing efficiency gains. These negative effects, caused by diseconomies of scale, result in higher long-term average costs and reduced output.

Under this technique, a corporation will incur greater costs as output increases rather than continuously cutting costs with increasing output.

Some examples of diseconomies of the scale include the following:

• Communication gap
• Challenges in Coordination
• Bureaucracy
• Challenges in retaining talent
• Challenges in Resource Allocation

This is the exact opposite of economies of scale, where the average cost decreases with increases in output, the cost benefits experienced by them when production becomes efficient.

Diseconomies of scale can be divided into two types: internal and external. Both pertain to diseconomies related to internal and external factors related to the business.

Understanding Diseconomies of Scale

Diseconomies of scale occur when an organization expands beyond its ability to manage and becomes inefficient in its operations. This expansion without efficiency and control can lead to increased long-term average costs that damage overall profitability.

The diagram above depicts a diseconomy of scale. At point Q1, this company has the lowest average unit cost whether it produces more or fewer products.

By producing more to the left of Q1, the firm can employ economies of scale to reduce average expenses. Unfortunately, the corporation is experiencing diseconomies of scale and an increasing average unit cost to the right of Q1.

These diseconomies can be caused by different factors, from bureaucracy (external factors) to communication and coordination breakdown (internal factors). These factors can lead to various inefficiencies, delays, and higher costs.

These factors negatively impact firms by decreasing profitability and later losing stakeholders' confidence.

One of the ways any organization can reduce the negative effects of diseconomies of scale is to divide the organization into more manageable divisions.

Causes of Diseconomies of Scale

Various factors can produce diseconomies of scale, including a breakdown in communication, a lack of motivation, a lack of coordination, and a lack of attention on the part of management and workers.

Communication Breakdown

Communication is essential in every organization, especially when managing economies of scale. A communication breakdown might result in scale diseconomies and have far-reaching negative implications.

An efficient communication channel is essential to every organization's success throughout its expansion. Communication gets increasingly challenging when hierarchies move and evolve. For example, increased command layers can distort a message as it goes above, below, or laterally.

Written forms of communication, such as notice boards, newsletters, and memos, are becoming more common. Unfortunately, the system will suffer due to such communication, which may not allow feedback.

Reduced Motivation

As the firm grows, so does the number of employees, which causes them to feel alienated and unmotivated. A small business employs many individuals who have a personal connection to the company and work closely with the owner and management.

A large workforce may lose focus with less interaction with top management, resulting in decreased profitability and scale diseconomies. Employee motivation and loyalty are commonly reduced, resulting in poorer productivity and marginal costs.

Improving empowerment, teamwork, and job enrichment can aid in treating low motivation.

Giving lower-level employees decision-making autonomy develops a sense of belonging. If employees' contributions are appreciated in their day-to-day operations, their motivation and engagement will likely increase.

Lack Of Coordination

Delegating jobs and responsibilities saves time and prepares lower-level people with more vital abilities rather than waiting for higher levels of management to offer instructions on every task. Because junior employees are function executors of specialized tasks, delegating allows them to be innovative and creative.

The proper response to a lack of coordination is to delegate duties and decision-making to lower levels of the organizational structure.

Loss of Direction

It becomes increasingly difficult to manage workers who have lost direction and motivation when an organization grows.

Many employees have become accustomed to a routine and risk losing motivation and interest in boosting the company's profitability. Managers and supervisors have similar issues when organizing operations and ensuring everyone is doing the right thing.

Businesses need to hire or promote more supervisors to manage growing operations and track employee performance. As a result, costs will rise as the firm seeks to enhance its operations.

Increased Transportation, Distribution, & Supplier Costs

As the size and scale of the organization increase, it becomes increasingly challenging for the branches of the organization in different geographical areas to transfer of goods and services.

This difference in the distance between two geographical can increase transportation and distribution costs.

This positive scaling of business can also impact supplier-customer relationships, negatively impacting the negotiating terms and the management of the supply chain.

Internal Diseconomies of Scale

Economies of scale can significantly impact a company's overall efficiency and performance as it grows. As a business owner, entrepreneur, investor, or economist, it is critical to grasp the complexity of production growth.

In addition, stakeholders should be aware that various issues may impact profitability as a company's demand rises.

Internal diseconomies of scale are produced by either technical constraints in the firm's manufacturing process or organizational problems that raise costs or waste resources without impacting the physical manufacturing process.

