*This is part four of The Diseconomies of Scale Series which takes a deeper look into why bigger is not always better.
As companies grow, they might be faced with increasing fixed costs to meet projected demand. But what happens when that demand falls through?
Any business will have what is considered fixed costs. These are costs that remain “fixed” or unchanging regardless of what happens within a business. It doesn’t matter if you produce one item or many items (up to a certain point). Fixed costs will be the same. For example, the cost of a factory will most likely be a fixed cost, especially if you are obligated to pay a certain amount of money towards rent or loan payment for that specific factory. Insurance to cover that factory, maintenance costs to keep the factory operating, and property taxes levied against the factory are all fixed costs.
The other costs associated with running a business are considered variable costs. Variable costs are specific to the cost per unit of product or service sold. These would be raw materials, labor costs, and other production costs like utilities.
Now, remember that I said it didn’t matter how many items you produce, but disclaimed that with ‘up to a certain point’. This is where we can see previously earned economies of scale take a significant hit.
Capacity
Capacity refers to the upper most output that is capable of being produced. If a business is managed well, we would assume that at the upper levels of capacity, we have achieved high economies of scale. We are producing each unit at the lowest possible cost.
For example, we will look at a company that has one factory. This factory, even with all proper efficiencies built-in, can only produce up to 50,000 units per year. So, it’s full capacity would be 50,000 units per year. So what happens when demand exceeds 50,000 units in a year? They would simply not be able to meet demand and could be losing out on potential business. They are now faced with the option of expansion. Here is where diseconomies of scales can occur. Management, would most likely try to forecast what that unmet demand was. Say, to their best estimate, they could have produced and sold an additional 40,000 units last year. They decide it is worth to open another factory that can produce up to 50,000 units at full capacity. This factory, introduces new fixed costs into the equation. This will immediately impact previously earned economies of scale, making each new product produced more expensive than they previously had been.
In this example, assuming we keep variable costs ($1.50/unit) constant for both factories, and each factory costs $100,000/year to operate, we would see a rise of overall per unit cost from $3.50 to $3.72.
One factory: (100,000 + (50,000 x 1.5)) / 50,000 = 3.50
Two factories: (200,000 + (90,000 x 1.5)) / 90,000 = 3.72
The situation becomes even worse if our initial projection was overstated and we are only producing an additional 20,000 units at the second factory because demand is not as high as we originally thought. Our overall per unit cost then becomes $4.35.
Understand there is uncertainty with scaling. Scaling comes with inevitable rises in fixed costs that are incremental based on increasing operations capacity.
Potential Solutions
Identify ways to do business in a more variable way. If there is a way to shift fixed costs over to variable costs, you could limit the effect that fixed costs has on profitability as your company expands and contracts based on fluctuating demand. One way to do this is to outsource some of your traditional fixed cost elements, whether it be outsourcing the actual manufacturing or back office functions. The downside to this is that you lose some control over your operations and you are now somewhat at the mercy of your external providers.
Another solution is to grow slow. That is, to not give into initial pressure to expand too quickly. Test the market to understand if there is actual longevity or if you just caught a trendy wave. If the former, you should be able to continue to grow, but if the latter, you might want to reconsider expanding before it eats away at profit and overall equity of the company.
System Tinker 