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What is the law of diminishing returns?

The law of diminishing returns says that each time we do something to receive a benefit, the benefit will be less and less. The best way to think of this is by a simple example. If we are with a small child on a hot summer day and we pass an ice cream stand and buy the child an ice cream cone, it will taste wonderful. A short time later we pass another ice cream stand and buy the child another ice cream cone. This time the cone does not taste as good as the first one. If we continue passing ice cream stands and buying ice cream cones for the child, we will find that the taste of the ice cream gets less and less wonderful with each ice cream cone. Eventually the child will become sick of eating ice cream cones (and may become sick as well) and will not want another one. This is the law of diminishing returns.

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In the world of business there are many applications of the law of diminishing returns. When we make reductions in the scheduled completion date of a project, we receive large reductions at first for relatively small amounts of time, effort, and money. As we continue to reduce the schedule, we will receive smaller reductions in schedule time for the same amount of spent time, effort, and money.

If we buy a piece of maintenance equipment, the benefits received from buying the first piece of equipment are a certain amount. If we are happy with that piece of equipment and buy another piece of the same equipment, the benefits received from the second piece of equipment are less than the benefits received from the first piece of equipment.

If we decide to get married, we receive many benefits from the marriage. If we decide to get married to a second spouse, the benefits received are considerably less than the benefits received from the first marriage . In this case the benefits might be considerably less since in most states bigamy is illegal and we could end up in jail with no spouse at all.

What is a cost improvement curve?

A cost improvement curve is based loosely on the idea of a learning curve. In some contracts, generally large ones, the client may require the vendor to reduce the price of items supplied later in the project to less than the delivery price of earlier items of the project. The application of cost improvement curves borrows heavily from the learning curve theory but is based on somewhat different concepts. In the cost improvement curve it is reasonable to think that even though there is little chance for real learning, the cost of delivering items that are produced later in the project should be less than the cost of producing similar items early in the project.

The rationale for this is that the vendor will learn how to deal better with the customer, the specifications of the project deliverables, and the quality requirements. Although the deliverables of the project are not the same, a certain amount of improvement can be gained with the delivery of each deliverable .

The improvement curve rationale is then put into the contract. The improvement curve specification specifies that the price will be a certain amount for the first quantity of deliverables and will be somewhat lower for the next quantity delivered, and so on. Frequently the price of subsequent items will show a fixed percentage of reduction in price for each doubling of the number of units delivered, which is the relationship with classical learning curves.

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Let us start with classical learning curves. The learning curve originated in the time of Frederick Taylor (1856–1915), many times called the father of industrial engineering and time study in industrial applications, and Henry Ford (1863–1947), the father of the assembly line. Taylor noticed that when workers were given a piece of work to do, the time that it took them to do the work decreased each time they repeated the piece of work.

After a considerable amount of study, Taylor found that the time that it took to do a piece of work decreased by a fixed percentage when the number of times the work was performed was doubled . This means that if it took four minutes to do a certain amount of work the first time, the second time the work was performed, it might take 85 percent of the first time or 3.40 minutes. The fourth time the same work was done, it would take 2.89 minutes, and the eighth time the work was done, it would take 2.46 minutes, and so on. Each time the number of times the work is performed doubles, the time it takes to do one piece of work becomes less by a smaller amount, since it is a fixed percentage of the last doubling of the work. The second time is less than the first, the fourth time is less than the second, the eighth is less than the fourth, and so on. Eventually, after enough doublings, the curve will flatten out and the reduction in time for additional doublings becomes relatively insignificant.

Henry Ford made great use of this information in developing the assembly line. If very short work operations are used, the amount of time that it takes to double the number of times to do the work becomes short as well. What this means is that if we were to design work so that the time interval to do the work is very short, people would come down the learning curve very quickly and reach the flat part of the curve. At this point they could be considered to be fully productive on their work assignment.

What Ford wanted was a way to incorporate new people into his factory with a minimum of training and experience. By making the work tasks very short, people would become proficient at them very quickly. This allowed him to dismiss people who were not working to his standards and replace them easily. Back in the days before unions, people were terminated without the slightest provocation, and it was important to be able to bring in a new person with very little experience or training to learn the job and do the job proficiently as quickly as possible.

Improvement curves (see Figure 3-3) are similar to learning curves in that the fixed percentage reduction of price is applied to each doubling of delivery of the product. The improvement curve is not really based on learning, as was the learning curve. Improvement curves are based on the idea that similar project deliverables will cost more early in the project than they will later in the project.

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Figure 3-3: 70% IMPROVEMENT CURVE

This is rational since the vendor of a multideliverable type of large project will learn how to deal with the customer's requirements as subsequent deliverables are delivered. There will be a certain amount of value engineering that will take place as well, and the vendor's vendors will have improvements as well.

The improvement curve is then a consistent way of recognizing that improvements do occur over time and that they will be significantly larger earlier in the project than they will be later in the project.

An example of the application of improvement curves: An aerospace contractor had a contract to produce a part that had a cost of $1,000 the first time it was made. Because it was the first time the part was made, it could be expected that subsequent parts would be made at a lower cost. It was agreed that a 70 percent improvement curve would be applied.

The cost of parts delivered subsequent to the original unit would be progressively less. These contractually agreed to reductions in cost are shown in the improvement curve plotted in Figure 3-3.

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Newell M.W., Grashina M.N.

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