Many business leaders believe that scale is an answer to inefficiency or poor production, the idea being that a business may be inefficient at a given scale but can unlock ‘scale efficiencies’ as it grows larger and can spread fixed costs across a larger platform. While scale can improve productivity, it is worth noting that increasing one particular factor of production does not always increase output. Economists refer to this idea as diminishing marginal returns.
What are diminishing returns?
The law of diminishing returns states that in a productive process, adding in more of a single factor of production results in decreasing per unit returns. In other words, increasing one factor of production several times results in a smaller increase in production each time. As total input increases following an increase in just one factor of production, the total output as a proportion of the total inputs decreases. Essentially, output responds poorly to increasing one particular input.
A classic example of diminishing returns is increasing labour inputs on a factory floor that is already full of people; having enough staff is important to keep the factory running smoothly, but at some point, increasing the number of workers is likely to result in smaller and smaller increases in production. As staff numbers increase, staff are likely to get in each other’s way or (particularly where staff take on specialised roles) have to wait to carry out their allocated task.
Diminishing returns is also an important concept in brewery inventory management. For a business that is closely managing grain to glass yield, it is important to optimise factor inputs, taking into account, of course, the need to vary ingredient mixes to achieve innovative flavours. Beyond a certain point, adding more grain to the mash tun is unlikely to improve the wort.
The law of diminishing returns does not prove that adding more of a factor will decrease production. This situation (known as negative returns) can be surprisingly common, particularly in a situation where adding one factor input beyond a certain point can slow production down or reduce yield.
How do diminishing returns affect product costs?
The price that your business charges will usually reflect your average total cost of production and, perhaps more relevantly, the average cost of goods actually sold. Average total cost is the total production cost spread across the total number of units produced. Increasing one or several factors of production even where returns are diminishing will increase your average total cost which, in turn, is likely to increase the cost of goods sold. To compensate for this increase in cost, you may need to increase price levels, noting, of course, that this is likely to reduce sales volumes.
Increasing inputs is not necessarily a bad thing particularly where all inputs (plant and machinery, labour and raw materials) are being increased together to increase total production. The key point of diminishing returns is simply, at the margins, increasing one input will only have a modest impact on production and is not a substitute for increasing other inputs or solving other problems in your business.Topics: business costs, diminishing returns