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What is productivity and how can it be increased?
HomeStrategyWhat is productivity and how can it be increased?
What is productivity and how can it be increased?
Every company wants to raise its productivity. We all want to raise our personal productivity. Most businesses understand the importance of productivity and believe they have a plan in place to improve it.
We often assume doing more, producing more or completing more tasks increases our productivity. Despite sitting at the heart of competitive strategy, productivity is often misunderstood. We will define productivity and explain how it should be used to develop a strategy and manage the operations of a business.
Summary: Productivity is the ratio of the total value of output divided by the total input cost. A competitive strategy is a plan to deploy a competitive advantage to increase productivity. A company essentially pursues one of two strategies to increase productivity: focusing on the output value or focusing on the input costs. It is a common mistake to increase productivity in the short-term by focusing on the wrong lever. The task of a COO is to organize the business to raise productivity by maximizing the lever the board has endorsed.
Viviana ran a lemonade stand. It was a basic stand outside her home composed of some old apple boxes. Viviana had the most basic ingredients, no branding, no marketing, and no real understanding of the market.
She was 10 years old after all.
She plucked some lemons from the scrawny-looking lemon tree in her backyard, used tap water and sugar she could find in her pantry. The sugar was so old it had settled into crystalline blocks in the packages and needed to be broken apart with a spoon.
Viviana sold 20 cups in that day for $1 each, but her total cost of running this operation was $10 (her initial investment to set up everything) and there was no opportunity cost. That means if she did anything else with the $10 investment, she could not make more than $20. So, her profit was $10.
Elena’s competing business
Her friend, Elena, a few blocks away decides to do the same thing. Elena is competitive. She is far enough away that she does not impact Viviana’s business in any way. She figures out a way to use riper lemons, so they are naturally sweeter. So, she cuts down on sugar costs. Elena also sells 20 cups at $1 but makes a profit of $14 off a cost base of $8.
She takes the $4 additional profit (versus the $10 Viviana made) and invests in better branding for her cups. Her mom prints out a photo of Elena with her dog and sticks them on the cups. Due to this, her profits rise to $20 the next day.
Elena now has $10 additional profits (versus the $10 Viviana is making) which she invests in better lemons, sparkling San Pellegrino water and setting up another stand.
Her profits rise to $30 a day.
WHAT IS PRODUCTIVITY
Productivity is measured as the output value divided by input cost. There is no other definition of productivity.
It is incorrect to define productivity as the speed at which one completes a task or the number of tasks completed in a year. This is because completing a task quickly that is of little value or completing many tasks that add little value will actually lower productivity. Incurring a significantly higher cost to perform the same task of the same value as a competitor makes one relatively less productive.
Completing just one task over an entire year that is very valuable, relative to the cost of completing the task, means one is very productive. Understanding productivity is important.
It will change your life if you manage your schedule with this definition.
Elena is more productive than Viviana. Her ratio of output value divided by input costs is higher since Elena’s profits are higher off a lower cost base. Assuming Elena wisely invests this tiny additional profit, she will slowly but surely grow and become more and more profitable than Viviana.
Elena starts with changing the branding on the first day.
By the second day, she has changed the lemons, water, and opened a new location.
Imagine the impact of the improvements if she makes 20 such improvements in each month.
This is why productivity matters.
A more productive enterprise generates incrementally more value which can be reinvested in the business to keep growing.
An unproductive enterprise cannot make the necessary investments to grow, fight in the market, introduce new products, block competitors, attract talented employees, etc.
A productive business can do so, and the most productive enterprise can do the most. It will have a major advantage in the market. Crucially, unless Viviana raises her productivity or finds an investor, she will never have sufficient excess cash to compete with Elena. And if she continues to invest in less productive activities, Elena will always overtake her.
And as Elena expands, this becomes harder for Viviana to do. So, coming from behind is hard to do with the same business and/or business model.
