Business · 4 Operations management

4.4.2 Economies and diseconomies of scale

Before you start

Average cost = Total cost ÷ Number of units, and why sharing fixed costs over more units lowers it (4.4.1).
Fixed and variable costs (4.4.1).
That businesses grow by opening new sites, employing more people or joining with other businesses.

Syllabus objectives covered (2)

concept of economies of scale: purchasing, marketing, financial, managerial, technical
concept of diseconomies of scale: poor communication, lack of commitment or loyalty from employees, weak coordination, lack of control

Part 1 of 4

What economies of scale are

Scale means the size of a business's operations — how much it produces. A bakery with one oven and a factory baking a million loaves a week work on very different scales.
Economies of scale are the factors that cause average cost to fall as a business increases its scale of production. Economies here means savings; it has nothing to do with a country's economy.
Everything in this lesson is about average cost — total cost ÷ number of units, from 4.4.1 — not total cost. A bigger business almost always has bigger total costs. The question is whether each unit gets cheaper to make.
An example. Kora Furniture makes 400 tables a month at a total cost of $$ 60,000$ : an average cost of $$ 150$ per table. After moving to a larger workshop it makes 1,000 tables a month at a total cost of $$ 120,000$ : an average cost of $$ 120$ per table.
Total cost doubled, yet each table became $$ 30$ cheaper to make. The five economies of scale below are the reasons this can happen.
Why it matters: a lower average cost gives the business a choice. It can keep its price and earn more profit on each unit, or cut its price to win customers from smaller rivals and still make a profit.

Part 2 of 4

The five economies of scale

The syllabus names five. If it helps, remember Tiny Plants Make Many Flowers: Technical, Purchasing, Marketing, Managerial, Financial. The phrase is only a memory aid; the five names are what you write.
Purchasing economies. A large business buys raw materials and components in bulk, and suppliers often give discounts on large orders. Each unit then contains cheaper materials, so average cost falls. This is often called bulk-buying.
Marketing economies. Many marketing costs stay much the same however much a business sells: an advertising campaign costs the same whether it leads to 10,000 sales or 1,000,000. A large business spreads that cost over far more units, so the marketing cost of each unit is smaller.
A large business can also afford ways of promoting and distributing its products that a small one cannot, such as national advertising or running its own delivery vehicles.
Financial economies. Banks see large businesses as less risky to lend to, because they have more assets that could be sold and a longer record of repaying. So large businesses find it easier to borrow, and are often charged lower interest rates. Lower interest payments mean lower costs.
Managerial economies. The owner of a small business may have to be the accountant, the marketing manager and the person who hires staff, all at once. A large business can afford specialist managers for each of these jobs. Specialists work more efficiently and make fewer costly mistakes, which lowers average cost.
Technical economies. A large business can afford expensive, advanced machinery and technology, such as automated production lines. These produce far more output per worker and per hour, so each unit costs less to make. A small business could not use such machines enough to make them worth buying.
The trap in a written answer: naming the economy earns only the knowledge mark. You must finish the chain — so the cost of each unit falls, so the business can lower its price or earn a higher profit per unit.

Part 3 of 4

Diseconomies of scale

Growth does not lower average cost for ever. Beyond a certain size, a business becomes so large that it is harder to run well, and average cost starts to rise. The factors that cause this are diseconomies of scale.
The syllabus names four. Notice that every one is a problem of managing people and information in a big organisation — none is about machines or suppliers.
Poor communication. A large business has more levels of management between the directors and the workers. Messages pass through more people, so they arrive slowly, get changed along the way, or are lost. Instructions are misunderstood and decisions take longer, wasting time and money.
Lack of commitment or loyalty from employees. In a business of thousands, workers may never meet senior managers and can feel like a number rather than a valued person. Employees who feel this way are less motivated: they may work less hard, be absent more often, or leave — and every leaver has to be replaced and trained.
Weak coordination. With many departments, factories or countries, it becomes hard to make sure everyone is working towards the same objectives. Departments may repeat each other's work or pull in different directions, so resources are wasted.
Lack of control. Senior managers cannot see or check everything that happens in a very large business. Mistakes, waste and poor quality can go unnoticed for longer, and it is harder to make sure rules and standards are followed everywhere.
Each of these raises the cost of producing each unit — through wasted time, lower productivity, more errors or higher recruitment costs. That link to average cost is what makes them diseconomies of scale, and it is the link your analysis has to make.
A common slip is to define a diseconomy of scale as "when a business gets too big". That describes the cause, not the effect. A definition must say that average costs rise as the scale of production increases.

