Three back rooms, then one bakery: Until last year each of Lena's three shops baked its own bread. Now one central bakery bakes for all three, and each loaf costs less to make.
Before: three back rooms
- Each shop baked its own bread in a cramped back room.
- Three small ovens.
- Three flour deliveries.
- Three sets of bakers starting at four.
Now: one bakery on Mill Lane
- The central bakery, the plan you followed in 1.4.3, bakes for all three shops in one place.
- The shops sell the same 1,200 loaves a day.
- Each loaf costs less to make.
To see why, look at the cost of one loaf, not the whole bill. Take everything the bakery spends in a day and share it out over the loaves it makes (the average cost, or cost per unit):
Average cost per loaf = total cost ÷ number of loaves
When a business grows and its average cost falls, it enjoys economies of scale: the fall in the cost of each unit that comes from operating on a bigger scale.
| Loaves a day | Total cost a day | Average cost per loaf | |
|---|---|---|---|
| Three back rooms | 1,200 | $1,920 | $1,920 ÷ 1,200 = $1.60 |
| Central bakery, three shops | 1,200 | $1,680 | $1,680 ÷ 1,200 = $1.40 |
| Central bakery, six shops (the plan) | 2,400 | $2,760 | $2,760 ÷ 2,400 = $1.15 |
Total cost goes up. Cost per loaf comes down.: Six shops cost more to supply than three: the daily bill rises from $1,680 to $2,760. That is not a problem, because twice as many loaves share it.
Say 'average cost', not 'costs': Economies of scale are about the cost of each unit, never the total. 'Costs fall when a business grows' is wrong as it stands; 'the average cost of each unit falls' is right.
Why it matters: Lena sells every loaf for $3. At $1.60 a loaf she kept $1.40 on each one; at $1.15 she would keep $1.85. She can take the extra as profit, or cut her price to win customers from Goldcrust. The move from back rooms to Mill Lane alone saves $240 a day, about $90,000 a year.
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Across town, Goldcrust plc runs 400 bakeries. A business that big saves money in six different ways.
In 1.1.6 you saw a big competitor sell a loaf for less than Lena could, because it bought flour by the lorry-load. That was one saving. A business as big as Goldcrust has six, and each one comes from its own size.
Savings from inside the business: A saving that comes from the business itself getting bigger is an internal economy of scale. Nobody else has to grow for Goldcrust to get it.
There are six types. Each has a name, and the name is what you learn.
The six internal economies of scale
Buying in bulk (purchasing economies)
Goldcrust buys flour by the lorry-load, so the mill gives it a lower price per bag. When Lena's order doubled for the central bakery, the mill took 10% off her price too.
Bigger, better machines (technical economies)
The Mill Lane oven bakes 600 loaves an hour. Kept busy all night, its cost is shared over thousands of loaves. Goldcrust's automated lines are too costly for any small bakery to fill.
Cheaper money (financial economies)
A bank sees a 400-bakery business as a safer borrower, so Goldcrust pays a lower rate of interest than Lena did on her $400,000 loan. It can also sell shares to raise money.
Advertising spread thin (marketing economies)
A $2 million television advert shared over 400 bakeries is $5,000 each. Lena's $2,000 poster campaign, shared over three shops, costs her far more per loaf sold.
Specialist managers (managerial economies)
Goldcrust can pay a flour buyer, an accountant and a marketing manager, each doing one job well. At Lena's, Lena and Marco still do all of those jobs between them.
Eggs in many baskets (risk-bearing economies)
Goldcrust sells bread, cakes and sandwiches in hundreds of towns. A bad month in one town or for one product is covered by the rest. Lena's three shops share one high street's luck.
Name the type, not the example: 'Goldcrust gets cheaper flour' is an example. 'Purchasing economies' is the type.
Asked to state two types of internal economy of scale, give two names from the six, a few words each. An example on its own does not answer the question.
Every one of the six works the same way: something the business must pay for is shared over more units, or bought more cheaply because the business is big. Either way, the average cost of each loaf falls.
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Twelve shops?: Six shops went well on paper, so Marco sketches twelve. Lena runs the numbers again.
Marco's twelve-shop plan
- 4,800 loaves a day from Mill Lane.
- A second night shift.
- Six new vans.
Lena's numbers
- The bill comes to $6,000 a day.
- Divided by 4,800 loaves, that is $1.25 a loaf.
- That is more than the $1.15 at six shops.
Growth does not cut costs for ever. Past a certain size the business becomes harder to run, and the cost of each unit starts to rise again (diseconomies of scale).
Nothing about the flour or the ovens has got worse. What goes wrong is people: too many of them, too far apart, for two owners to keep in step.
