Doubling your company's output doesn't guarantee that you double your profits. In economics, the law of increasing costs says that if you double or triple production, your production costs may go up more than two or three times. This is also known as the law of diminishing returns.
TL;DR (Too Long; Didn't Read)
The law of increasing costs says that as production increases, it eventually becomes less efficient. For example, if increasing production requires your staff to put in overtime, the labor costs on each extra item will go up. If you change your methods of production, you may be able to work around the law.
The Law of Increasing Costs
Suppose your company introduces a new product, and it's a hit. You're making 100 widgets a week, but the market could easily support more. If you double, triple or quadruple production and people keep buying, it might seem like profits will go up two, three or four times.
However, the law of increasing costs says that as you ramp up production, costs may increase faster than your output does. Instead of 50 cents per item, production costs go up to, say, 75%, cutting into your profit. There are many ways this can happen.
- The supply of raw materials is limited. As you buy more materials to boost production, the scarcity makes the price go up.
- When you open your factory, you aren't using the equipment or your workforce to full capacity, so it's cost efficient to increase your output. When you max out your current capacity, you may have to pay your workers overtime or invest in new machines.
- If you have to divert resources from one project or product line to another, they may not be used as effectively.
- If you increase staff, this can initially increase your company's output. As you start to run out of raw materials or work, the productivity gains from each additional worker go down but the cost of hiring remains the same.
The Law in Action
The law of increasing costs only kicks in above a certain level. Suppose you open a bakery, and initially, the daily demand for bread is lower than the amount of bread you can bake. If demand increases, you can bake more bread without a spike in cost per loaf.
Once you reach full capacity, though, it gets more complicated. If, say, you hire a baker who can make an added 20 loaves a day but the demand is only for seven or eight, your employee costs per loaf will increase.
Economists have figured out that it's possible to translate the law of increasing costs into a graph. It's different for each business, but it should be possible to calculate the point at which increasing productivity would trigger the law of diminishing returns.
Do Returns Always Diminish?
There are situations where the law of increasing costs doesn't hold true. Underlying the law is the assumption that other than increasing output, everything else stays the same. If you change your method of production, you may be able to work around the risk of diminishing returns.
For example, suppose you're dealing with a finite supply of raw material. Increasing productivity creates a shortage, and the price goes up, increasing your costs. However, if you can find a substitute for the original material, then the law of increasing costs may not kick in.
Similarly, if you're able to update your methods of production to make them more efficient, you may be able to push the point of increasing costs further down the road, keeping your business much more profitable. The old-time economists who formulated the law of diminishing returns didn't anticipate the radical changes in technology that have become possible since then.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com