Part 4 of 4

Weighing economies against diseconomies

A growing business usually gets both at once: bulk discounts from suppliers and slower communication. Whether growth lowers average cost overall depends on which effect is stronger.
Figures show which one is winning. If Kora Furniture grows again, to 3,000 tables a month, and its total cost becomes $$ 390,000$ , its average cost is $$ 390,000$ ÷ 3,000 = $$ 130$ per table. That is higher than the $$ 120$ it reached at 1,000 tables: the diseconomies now outweigh the economies.
When a question asks you to judge growth, use the business's own details to decide which effect is likely to be stronger. A business that buys huge quantities of one raw material may gain a great deal from purchasing economies. A business spread over several countries with thousands of employees is more at risk from poor communication and weak coordination.
You can also argue that diseconomies can be reduced — for example, by giving managers at each site authority to make their own decisions, or by improving communication systems. This is reasoning you can use to support a judgement, not a list you need to learn.

Worked examples

Example 1. Kora Furniture used to make 400 tables a month at a total cost of $$ 60,000$ . After expanding, it makes 1,000 tables a month at a total cost of $$ 120,000$ . Calculate the average cost per table before and after expansion, and identify whether Kora has benefited from economies of scale.

Show the working

Economies of scale are judged by average cost, so calculate it at both levels of output. Write the formula first.
$Average cost = \frac{Total cost}{Number of units}$
Before expansion:
$\frac{$ 60,000}{400} = $ 150 per table$
After expansion:
$\frac{$ 120,000}{1,000} = $ 120 per table$
Average cost fell by $$ 150$ − $$ 120$ = $$ 30$ per table, even though total cost doubled.
A fall in average cost as the scale of production increases is what economies of scale are, so Kora has benefited overall. The figures alone do not tell you which economies caused the fall; that needs information about what Kora buys, makes and uses.

Answer: Average cost was $$ 150$ per table before and $$ 120$ per table after — a fall of $$ 30$ — so Kora has benefited from economies of scale.

Example 2. Kora's timber supplier normally charges $$ 50$ for the wood in one table, but gives a 10% discount on orders for 800 tables or more. Calculate how much Kora saves on wood each month by making 1,000 tables, and identify the economy of scale.

Show the working

Find the discount on one table's wood:
$10 % of $ 50 = 0.10 \times $ 50 = $ 5$
So the wood for each table now costs $$ 50$ − $$ 5$ = $$ 45$ .
Saving over a month of 1,000 tables:
$$ 5 \times 1,000 = $ 5,000$
Kora only gets this discount because it now orders enough wood for at least 800 tables. A saving that comes from buying in bulk is a purchasing economy of scale.

Answer: Kora saves $$ 5,000$ a month ( $$ 5$ per table × 1,000 tables). This is a purchasing economy of scale.

Example 3. Kora Furniture has expanded to 1,000 tables a month, and its workforce has grown from 20 to 80 employees. Explain one economy of scale and one diseconomy of scale Kora might experience.

Show the working

Each half of this answer can earn three marks: one for naming the point [k], one for tying it to Kora [app] and one for developing what follows [an]. Plan all three before you write.
Economy — name it: technical economies of scale. [k]
Apply it: at 1,000 tables a month, Kora can afford automated cutting machines that would stand idle much of the time in a 400-table workshop. [app]
Develop it: the machines cut more table parts per hour than workers can by hand, so the cost of producing each table falls, and Kora can lower its prices or earn more profit per table. [an]
Diseconomy — name it: lack of commitment from employees. [k]
Apply it: with 80 employees instead of 20, the owner can no longer know and work alongside every worker. [app]
Develop it: workers who feel less valued may be absent more often or leave, so Kora spends more on recruiting and training, which raises the cost of each table. [an]
Notice that each [an] ends at a consequence for cost, price or profit. An answer that stops at "the workers are unhappy" has not shown why it matters to the business.

