Diseconomies of scale: when a bigger team costs more

Key takeaways

Diseconomies of scale occur when a business grows and its cost per unit of output rises instead of falling. In small businesses the cause is usually coordination: more people need more meetings, more management and more internal communication. Adding every function in-house speeds this up.

• A team of 5 has 10 working relationships; a team of 15 has 105.
• Management layers appear at around 8 to 10 direct reports.
• Support headcount tends to grow faster than revenue.
• Buying in non-core capacity keeps the core team small and fast.

What are diseconomies of scale?

Diseconomies of scale are the increases in average cost that appear when an organisation grows beyond the size it can coordinate efficiently. They are the opposite of economies of scale. For a small business they rarely come from factories or logistics; they come from people needing to coordinate with more people.

• The hidden costs of doing everything in-house
• What are hidden costs in a business?

Why does a bigger team cost more per person?

A bigger team costs more per person because communication paths grow faster than headcount. Five people have 10 possible one-to-one relationships. Fifteen people have 105. Each new hire adds meetings, handovers and decisions that involve more people, and at some point a manager is needed whose time produces no direct output.

• The management time cost of an in-house team

What are the warning signs?

The warning signs are measurable. Check them once a year as headcount rises.

• Revenue per employee is falling.
• Support staff are growing faster than fee earners or sales.
• Decisions that took a day now take a week.
• Meetings fill more than a quarter of managers' time.
• New hires take longer to become productive.

• Direct vs indirect costs: what small businesses miss

How does doing everything in-house make it worse?

Every function brought in-house adds people who need managing, equipping and covering, in an area where the business has no depth. A 20-person firm with its own one-person IT, HR, marketing and finance functions has four specialisms to supervise without the knowledge to supervise them.

• The one-person department: risks and hidden costs
• Core vs non-core activities: what to keep in-house

When do economies of scale still apply?

Economies of scale still apply to the core work a business does repeatedly. A team that processes the same type of job in volume gets faster and cheaper per job. The goal is scale in the core and bought-in capacity around it, not a small team in every function.

• When is in-house cheaper than outsourcing?

How do you measure it in your own business?

Measure three ratios each year and compare them with your own history. Revenue per employee shows whether output is keeping pace with headcount. The ratio of support staff to customer-facing or fee-earning staff shows where growth is going. Management hours as a share of total hours shows the coordination load.

• Revenue per employee: turnover divided by average headcount.
• Support ratio: support roles divided by delivery roles.
• Coordination share: hours in internal meetings and supervision divided by total hours.

What does the extra coordination cost in pounds?

Coordination cost is easy to estimate. If 15 people each spend 3 hours a week in internal meetings and handovers, that is 45 hours a week. At an average loaded cost of £23.20 an hour, it comes to about £48,000 a year. Some of that time is necessary. The question is how much of it exists only because functions were added that need coordinating.

What are the alternatives to adding headcount?

There are four alternatives to hiring for every new need, and most growing firms use a mix.

• Stop: drop work that no longer earns its place.
• Simplify: standardise the process so it needs less coordination.
• Buy: use a provider for non-core functions and pay for output.
• Specialise: let the core team do more of what it is best at.

• Delegate vs outsource: which should you choose?
• How to reduce hidden costs in a business
• How to run a cost review in a small business

What does this look like in practice?

A pattern we see in firms growing from 10 to 25 people: turnover doubles and profit stays flat. The extra margin has gone on an office manager, a marketing assistant, an IT contractor and a second layer of supervision. None was a bad hire. Together they changed the cost structure.

• See client work
• BPO Solutions for UK businesses

Checklist: grow without diseconomies

Review these before each new support hire.

• Track revenue per employee each quarter.
• Ask whether the role is core or support.
• Check whether the work fills a full-time role.
• Consider buying the capacity instead.
• Limit direct reports to what one manager can handle.
• Document processes before adding people to them.

• The hidden cost audit: score your business in an hour

Next step

Tell us your headcount by function and how it has changed over two years. We will show where coordination cost is building in a 30-minute call.