What it means
Every business has a lever it can pull harder, such as marketing spend, sales calls, fertiliser on a field or hours of overtime. At first the lever works well, because the best opportunities are used up first.
After a point, each extra unit pulled adds a smaller benefit than the one before. The law is closely related to diminishing marginal productivity, but it is used more widely.
Where the productivity version focuses on factory inputs such as labour, the returns version is often applied to any spending where the extra return, in output, leads or profit, can be measured. The finance angle is the comparison of the marginal return with the marginal cost.
As long as the extra gain from the next dollar exceeds that dollar, spending more adds value. When the extra gain falls below the cost, the spending should stop.
This is why averages can mislead. A campaign may show a respectable average cost per lead across the whole budget while the last tranche of spending is producing leads at a price that loses money.
Looking at the marginal figure, rather than the average, reveals where the budget should be capped. The nuance to remember is that the law holds with a fixed constraint behind it, such as a limited audience, one machine or one acre of land.
If the constraint is removed, for example by finding a new advertising channel, returns can recover. That is why diminishing returns are a signal to look for a new lever rather than to push the old one harder.
In practice
Real-world examples.
Example
A farmer applies more fertiliser to a field each season. The first bags lift the harvest noticeably, the next bags add a little, and the last bags add almost nothing because the soil is already saturated. The farm accountant sets the fertiliser budget where the extra crop value equals the extra cost.
Example
A consulting firm lets its best partner take on more clients each quarter. Income per additional client falls because the partner has less time for each, and the quality of advice slips. The managing partner decides to hire a deputy instead of loading more onto the same person.
Example
A restaurant adds more tables to a fixed dining room to boost covers. The first three tables raise nightly sales sharply, but with ten more the room is cramped, service slows and customers leave earlier unhappy. The owner stops adding tables at the point where extra sales no longer cover the cost of lost goodwill.
Formula
Calculation
Marginal cost per extra unit of return = extra spend / extra return
A company spends in steps of $10,000 on online advertising and records total leads of 500, 900, 1,150, 1,350 and 1,450 after each step. The extra leads from each step are 500, 400, 250, 200 and 100. The cost of each additional lead is $10,000 / 500 = $20, then $10,000 / 400 = $25, then $10,000 / 250 = $40, then $10,000 / 200 = $50, then $10,000 / 100 = $100. If each lead is worth $45 in gross margin, the third step ($40 per lead) is still worth taking, but the fourth ($50) and fifth ($100) lose money, so the sensible budget is $30,000.Case study
Seen in the real world.
Meridian Pet Supplies is an illustrative, fictional online retailer that doubled its search advertising budget from $40,000 to $80,000 a month after a strong quarter. Sales rose from $400,000 to $520,000, so the extra $40,000 of spending produced an extra $120,000 of revenue.
When the budget went up again to $120,000, monthly sales only reached $560,000, an extra $40,000 of revenue for another $40,000 of spend. With a gross margin of 30%, that final step earned just $12,000 of gross profit against $40,000 of cost. The finance manager used these figures to cap search spending at the earlier level, and the illustrative lesson is that growth that looks healthy in total can be unprofitable at the margin.
Watch out
Common mistakes.
- Judging a spending decision on the average return rather than the marginal return, which hides the point where extra spending stops paying for itself.
- Assuming diminishing returns mean the activity has failed, when it simply means the next unit is less productive than the last.
- Believing the law is permanent, when finding a new channel, process or machine can reset the curve.
Questions
People also ask.
Is diminishing marginal return the same as negative returns?
No. Returns are diminishing when each extra unit adds less than the previous one, but they are negative only when an extra unit reduces the total.
Does the law apply to investing?
Broadly yes, in the sense that a strategy has a limited capacity, so putting in ever more money tends to earn a lower extra return on each additional dollar.
How do I find the right stopping point?
Calculate the marginal return of each additional step and compare it with the cost of that step, stopping when the marginal return no longer exceeds the cost.
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