Answer: Technical economies [k]: making 1,000 tables a month lets Kora use automated cutting machines [app], which raise output per hour and lower the cost of each table [an]. Lack of commitment from employees [k]: with 80 workers instead of 20 there is less personal contact with the owner [app], so absence and staff turnover may rise, increasing the cost of each table [an].

Where people go wrong

Mistake: Saying economies of scale make total costs fall.

Instead: Economies of scale lower average cost — the cost of each unit. Total cost usually rises as output rises.

Kora's total cost doubled from $$ 60,000$ to $$ 120,000$ while its average cost fell from $$ 150$ to $$ 120$ .

Mistake: Defining a diseconomy of scale as "when a business becomes too big".

Instead: Say that average costs rise as the scale of production increases.

The definition has to state the effect on average cost. Size is only the cause.

Mistake: Mixing up purchasing and marketing economies.

Instead: Purchasing: cheaper materials from buying in bulk. Marketing: advertising and distribution costs spread over more units.

Both involve spending money with other businesses, but purchasing economies are about the inputs that go into the product itself.

Mistake: Writing "it saves money" as the analysis.

Instead: Say what the saving does: the cost of each unit falls, so the business can lower its price or raise its profit per unit.

Development has to show the consequence for the business, not repeat that something is cheaper.

Mistake: Giving a problem with machinery or suppliers as a diseconomy of scale.

Instead: The four syllabus diseconomies are poor communication, lack of commitment or loyalty from employees, weak coordination and lack of control.

All four come from the difficulty of managing people and information in a large organisation.

Check yourself

Define economies of scale.
Answer
The factors that cause average costs to fall as a business increases its scale of production.
Define diseconomies of scale.
Answer
The factors that cause average costs to rise when a business increases its scale of production beyond a certain size.
A chocolate maker gets a 15% discount on cocoa because it orders 50 tonnes a month. Identify the economy of scale.
Answer
Purchasing economies of scale (bulk-buying).
A bank lends to a large supermarket chain at a lower interest rate than it charges a single corner shop. Identify the economy of scale and give the reason for it.
Answer
Financial economies of scale. The bank sees the large business as less risky, because it has more assets and a longer record of repaying.
A business spends $$ 200,000$ on an advertising campaign. Calculate the advertising cost per unit if it sells 100,000 units, and if it sells 400,000 units. Which economy of scale does this show?
Answer
$$ 200,000$ ÷ 100,000 = $$ 2.00$ per unit; $$ 200,000$ ÷ 400,000 = $$ 0.50$ per unit. This is a marketing economy of scale.
State the four diseconomies of scale named in the syllabus.
Answer
Poor communication; lack of commitment or loyalty from employees; weak coordination; lack of control.
Explain how poor communication can raise a large business's average cost.
Answer
With more levels of management, messages travel slowly and can be distorted, so instructions are misunderstood and decisions are delayed. The wasted time and mistakes raise the cost of producing each unit.
A business's average cost falls from $$ 8.00$ to $$ 6.50$ when its output doubles, then rises to $$ 7.20$ when output doubles again. What does each change suggest?
Answer
The first change suggests economies of scale are outweighing diseconomies. The second suggests diseconomies of scale are now outweighing the economies.

Exam questions

Try each part first. Open the mark scheme after you have written your answer.

Question 1. GreenLeaf Ltd is a private limited company that makes organic tea. Five years ago it had one factory and 60 employees, and produced 500,000 packs of tea at a total cost of $$ 1.5$ million. It now has five factories in three countries and 900 employees. Last year it produced 4 million packs at a total cost of $$ 10$ million. It buys 2,000 tonnes of tea leaves a year and has just launched its first television advertising campaign.

(a) Define 'diseconomies of scale'. 2 marks

Mark scheme

pt2 Award 2 marks for clear understanding, 1 mark for some understanding. Clear: factors that cause average costs to rise as a business increases its scale of production (2). Some: problems caused by a business being too big / costs rise when a business grows (1). Do not award examples alone.

(b) Calculate GreenLeaf's average cost per pack five years ago and last year. 2 marks

Mark scheme

pt1 Five years ago: $$ 3.00$ per pack ( $$ 1.5$ million ÷ 500,000).
pt1 Last year: $$ 2.50$ per pack ( $$ 10$ million ÷ 4 million).