Within each market, there are several forms of internal diseconomies:

• Technical
• Organizational
• Buying
• Competitive/monopoly, and
• Financial diseconomies

These scales might occur individually or concurrently, depending on each company's decision-making. Let us discuss these internal diseconomies.

Technical

Technical diseconomies of scale can be seen in physical limits on handling and combining inputs and commodities. Two examples are overcrowding and mismatches between the feasible scale or speed of various information and processes.

An overcrowding effect inside an organization typically causes diseconomies of scale. This happens when a company grows too quickly, assuming it can obtain economies of scale indefinitely.

If, for example, a company can reduce the cost of its product per unit each time it adds a machine to its warehouse, it may assume that expanding the number of devices to the maximum is the best method to save money.

If a machine takes one person to operate and ten engines are added to the warehouse, ten more employees are likely to interfere, making it more challenging to create the same output per hour. This boosts costs while decreasing output.

Organizational

Beginning communication becomes rigid as the size of the organization increases exponentially. As a firm expands, communication across departments becomes increasingly tricky. 

Employees may need specific instructions or expectations from management. This can occur if no proper plan complements the organization's growth.

Another problem is motivation. Employees in more prominent organizations may feel alienated and unloved, resulting in lower productivity.

Effects of Organizational Diseconomies:

1. Communication: Organizational diseconomies occur when an organization expands. An employee may need assistance from other departments to perform a task. Successful major organizations frequently resolve such issues. However, some inefficiencies may exist.
2. Demotivation: As the firm grows, there may be psychological issues that arise. For example, being one of 30,000 employees may make you feel insignificant. Furthermore, managers tend to disregard individual successes. Employees may become demotivated, resulting in underperformance and inefficiencies.
3. Employee Health: As previously said, employees may feel like cogs in the wheel of a giant organization. On the other hand, large businesses may isolate many people. This sense of insignificance and loneliness influences motivation and health. As a result, employees may take more sick days and become less productive and imaginative.

Purchasing Diseconomies

Large corporations may occasionally pay more than small ones. For example, Google, Apple, and Microsoft all produce significant cash flow.

For example, Apple generates over $55 billion in yearly revenue. As a result, such companies inevitably overpay for various commodities.

A vast firm is naturally willing and able to pay a premium price for an asset, object, or service. This is because it possesses both the desire and resources that a smaller firm may lack.

Effects of Purchasing Diseconomies:

1. Higher Costs: Firms' spending propensity increases their proclivity to overpay for goods and services, which will suffer the bottom line of the financial report.
2. Greater Waste: As a firm expands, the distance between management and the average employee gets wider. As a result, worker requests should be regularly noticed. Employees may not require or desire resources purchased by management.
3. Deadlock: Some large businesses are aware of unnecessary spending. Consequently, purchasing decisions may pass through several approval stages before being halted at the ultimate level. However, the business may become stagnant.

Competitive/Monopoly Diseconomies

Strong and competitive markets are required for organizations to operate efficiently. Conversely, when there is less competition, there is less incentive to lower prices.

Because it has minimal competition, a monopoly business, for example, has little motivation to reduce costs and enhance efficiency. On the other hand, customers have no choice but to pay the price.

As a result, the costs of non-competitive markets are higher than those of competitive markets.

Effects of Competitive/Monopoly Diseconomies:

• Increased Competition: As the monopolist corporation becomes big and inefficient, but with high profits, new competitors may have a chance to enter the market.

Financial Diseconomies

As a firm expands, it may invest in new factories or real estate. As a result, new funding sources will be sought. If they are not raised appropriately from suitable sources that don't complement the organization's structure and philosophy, it might lead to problems (diseconomies).

They should be obtained from sources that support the organizational strategy and goals, such as banks or other financial instruments. As a result, the corporation will be obliged to pay interest. This adds a cost that smaller firms may need help to afford.

As financing costs rise, so do the costs of keeping financial records. More accountants and legal teams could be required. Consequently, if productivity does not improve above these expenditures, the overall cost of production may rise.

Effects of Financial Diseconomies:

1. Increased Workforce: Borrowing more assets demands more personnel to handle money and assets. Because the firm has to recruit more workers, it may need to borrow more money.
2. High-Interest Rates: It may become expensive when a firm needs external capital to grow organically. The more a firm borrows, the riskier it becomes in the eyes of investors. As a result, lenders charge higher interest rates to compensate for the risk.

