Problems of growth: diseconomies of scale, communication and overtrading

Diseconomies of scale

Diseconomies of scale are rises in average cost that happen when a business grows beyond a certain size. Causes:

• Coordination: more departments, sites and products are harder to plan and control.
• Communication: more layers of hierarchy and longer chains of command slow messages and distort them.
• Motivation: workers in a huge organisation may feel like a small cog, with little contact with senior managers, leading to lower morale, absenteeism and labour turnover.
• Control: more opportunity for waste and inefficiency to go unnoticed.

Businesses respond by decentralising, creating smaller units or profit centres, and improving communication systems.

Internal communication

Growth often adds layers of management and sites in different places or countries, so communication problems are a particular risk:

• Messages pass through more people, so they are slower and may be changed along the way.
• Information overload: managers receive more than they can act on.
• Different languages, time zones and cultures after an international takeover.
• Departments may develop separate goals and stop sharing information.

The results can include poor decisions, duplicated work, mistakes with customers and lower staff motivation.

Overtrading

Overtrading happens when a business expands too quickly without enough working capital (cash) to fund the expansion. It buys more stock, pays more staff and gives customers credit before the revenue arrives, so it runs out of cash even though it is making sales and may be profitable on paper.

Warning signs: falling current and acid test ratios, a growing overdraft, paying suppliers late.

Remedies: arrange finance before growing (an overdraft facility, a share issue), grow at a planned pace, tighten credit control, use factoring or negotiate longer credit from suppliers.

Worked example

A furniture retailer doubles its number of stores in a year. Sales rise strongly but it cannot pay suppliers on time and its overdraft is at its limit. Explain what is happening.

1. New stores need stock, staff and fittings paid for in advance of revenue.
2. Cash flows out faster than it flows in, so working capital runs short.
3. This is overtrading: the business is growing faster than its cash allows.
4. It needs to slow expansion or raise long-term finance, otherwise suppliers may stop supplying and it could fail despite strong sales.

Answer: Overtrading: rapid growth without enough working capital.

Check yourself

1. Which is the best definition of diseconomies of scale?
   • Increases in average cost as a business grows beyond a certain size
   • Falls in average cost as output increases
   • Increases in total cost as output increases
   • A fall in sales after a merger
   Show answer

   Increases in average cost as a business grows beyond a certain size. Average (unit) cost rises with scale.

2. Why does communication often become harder as a business grows?
   • Employees use more technology
   • Larger firms have fewer managers
   • There are more layers of hierarchy, so messages pass through more people
   • Customers are further away
   Show answer

   There are more layers of hierarchy, so messages pass through more people. Longer chains of command slow and distort messages.

3. Which is a motivational diseconomy of scale?
   • Workers feel remote from senior managers and less valued, so morale falls
   • Bulk-buying discounts increase
   • Interest rates on loans fall
   • Specialist machinery is bought
   Show answer

   Workers feel remote from senior managers and less valued, so morale falls. Alienation lowers motivation and productivity.

4. Overtrading is best described as
   • producing more than customers want to buy
   • selling at a price below cost
   • having too many competitors
   • expanding too quickly without enough working capital
   Show answer

   expanding too quickly without enough working capital. It is a cash problem caused by rapid growth.

5. Which is a warning sign of overtrading?
   • A rising gross profit margin
   • A falling current ratio and a growing overdraft
   • Falling sales
   • Rising labour productivity
   Show answer

   A falling current ratio and a growing overdraft. Liquidity worsens as cash is used up.

6. Which action would most directly help a business that is overtrading?
   • Give customers longer credit periods
   • Open more branches to raise sales
   • Pay suppliers earlier
   • Arrange long-term finance, such as a share issue, before expanding further
   Show answer

   Arrange long-term finance, such as a share issue, before expanding further. It needs more working capital; the others worsen cash flow.

7. Explain why a profitable business can fail because of overtrading.
   Show answer

   Profit is not the same as cash: when growing fast the business pays for stock, wages and expansion before customers pay, so it can run out of cash and be unable to pay its bills, even though its sales are profitable.. Profit is not cash; timing of payments; consequence.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (XBS11/YBS11, 2018), Unit 3 Business decisions and strategy and Appendices 6, 7 and 9

Last updated 8 November 2026. Spotted a mistake? Tell us.