There is no such thing as a productive or unproductive business/person. There is no absolute measure of productivity. A business can only be less or more productive relative to some comparison business.
Productivity is always a relative measure.
So, when someone says, “I am very productive,” the response should always be, “Relative to whom?” This is because competition is always between two or more companies/people and if productivity is essential to competing, it can only be measured relative to competitors.
The next question should be, “Why are you comparing yourself to this person/company?”
The principle of productivity applies to people, their lives, and/or careers. In a manner of speaking, we all start with the same cost base, only 24 hours in a day. For example, someone who invests in themselves to study, build relationships, understand clients, etc., will likely earn a higher salary than someone who does not do much of the above and, partly as a result, earns a lower salary.
The high-income earner is typically left with greater cash on hand at the end of the year to further invest in their development. Provided the investments are made wisely, their productivity ratio (total output value divided by total input costs) should rise. That is, their productivity should keep rising.
It is a virtuous cycle that starts with very little results at first.
And they will have incrementally larger and larger excess funds to reinvest to sustain earning higher and higher returns. Yet, it does not matter where you start. Even if you start at the lowest possible career level, as long as you keep earning some excess value and continue wisely reinvesting this excess in your development, you will benefit significantly in the long-term.
It adds up like compounding interest. This is compounding productivity. It’s a term we coined.
Within FIRMSconsulting we follow this philosophy.
COUNTRY / CITY/ REGIONAL PRODUCTIVITY
The very same principle applies to a country. A country is more productive if it is producing incrementally more value relative to other countries. It does not matter how poor the country is. Provided it keeps investing the money wisely to increase productivity (raise output value at a faster rate than input costs relative to competing countries), it will end up with more funds to invest.
And since a country’s total productivity is the aggregate of the productivity of all individual businesses, people, organizations, etc., we can look at one business to explain country productivity.
For example, a factory in a relatively poor country may have a total input cost of $20 to produce one product item and let’s assume it takes a full work day to produce that one item and it takes only one worker to make that item.
Of the $20, let’s assume $13 is labor costs and $7 is all other costs. If we assume the factory is paid $22 for the product, it generates $2 of profits.
Assume $0.50 is invested in better production, $0.50 in R&D, and $0.50 in salaries, the factory takes a $0.50 profit on each product.
That may not seem like much.
Assuming the investments are made wisely, the factory can grow, and two things happen.
First, more people who never earned much start earning this base salary as the factory hires them. They are naturally better off, can consume more, save, and pay taxes.
Second, over time, their salaries increase due to inflation, improvement in skills, and demand for skills. Over 30 to 50 years the changes can be dramatic.
Look at China, Singapore, and South Korea. This is essentially what they did. The key is to be consistent. Countries, like people, sometimes start with unfair disadvantages. Provided you are earning even a little excess cash that can be redeployed and provided it is redeployed into the business wisely, things will improve.
A person, company, and country must be productive. The point of being competitive is to drive up productivity. Without greater productivity, you cannot hope to win. And one cannot be competitive unless one is productive. They reinforce each other.
HOW PRODUCTIVITY DRIVES COMPETITIVE ADVANTAGE
A person, organization, or country must be productive to succeed in the long-term. Competitive advantage is how one will go about being productive. We know that productivity is total output value divided by total input costs.
Competitive advantage is knowing whether the company will mostly differentiate itself on the numerator or denominator and how it will differentiate itself to be productive.
See the two exhibits below from Succeeding as a Management Consulting, 2nd Edition.
Exhibit 1: Productivity Definition – Output lever
Exhibit 2: Productivity Definition – Input lever
There is no other reason to be competitive nor a way to be competitive. You have to do both but truly excel at one. To make this point, let’s step outside the lemonade example and think about the luxury auto sector.
AUTOMOTIVE PRODUCTIVITY EXAMPLE
Let’s assume an Italian sports car maker has a productivity ratio of 2.7.
