Economies, Diseconomies and Average Unit Costs

A business buying large quantities of raw materials or components may receive a bulk-purchase discount from its supplier. The materials used in each finished item then cost less, reducing average unit cost.

For example, a growing bakery may order much larger quantities of flour. If its supplier offers a lower price per kilogram for these larger orders, the flour needed for each loaf becomes cheaper. The saving comes from the lower price per kilogram, not merely from buying more flour.

Large food retailers can use their buying power when negotiating with farmers and other suppliers. A small independent shop may not purchase enough to secure the same discounts. However, a discount is not automatic: it depends on what suppliers are willing to offer.

Technical economies: more efficient machinery and technology

Operating on a larger scale can make investment in expensive, efficient machinery worthwhile. Technical economies of scale arise when this machinery or technology reduces the average cost of production.

For example, an automated production machine may produce more items in the same time than a less advanced machine. Its purchase cost can be spread across a large output, while greater efficiency reduces the resources needed per item. A small business producing only a few items may not generate enough output to justify the investment.

Technology can also improve operations beyond the factory floor. A supermarket chain such as Tesco or Sainsbury’s can invest in sophisticated stock-control technology that may not be cost-effective for a small corner shop.

Lower unit costs give a business choices. It could keep its selling price unchanged and earn more profit per item, or reduce its price to compete more strongly. The financial benefit depends on demand as well as costs: producing more is not useful if the extra output cannot be sold.

When growth creates diseconomies of scale

Growth does not guarantee continuing cost savings. Diseconomies of scale occur when a business becomes less efficient as it grows, causing average unit cost to rise.

Poor communication: a larger business may have more management layers between senior managers and employees. Messages can take longer to arrive or become misunderstood. Incorrect instructions may lead to faulty products, wasted materials or work that has to be repeated, increasing costs per item.

Coordination difficulties: more departments, employees and sites must work together. For example, if purchasing does not arrange for materials to arrive when production needs them, workers and machinery may stand idle. The business still pays costs such as wages but produces fewer items during that time, raising average unit cost.

Reduced staff motivation: employees may have less contact with managers and feel that their contribution is less valued. If motivation falls, they may produce less in the same working time. Wage costs are then spread over fewer items, increasing the cost per item.

These are risks, not inevitable outcomes. Clear communication and effective coordination can help a growing business retain its cost advantages. Whether expansion is worthwhile depends partly on whether the savings from purchasing and technology outweigh the inefficiencies of managing a larger organisation.

Calculating and interpreting the impact of expansion

Consider this bakery example. Each row shows production and costs for one week. Total costs include all fixed and variable costs for that week.

At an output of 2,000 loaves, the calculation is:

$$\text{Average unit cost} = \frac{£9{,}000}{2{,}000} = £4.50\text{ per loaf}$$

From 1,000 to 2,000 loaves, total weekly costs rise, but average unit cost falls from £6.00 to £4.50. This is the pattern associated with economies of scale: output has increased faster than total costs.

From 2,000 to 3,000 loaves, average unit cost rises to £5.00. This is the pattern associated with diseconomies of scale. If selling price stays unchanged, profit per loaf falls by £0.50 compared with the 2,000-loaf level.

The figures show where unit costs improve or worsen, but they do not identify the cause by themselves. Managers would need to investigate purchasing prices, machinery efficiency, communication, coordination and staff motivation before deciding how to respond. Nor does the higher unit cost alone prove that total profit has fallen: the number of loaves sold also matters.

• Purchasing: larger orders → bulk discounts → lower material cost per item.
• Technical: efficient machinery or technology → greater efficiency and investment spread over more output → lower cost per item.

Total costs may still rise. Lower unit costs allow lower prices or higher profit per item.

Diseconomies of scale

Increasing scale → higher average unit cost.

• Poor communication → delays, mistakes and waste.
• Coordination difficulties → idle resources and disrupted production.
• Reduced motivation → less output from the same working time.

Interpreting growth

Compare unit costs before and after expansion, not just total costs. At an unchanged selling price, higher unit costs reduce profit per item. Judge expansion by whether its cost savings outweigh its inefficiencies; total profit also depends on sales.