Tue, 10 May 2005

The Law of Returns

Whenever you create something, it requires a mix of inputs. Perhaps you're just whittling a stick into a shape. You'll need a stick and a knife, but you'll also need a person's time. Some combination of sticks, knives, and time will generate the most shaped sticks. That's obvious for something simple. Try creating a pencil. There are hundreds of steps involved requiring at least seven inputs: brass and rubber for the eraser, wood, graphite, glue, and paint for the pencil, plus varying amounts of labor.

These inputs do not come in infinitely varying quantities. Labor only comes in one-person chunks. You can hire people part-time of course, but they need to be trained. Wood comes in some definite length, width, and height related to the size tree it came from. Glue and paint come in pots. Graphite is malleable and is shaped to fit the size pencil being made. It would seem to be an exception, but no doubt you have to buy graphite in certain discrete amounts, e.g. a ton at a time.

Everyone is familiar with the fact that hot dogs come ten to a package, but hot dog buns come just eight to a package. These are the inputs to a hot dog. You can make yourself one hot dog, but you'll end up with nine dogs and seven buns. Another one gets you eight dogs and six buns. Keep going and you'll have two dogs left over. Optimal mix is forty hot dogs: four packages of dogs, and five packages of buns.

This implies that the larger the enterprise, the easier time it will have balancing its inputs. The larger the enterprise, however, the larger its communication and coordination costs. Bigness has its advantages pushing companies larger and its disadvantages pushing them smaller.

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