Financial Clarity for Entrepreneurs

ZMP: The Drag On Profits

The Law Of Diminishing Returns states that in any system adding more of one factor of production, while holding others constant, will eventually yield declining additional output.  Taken to it’s logical conclusion, additional inputs will eventually lead to zero, or even negative, additional output.  The point at which additional inputs do not result in additional outputs is Zero Marginal Product – ZMP.

ZMP is more than an academic exercise – it has real implications for entrepreneurs.

If we expand the concept of ZMP beyond factors (labor and capital) to include activities (which are bundles of factors) we can begin to see how to apply it to business.  These activities could include items such as geographic expansion, advertising, product features, target markets, back office processes, etc.  Every one of these activities, and scores of others, has a point at which they cease being produce additional returns.

Entrepreneurs Have An Instinctive Feel For ZMP

When it comes to new activities, the entrepreneurs I meet have a feel for the idea that something may not be worthwhile to do.  Comments like: “I don’t now if I’ll get the payoff for adding a new product line.” or “I’m not sure a new sales rep will make sense right now.” are indications the entrepreneur is weighing the costs versus the benefits.

What I don’t see as often is entrepreneurs taking this same approach to the activities their businesses already engage in.  And therein lies the opportunity for profit improvement.

Look For The ZMP and NMP

Eliminating, or cutting back on, the activities that have zero or negative marginal product will result in direct improvement to the bottom line by eliminating costs in excess of any revenue.  And often the entire amount of cost reduction will be added to the bottom line as many ZMP activities are non-revenue-producing back office functions.

A Simple How To

While the goal of eliminating ZMPs is desirable, the process can seem daunting.  Here’s how I go about it with my clients:

Write down the major categories of activities your business engages in: Finding new business (marketing, sales, etc.), Fulfilling customer requirements (delivering product, providing service), and  Keeping the business running (overhead).

For each of these categories list the individual activities that you engage in.  For example:

– Finding new business – newspaper ads, brochures, SEO, PPC, cold calling, CRM, etc.

– Fulfilling customer requirements – ordering product from vendors, warehousing, shipping, travel to customer sites, performing services, etc.

– Keeping the business running – building maintenance, accounting, customer service, management, etc.

From this list of activities, spend a few minutes thinking about which ones might not be pulling their weight.  At this stage you’re using you intuition and your knowledge of the business.  Pick two or three of the most likely candidates.

Take a deeper look into the two or three activities from the previous step.  Gather the expense information, the revenue (if any) and the non-revenue benefits to your business. 

Reflect on the implications of reducing or eliminating any or all of these candidate activities.  If you think there’s a strong chance you’ve identified a ZMP…

Test it out and see what happens.

If you’ve never engaged in this kind of process before, don’t worry too much about making mistakes.  There’s a good bit of low hanging fruit and you stand a good chance of identifying ZMPs.  This is an iterative process – wash, rinse, repeat. 

But keep this in mind, the Law Of Diminishing Returns applies to eliminating ZMPs as well!