Diminishing Returns

Total costs in a business are composed of fixed and variable costs. These costs are attributable to the costs for fixed and variable inputs. The total cost function for most businesses is non-linear, as costs are subject to the law of diminishing returns. That is, as a firm increases its use of one factor of production while others remain constant, the output will decrease after a certain point.

For example, consider the two most basic and common inputs for most firms: labour and capital. Labour is a variable cost in the short-run – the quantity of labour employed will vary according to a firm’s output. Other short-run variable costs include raw materials and energy, Capital, in contrast, is a fixed factor in the short-run – firms cannot readily adjust the size or number of their plants and facilities, etc. As the variable factor (labour) is added to the fixed factor (capital), a firm’s output will rise and then eventually fall. It will fall because, at a certain point, there will be too much labour and it will be inefficiently combined with the fixed factor input, causing output to fall.

Unless a firm is going to eliminate all of its fixed costs, variable costs usually have the greatest potential for cost reduction in a firm. Lean production methods can allow a firm to reduce the amount of variable input it requires to achieve a given level of output. Using less variable input reduces the costs associated with this category of input.

At Anderson Lyall Consulting Group, we have developed a framework for analyzing, modeling and predicting the impact on profit from using Lean methods to reduce variable costs. While cost reduction is important, it is not the only factor that should be considered : depending on a firm’s situation, increased revenues through higher sales volumes may also be achievable. With any improvement intervention, the focus should always be on impacting a firm’s bottom line, not on using tools or a toolbox. Improvement must always be rooted in economics because firms are profit-maximizing entities.

Stewart Anderson

stewart@andersonlyall.com

www.andersonlyall.com

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