External Diseconomies of Scale

Economic resources or other constraints imposed by the external environment on a firm or industry might result in external diseconomies of scale.

External capacity constraints may emerge when a shared pool resource or a local public benefit cannot fulfill escalating demand. This diseconomy of scale is visible in the traffic on public roads and other forms of transportation used to deliver a company's goods.

The depletion of a critical natural resource below its reproductive capacity is equivalent to diseconomies. As the resource becomes scarce, it becomes increasingly difficult to obtain. Let us discuss the external diseconomies below.

Diseconomies of Pollution

An industry's growth may raise costs for the local or national population. Several factories, for example, may open near one other to increase efficiency. Knowledge, supplier, and comparable efficiency may all play a role.

As a result, such industries may suffer enormous environmental costs in their surrounding communities, which frequently plague residents with severe respiratory ailments.

Although the firm is not necessarily responsible for pollution, it can be costly to employees and citizens. This might emerge as air pollution and noise. For example, a new airport may charge a third party for noise pollution, which might lower house values.

Effects of Diseconomies of Pollution:

1. Poor Health: The effects of air pollution on respiratory health are well known. Long-term harmful consequences include heart disease, lung cancer, nerve, brain, kidney, and other organ damage.
2. Reduced House Prices: Communities with high air and noise pollution levels may lose value over time. A new airport, for example, may cause significant noise pollution among homeowners, deterring prospective buyers.

Limited Natural Resources

All industries require natural resources. These might include everything from labor to land to physical resources such as coal. As a company grows, it requires more and more resources.

One example is the extraction of natural resources such as coal, oil, or gold. Because there is a finite supply, locating and extracting them becomes more expensive as they become scarcer.

As a result, prices grow, making more complicated resource exploitation more viable and advantageous. For example, oil fields in the ocean might be a logistical and expensive headache.

Effects of Limited Natural Resources

• Higher Prices to the Consumer: Higher prices are unavoidable as natural resources become scarcer. Greater compensation is provided for scarce workers, resulting in larger long-term earnings.

Infrastructure Diseconomies

The localization of industry places undue strain on the region's transportation and infrastructure. As a result, raw materials and completed commodities are delayed in transit.

Infrastructure diseconomies occur when an industry grows so large that it strains local infrastructure. Highways, for example, may get congested, and trains may become inoperable.

Due to infrastructural and financial constraints, the region's communication system is also overburdened, and real production costs are rising.

Transportation, taxis, and retail are all good examples. The completed product costs more when it takes an extra hour to deliver things to the store. Thus, most developing countries will provide comprehensive urban planning to attract investors and multinational corporations to invest in their country.

Challenges to Business Efficiency

Business efficiency is one of the key aspects of organizational success. And, there are a number of factors that can contribute towards hindering these efficiencies. Businesses become inefficient for various reasons.

1. Inefficient Processes: Businesses thrive when processes are efficiently planned and executed. Inefficient processes can lead to productivity losses, increased costs, and diminished customer satisfaction. This can be minimized by streamlining operations, automating tasks, and utilizing technology.
2. Human Resource Management: Growing size of the corporation can lead to decreasing employee motivation, satisfaction, and improvement. This can also result in loss of employee morale. This can be minimized by taking employee considerations into decision-making.
3. Scaling Operations: One of the biggest challenges when the operations are positively scaled is the maintaining the quality of the products and services. This can be minimized through cash flow management, adapting to technological advancements, and maintaining healthy financial statements.
4. Strategic Alignment: As the size of the firm grows, the strategies change. It becomes increasingly difficult to make whole of the organization to align with the current strategic status. This can be minimized through appropriate resource allocation, collaboration, and clear communication.
5. External Challenges: Changes in market trends, global crashes, and changes in customer preferences are factors that all amount to external challenges. These factors impact the overall business operational efficiency. Adapting to new market trends and innovating along the way can benefit organizations.

Diseconomies of scale are not permanent, but they usually necessitate additional capital investment or the implementation of a new process management approach. Many economists claim natural monopolies cannot arise because scale economies render antitrust legislation redundant.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Economic Efficiency

• Economies of Scale

• Economies of Scope

• Expansionary Monetary Policy

• Foreign Direct Investment (FDI)