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

Are you thinking about investing, but are not sure what return it would bring? Or have you made an investment that did not quite bring the desired result? In both cases, it is good to keep track of what marginally diminishing returns mean, to ensure that none of the company's resources take out anyone else.

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Every company has resources to deal with. These resources are called production factors and control how much a company can produce. As an entrepreneur, it is good to have a general understanding of how they affect and are related, in order to be able to plan their investments and to ensure that the investments give the best possible results. There are, of course, a variety of factors and variables that affect a company's output, but generally speaking, it is generally said that there are two basic factors of production 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 production itself, such as machinery, premises and cash. How much labor and capital are then invested in production, respectively, controls how much the company produces of a good or service.

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The benefit of adding another resource

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Adding, or removing, a unit of a factor of production will affect the quantity that the company produces. The change in the quantity of production implied by the changing factor is called marginal product. For example, the marginal product of labor is the change in the quantity of production that the increase or decrease of a worker would result; all that most often companies strive to increase their capacity, which is why one chooses to increase either the labor or capital of the company. Increasing a factor of production will in most cases lead to increased utility for the company. However, if one factor of production continues to increase, while keeping the others constant, it will in the long run lead to a slowdown in the rate of production. The result is then 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 yields marginally diminishing returns.

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Marginally diminishing returns are something you should consider when you intend to invest, as it 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 each investment you make in the company. But it is good to keep in mind how an investment that adds a factor of production to your company can affect other factors. Let's take a hair salon to exemplify this. A hair salon that has four hairdressing chairs, but only one hairdresser, the marginal rate of return will be the same for each additional hired hairdresser up to the four chairs being filled. If the salon employs a fifth hairdresser, the marginal return for them will be less than for hairdressers 2—4. The fifth hairdresser will still provide some increase in production as he can do other tasks and cover for the rest when they have lunch or are sick. However, since there is no barber chair for him to use, the production increase will be less than it was when the salon employed the other hairdressers. Does the salon then continue to employ hairdressers without investing in more hairdressing chairs or a larger venue it will eventually come to a point where production actually drops. Should they, on the other hand, invest in an additional barber 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 good to have an understanding of how the company's resources interact with each other. If you plan to expand, you can expect that it will require investments in both labor and capital, to have the desired effect on the company's output. And if you feel that a recent investment has not quite yielded the result you had hoped for, it may be that the marginal product of the resource you invested in has shifted to being waning and that you need to balance up by investing in any other of the company's production factors with. Being aware of marginally diminishing returns can therefore help you plan your investments, identify the needs of your business, and subsequently make decisions that will allow you to get the maximum return on your investment.

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Does your company need help with financing?

Froda was founded in 2015 with a clear idea — to give SMEs 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 digitising the process, we have made it possible to help more companies with tailored financing according to their unique business and its needs. A smarter business loan, simply.

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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 supervised by Finansinspektionen (FI).