Simply put, diminishing returns are when you received a return for something one day and then with time, this amount decreased until a point where the input is no longer viable. This can be seen in multiple situations in life but can also drastically affect business operations for a manufacturer or distributor. Here are some examples of the Law of Diminishing Returns in action.
You leave for work at a certain time each day, taking the same route and find that you are always half an hour early. After work, you have chores to do before you can call it a day and so your day starts when you leave the house and ends when you have finished your chores. You then realise that perhaps you could do your chores when you arrive early, and then still be on time to work. You essentially achieve the same amount and your day has become shorter. You then decide because you are being so productive, you should add in more jobs to complete in the morning. You think this would save you time in the long run, while still make it to work on time.
At first, this goes well, however eventually you start leaving the house a little too late and end up late to work. One day, you are half an hour late to work, having completed all your extra chores. You now have to work half an hour extra to make up the time. So, your day just became half an hour longer. At which point would it have been a good time to stop adding jobs to your morning routine?
Perhaps another example could be that a factory has ended up with an oversupply of raw ingredients that are costing the business to store and should be converted into product as soon as possible. Currently, two employees are busy trying to manufacture the product with a set amount of ten products manufactured per day. The inventory remains at costly levels so you decide to hire two more people to help, each producing ten units per day. Your total product manufactured per day goes up to 40 units. Still, you have an excess and so you employ more people. After a week, the inventory has diminished so much so there is only enough for each person to make five units a day. This means the return on each employee hour that you are paying for has now diminished with time while all other variables have remained constant.
A third example may be that you purchase some meat in bulk to make five meals. Instead you make two meals and freeze the rest. A week later, you remember you have the frozen meat in the freezer and wish to make those extra three meals. The latter three meals now cost more than the first two as they now have the cost of a week’s worth of freezer electricity included in the cost. The return on your initial investment has just decreased because the price of the meat has an added electricity component.
What are the key takeaways?
As with the previous examples, when the Law of Diminishing Returns is applied to manufacturing or distribution, it usually signifies an issue with inventory management, production and sales. Whenever there is too much inventory stock on hand, there is a cost to the company that impacts directly on the profit: the return is less. This may be in the form of production line adjustments or added storage and insurance costs. Sometimes, there are other reasons to hold inventory but these need to be balanced with the costs involved and the impact it has on the profits.Topics: inventory cost, inventory management