Generally the firm starts with a small scale and it expands gradually. As the firm expands, the economies of large scale are available to the firm, which decreases its average unit cost of production. This process does not continue infinitely because beyond a particular point, any increase in size may prove disadvantageous. The economies of scale will increase the average cost per unit beyond a point. So there is a possibility of a specific point at which the average cost of production will be at the minimum. Any increase or decrease in scale of activity from this point will increase the average cost of production. This ideal point is known s the optimum size of the firm.
Factors Affecting the Optimum Size of the Firm
Following forces determine the optimum size of the firm:
1. Technical Forces
2. Managerial Forces.
3. Financial Forces.
4. Marketing Forces.
5. The forces of risks and fluctuations.
Now each factor is considered in detail as under:
Technical optimum is generally available under large-sized unit. In the larger unit, following technical advantages are available
1. In the larger unit the advantage of division of labor is possible.
2. Effective machine-balancing is possible only large scale activity. Varied machines having different production capacities are balanced in such a way that the idle capacity is either eliminated or reduced to the minimum.
3. Similarly integration of processes is possible only under large unit. Under integration of processes, various processes are combined in such a way that they are reduced to the minimum.
The advantages of division of labor can also be realized in the field of management. A large unit can afford to divide the managerial functions into different sections and departments. Fat-salaried experts can be appointed to head these different sections and departments like production, purchase, sales, financing, accounting, legal advice, correspondence etc. The large organization provides sufficient work to different experts and specialists to tap their abilities in the best interest of the organization. Due to large volume of production, the unit cost contribution of such specialized knowledge is very less. However, division of labor necessitates co-ordination.
Large firms enjoy certain financial advantages as compared to smaller firms. They possess a good credit standing and can raise the long-term and short-term funds easily and economically. Due to their sound financial position and greater profitability, there is always a warm welcome to the issue of shares and debentures. Commercial banks also provide working capital on moderate terms. They command huge assets which can be offered as security. They are in a position to retain greater profits for reinvesting them back in the business.
Sometimes huge financial resources are diverted to less remunerative channels which affect the profitability of the firm adversely. If the firm is engaged in only single line of product, it will expose the firm greatly to business risk. If it depends excessively on borrowed funds (i.e. greater debt-equity ratio), it will be exposed to the financial risk of liquidation. If it depends more on equity capital, it will dilute the controlling interest of original share holders.
Large firms are in a position to tap certain economies advantageously which is attached to bulk buying and selling. In bulk buying they can bargain effectively, can economize in transportation and can avail of the services of an expert. Similarly in bulk selling they can arrange effective distribution channel, employ effective sales forces, advertise effectively, and can use services of experts etc. If it is a multi-product firm, the selling cost per unit will be less because the same salesmen will manage to promote the sales of all products at a time. However, a large firm is sometimes exposed to certain typical unfavorable situations like wrong buying of raw material. This will amount to huge financial losses as it is not easy to rectify the mistake. Similarly under unfavorable business conditions, it shall have to maintain costly distribution machinery and allied costs.
Forces of risk and fluctuations
There always exists a business risk of demand fluctuations. The fluctuations in the demand arise due to four factors:
Ã˜ Changes in taste and fashions
Ã˜ Cyclical occurrence of booms and depression
Ã˜ Secular changes caused by changes in culture
The business risk of demand fluctuations is relatively greater in large firms. Due to huge investment in fixed assets and long-term commitments, they are highly inflexible to the changing conditions. Such business risk will be greater for firm having only single product line. In multi-product units, the production strategy can be developed in such a way that the decline of one product can be compensated by the growth in other product.
Firms intending to attain the optimum size should try to spell out the various types of economies enjoyable by them. They should attempt to arrive at such a size where the advantages of all the factors reduce the average unit cost to the minimum.