Understanding Diminishing Returns

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Diminishing returns is an economic principle that theorises about the relationships between an increase in the number of employees and a reduction in productivity. According to this principle, an increasing number of new employees causes the productivity of another employee to be smaller than the productivity of the previous employee at some point.

Business managers need to understand the principle of diminishing returns, since increasing employee numbers can, counter intuitively, become a detrimental factor affecting inventory management, among other things. In this article, we explain what diminishing returns are and how they may affect your business decisions.


Diminishing returns is also known by other names, including the law of diminishing returns, the principle of diminishing marginal productivity and the law of variable proportions. The principle of diminishing returns originated as early as the mid-1700s, economist Jacques Turgot being one of the first to use the term.

Other early economists such as Robert Malthus and David Ricardo suggested that diminished productivity resulted from a decrease in the quality of input. For example, Riccardo demonstrated how additional labour and capital to a fixed piece of land would successively generate smaller output increases over time.

Later classical economists have suggested that each “unit” of labour is exactly the same, and decreases in productivity – diminishing returns – are caused by a disruption of the entire production process as extra units of labour are added to a set amount of capital.

The Basics

The law of diminishing returns suggests that the addition of a larger amount of one factor of production, while all others remain constant, inevitably yields decreased per-unit incremental returns.

To illustrate, imagine that a factory employs numerous workers to manufacture their products. So long as all other factors of production remain the same, the increase in the number of employees will see each additional worker generating less output than the worker before him. So, as a company employs more workers, each additional worker becomes less productive and provides smaller and smaller returns. If the company continues to employ more and more staff, eventually the factory will become so cramped that the increase in numbers may actually begin to hinder production.

Therefore, in this scenario a company may experience diminishing returns by way of reduced productivity. Adding too many workers can inhibit the efficiency of the production process, thereby reducing productivity. This is a key factor affecting inventory management which managers should take into account when considering employing additional staff members.

Diminishing Returns a Key Factor Affecting Inventory Management

Understanding how the principle of diminishing returns works is important for companies, since increasing production through hiring more staff may end up being counterproductive. Common sense suggests that the more staff you have, the more product you can make and the more you can sell. However, unchecked employment increases may have little effect on productivity, and may even reduce it.

Understanding this as a key factor affecting inventory management is essential for any business manager. The number of employees you hire to do the job can have a huge influence on the way you manage your inventory, especially if or when productivity begins to slow.

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Melanie - Unleashed Software

Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.

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