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Back in the DOS days, when data needed to be saved to the hard drive it would be saved in the very first available space on the disk, regardless of the size of that space. So if you had a 1000 kilobyte file and the first available disk space was a mere 2 kilobytes, 2 kilobytes of the file would be stuck there and the rest elsewhere. This would quickly lead to heavy disk fragmentation as all the files wound up scattered around the disk in tiny little pieces.
Starting with Windows 95 things were done a bit differently. Windows has a certain amount of free space that it looks for, called the contiguous file allocation size. The default value is 512 kilobytes. So now if you have a 1000 kilobyte file to be saved, Windows will search the disk looking for the first 512 kilobyte or larger block of free space. Now your 1000 kilobyte file might only get chopped into only two segments instead of hundreds. Only when Windows can no longer find a 512 kilobyte block of free space on the disk does it revert back to the DOS method.
So the file allocation size tweak allows you to change the amount of free space that Windows looks for when saving data. Like most other settings, there's a balancing act. If you set the allocation to a smaller number you will get a more efficient use of disk space, much like how sand fills a glass more efficiently than marbles would. However, this will lead to more disk fragmentation. Setting the allocation size to a larger number will minimize disk fragmentation, but at the cost of less efficient use of disk space.
Considering the size of modern hard drives it makes more sense to lean toward a larger allocation size, since space is generally not as in-demand as performance. However, if you have a small drive in a relatively fast computer, then perhaps space would be more of an issue than performance and a smaller allocation size might be a benefit.
For more information on disk fragmentation see the Disk Defragmenter help article.