Why several investments may need to be made at the same time

Are you thinking about investing, but unsure of the return? Or have you made an investment that didn't quite deliver the desired results? In either case, it's good to know what marginally diminishing returns mean, to make sure that one of your company's resources doesn't take out another.

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Every business has resources to contend with. These resources are called production factors and determine how much a company can produce. As an entrepreneur, it is good to have a general understanding of how they affect and interrelate, to be able to plan your investments and for the investments to provide the best possible outcome. There are, of course, a number of factors and variables that affect a company's production, but in general it is usually said that there are two basic production factors that apply regardless of what the company produces - labor and capital. Labor is the employees of the company and what they contribute to production, while capital is what is used in the actual production, such as machinery, premises and cash. How much labor and capital are then invested in production determines how much the firm produces of a good or service.

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The benefits of adding an additional resource

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Adding or removing a unit of a factor of production will affect the quantity produced by the firm. The change in the quantity of output resulting from the change in the factor is called the marginal product. For example, the marginal product of labor is the change in the quantity of output that would result from the increase or decrease of one worker. More often than not, firms seek to increase their capacity, so they choose to increase either the firm's labour or capital. Increasing a factor of production will, in most cases, lead to increased utility for the firm. However, if one factor of production continues to increase, while the others are held constant, it will eventually lead to a decline in the rate of production. The result will be that the benefit, or return, of adding an additional unit of the same factor of production will be less than the previous one. That is, production will yield marginally diminishing returns.

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Marginal diminishing returns are something you should consider when thinking about investing, as they can have an impact on whether or not you get the maximum benefit from the investment. This does not mean that you need to do a lot of economic analysis before every investment you make in the company. It means that it is good to keep in mind how an investment that adds one factor of production to your business may affect other factors. Let's take a hairdressing salon as an example. A hairdressing salon that has four hairdressing chairs, but only one hairdresser, the marginal rate of return will be the same for each additional hairdresser employed until the four chairs are filled. If the salon hires a fifth hairdresser, the marginal return for this hairdresser will be less than for hairdressers 2 to 4. The fifth hairdresser will still provide some increase in output as he can do other tasks and cover for the others when they have lunch or are sick. However, as there is no barber chair for this person to use, the increase in production will be less than it was when the salon hired the other hairdressers. If the salon then continues to employ hairdressers without investing in more hairdressing chairs or a larger space, it will eventually reach a point where production actually drops. On the other hand, if they were to invest in an additional chair for each hairdresser hired, the marginal rate of return would be constant.

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How it can affect your investments

The reality is of course more complex than the example above, but the principle can be applied to most investment situations your company may face. When investing, it is helpful to have an understanding of how your company's resources interact with each other. If you are planning to expand, you can expect that investments in both labor and capital will be required to have the desired effect on your company's output. And if you feel that a recent investment has not quite yielded the results you had hoped for, it may be that the marginal product of the resource you invested in has become diminishing and that you need to balance it out by investing in another of the firm's factors of production as well. Knowing about marginal diminishing returns can therefore help you to plan your investments, identify the needs of your business and then make decisions that will allow you to maximize the return on your investment.

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Does your company need help with financing?

Froda was founded in 2015 with a clear idea - give small and medium-sized businesses the same opportunities to grow as large ones. With our service, we make it easy and affordable for entrepreneurs to invest in their ideas. By digitizing the process, we've made it possible to help more businesses with financing tailored to their unique business and its needs. A smarter business loan, simply put.

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Today, we are one of Sweden's fastest growing fintech companies and have helped more than 15,000 companies grow. Froda is a credit institution covered by the state deposit guarantee and is under the supervision of Finansinspektionen (FI).