Messages go astray
- Today Lena tells the bakers herself
- At twelve shops her orders pass through shop managers and a night supervisor
- Each handover slows the message or changes it, so a wrong order means a van of wasted bread
Nobody holds it together
- Two owners cannot watch twelve shops and two shifts
- One shop runs out at ten while another bins forty loaves
- Paying extra managers to coordinate is a cost the three-shop bakery never had
People care less
- The nine staff know Lena by name; ninety would not
- A baker who feels like a number works more slowly and leaves sooner
- Hiring and training replacements costs money on every loaf
Decisions wait
- A new recipe needs the managers, then Lena, then Marco
- Layers of approval take weeks
- Meanwhile Goldcrust or a new bakery gets there first
| Loaves a day | Total cost a day | Average cost per loaf | |
|---|---|---|---|
| Central bakery, six shops | 2,400 | $2,760 | $1.15: economies of scale |
| Central bakery, twelve shops | 4,800 | $6,000 | $1.25: diseconomies of scale |
A problem is not yet a diseconomy: 'Communication gets harder' describes a problem. It becomes a diseconomy of scale when you say what it does to cost: wasted loaves, extra managers, staff who leave, so the cost of each unit rises.
Always finish the chain at the average cost.
A town full of bakers: Over five years the town becomes known for bread. Lena's Bakery has not grown at all in that time, but its costs change anyway.
What happens in town
- Goldcrust opens a regional bakery on the ring road.
- Two small bakeries open near the station.
- The mill doubles in size to keep up.
Savings and extra costs can come from outside the business, when the whole industry grows in one area. These are external economies of scale and external diseconomies of scale. The six savings and the twelve-shop problems above come from the business's own growth, so they are internal.
What the busier town gives Lena (external economies)
Trained workers nearby
The local college starts a baking course. Lena hires bakers who already know the job, so she spends less on training each one.
Suppliers close at hand
With more bakeries to serve, the mill buys more wheat from Valley Grain and delivers every morning instead of twice a week. Lena needs less storage and wastes less flour.
Services built for bakers
An oven-repair firm opens in town. A broken oven is fixed the same day, not after a lost night of baking.
Crowding has a price too. When every bakery wants the same streets, the same shops and the same bakers, costs rise for all of them (external diseconomies of scale): high-street rents go up, Goldcrust offers bakers more money so Lena must pay more to keep hers, and the roads fill with delivery vans at seven in the morning.
| Cost per unit falls (economies) | Cost per unit rises (diseconomies) | |
|---|---|---|
| Internal: the business itself grows | Purchasing, technical, financial, marketing, managerial, risk-bearing | Poor communication, weak coordination, lower motivation, slow decisions |
| External: the industry grows in the area | Trained workers, nearby suppliers, specialist services, better roads | Higher rents, higher wages for scarce workers, traffic, dearer local supplies |
Ask what grew: If the business grew, the saving or the cost is internal. If the industry around it grew, it is external.
Lena's cheaper flour at Mill Lane is internal: her order grew. The daily delivery is external: the mill grew because the whole town's bakeries did.
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How this comes up: This topic comes up as short questions, some with a case.
The short questions
- Define the term economies of scale, for two marks.
- State two types of internal economy of scale, for two: names only, from the six.
- Explain one diseconomy of scale that a named business could experience, for two, with a case.
- The case usually shows a business growing fast with few managers or little space.
The two-mark pattern for a diseconomy
- Name the diseconomy and its cause. Poor communication and coordination as the business grows.
- Show it in the case. Twelve shops and two night shifts, run by the same two owners who once ran three.
- Finish at the cost. Wrong orders, wasted loaves and extra managers, so the average cost of each loaf rises.
The trap: stopping before the cost: 'The business will have communication problems' names a problem and stops. The second mark needs the link to cost: because of it, the cost of each unit goes up.
The other half of the trap: a general answer with nothing from the case. Use a number or a name.
Explain one diseconomy of scale that Lena's Bakery Ltd could experience.
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.
When bigger becomes worse
Diseconomies of scale occur when a business gets too big and its average costs start rising instead of falling.
- Communication problems -- in large organisations, messages get lost, distorted or delayed as they pass through many management layers
- Coordination difficulties -- managing thousands of employees across multiple locations is complex. Departments may work at cross-purposes
- Motivation issues -- workers in very large companies may feel like a small cog in a big machine, reducing effort and pride
- Slower decision-making -- too many management layers (bureaucracy) means decisions take longer to make and implement
- Loss of personal touch -- large businesses may lose the close customer relationships and flexibility that small businesses enjoy
Economies of scale = average costs FALL as you grow. Diseconomies of scale = average costs RISE because you have grown too much.
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