(c) Outline two economies of scale GreenLeaf might benefit from. 4 marks

Mark scheme

k1 First economy identified, e.g. purchasing / marketing / financial / managerial / technical economies of scale.
app1 Applied to GreenLeaf, e.g. bulk discounts on 2,000 tonnes of tea leaves / TV advertising cost spread over 4 million packs / lower interest as a large private limited company / specialist managers across five factories / advanced machinery for packing tea.
k1 Second, different economy identified.
app1 Applied to GreenLeaf. The reference must make sense for the economy named.

(d) Explain two diseconomies of scale GreenLeaf might experience. 6 marks

Mark scheme

k1 First diseconomy identified, e.g. poor communication / lack of commitment or loyalty from employees / weak coordination / lack of control.
app1 Applied, e.g. five factories in three countries / 900 employees (up from 60) / organic tea.
an1 Developed, e.g. messages between factories are slow or misunderstood, so decisions are delayed and mistakes raise the cost of each pack / demotivated staff are absent more or leave, raising recruitment costs and lowering productivity.
k1 Second, different diseconomy identified.
app1 Applied to GreenLeaf.
an1 Developed to an effect on cost, productivity, quality or profit, e.g. factories work to different standards, so quality of the organic tea varies and waste increases average cost.

Question 2. Tomás owns CityBake, a chain of 4 bakeries with 30 employees. He makes all the important decisions himself. He is considering buying a rival chain of 12 bakeries. This would increase CityBake's workforce to 120 employees and allow it to buy flour in much larger quantities.

(a) Do you think CityBake's average costs will fall if Tomás buys the rival chain? Justify your answer. 8 marks

Mark scheme

k2 Identification of relevant points, e.g. purchasing economies / marketing economies / managerial economies / financial economies / poor communication / lack of commitment or loyalty from employees / weak coordination / lack of control.
app2 Relevant application, e.g. flour bought in larger quantities / 16 bakeries instead of 4 / 120 employees instead of 30 / Tomás makes all the important decisions himself / rival chain.
an2 Relevant development, e.g. bulk discounts on flour lower the cost of each loaf / one advertisement covers 16 bakeries, so marketing cost per sale falls / Tomás cannot check 16 bakeries himself, so waste and mistakes go unnoticed and raise costs / staff from the rival chain may feel little loyalty to a new owner and leave.
eval2 A justified decision, e.g. "Average costs are likely to rise at first, because Tomás making every decision himself will not work across 16 bakeries, and lack of control could waste more than the flour discount saves. They could fall later if he appoints managers for each bakery." The justification should not repeat earlier points.

How this is examined

Judging whether growing larger will lower or raise a business's average cost: a final 8-mark part, "Do you think…? Justify your answer.", about a business that is expanding, buying another business or opening new sites At least one economy and one diseconomy, each tied to the business's details (what it buys, how many employees or sites it has) and developed to an effect on average cost, price or profit — then a decision on which effect is likely to be stronger for this business, with a reason that does not repeat earlier points.
Explaining how a named economy or diseconomy affects a business: an Explain part (6): two economies, two diseconomies, or one of each The correct name [k]; a detail from the case, such as its number of employees or what it buys [app]; and the chain to cost — "so the cost of each unit falls / rises" — ideally on to price or profit [an].
Outlining economies of scale a growing business could gain: an Outline part (4) For each: the name [k] plus a detail from the business [app], e.g. "purchasing economies — discounts on its 2,000 tonnes of tea leaves".
Defining economies or diseconomies of scale: a Define part (2) Both ideas together: average cost, and the scale of production increasing — "average costs fall (or rise) as the scale of production increases". A vaguer answer such as "saving money by being big" shows only some understanding.

Words to know

Scale of production: The size of a business's operations — how much it produces.
Economies of scale: Factors that cause average costs to fall as a business increases its scale of production: purchasing, marketing, financial, managerial and technical.
Diseconomies of scale: Factors that cause average costs to rise as a business grows beyond a certain size: poor communication, lack of commitment or loyalty from employees, weak coordination and lack of control.
Bulk-buying: Buying in large quantities, usually at a discount. The source of purchasing economies of scale.
Specialist managers: Managers employed for one area, such as finance or marketing, whom a large business can afford.

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