The formal calculations for productivity can be tedious. They need to factor in opportunity cost, cost of labor, cost of time and many other things. You do not need such a detailed calculation to significantly improve your life or your company’s performance. The most rudimentary calculation is just as valuable. Just knowing the definition is going to add value to the way your work.
The company designs and handmakes cars in Italy. Most of the suppliers are domestic and it launches two new models a year in very limited volumes of about 5,000 total vehicle sales per year across all models.
All the cars are sold in company-owned showrooms or through select prestige online distributors. Broadly speaking, the input costs are driven by five areas:
Handcrafted/assembled (Labour costs)
Manufactured in Italy (Production costs)
Domestic suppliers (Raw materials costs)
Two new models (R&D costs)
Private showrooms (Distribution costs)
The CEO and board want to keep the company in the high-end luxury performance vehicle space. They have defined the positioning of the car as such.
The job of the COO is to maintain this position, but he has quite a lot of freedom in how he manages the production process to achieve this goal.
At the highest level, and in aggregate, a person, organization, or country is either trying to raise productivity by competing primarily by raising output value or lowering input costs. While they will pursue a combination of both, only one lever is the goal that cannot be compromised.
This company is clearly competing on the output value side. They incur steep costs to produce a car that sells for the highest possible output value. That is not to say they ignore input costs, but it is not their point of differentiation. If they have to spend more to manufacture the car, they will do it provided the return is very high as evidenced in the sales price and margin.
This is where it gets interesting. It is possible to raise productivity significantly by hurting the company. That is a counterintuitive yet common strategy and operations mistake made in business.
And this is why it is not sufficient to just raise productivity. One has to raise productivity by pursuing the right competitive strategy.
LET’S LOOK AT SOME OF THE THINGS THE COO COULD DO TO INCREASE PRODUCTIVITY TO ILLUSTRATE THIS POINT
Keep the status quo. That seems plausible since they are very profitable. In this option, he runs everything as is but does it better. The same production line, the same suppliers, same components, same factories, the same configurations, etc.
Focus on the value output lever but change things to improve the car. Leather crafting would move to France for the seats and interior. The design would move to Germany or the UK. He may find some cheaper suppliers and have different dates for the rollout of the sedans and SUVs. He may allow test drives in the showrooms.
The changes are not radical but since Germany, the UK, and France have higher labor costs than Italy, total input costs will rise at a faster rate than output value in the short-term and the productivity ratio drops to 1.9 from 2.7.
However, the positioning remains the same and it is believed in the long-term, as more production moves to France and Germany, the cost savings and better quality reflected in higher prices will lead to rising productivity that will eventually exceed 2.7.
Vault the productivity up to 8.7. Who wouldn’t want that? That is essentially a tripling of productivity. To accomplish this, he would radically lower the costs.
He would shift all design and R&D work to Bulgaria, knowing that the skill level and track record of this new team is inferior to the previous design and R&D team. Assembly would shut down in Italy and move to a less advanced facility in Hungary.
For the components of the car hidden from consumers, they would use suppliers who supply cheaper rival passenger vehicles. SUVs would be rolled out first and sports car rollouts would be pushed back since the latter requires more costly development.
Online sales would be prioritized across all viable platforms versus high-end sites, and glitzy showrooms would close.
Exhibit 3: Options to raise productivity
As you can see, the third option would be a disaster. While productivity rises steeply due to dramatically lowering the cost base, they are no longer making a luxury car and that will lead to a steep and sustainable drop in revenue over time.
The COO is also competing on the cost lever versus the required value lever.
Initially, sales will rise as the volume of cars produced rises in Hungary. Yet, over time, the car will lose its appeal for two reasons.
First, it is no longer exclusive since more people own the car.
Second, customers will notice the poorer quality and cheaper parts.
That will drive down demand and prices. Over time, productivity will suffer and drop far below 2.7. As this example shows, it is not enough to increase productivity in the short-term, one has to do it by focusing on the competitive advantage that is appropriate to the company’s strategy and think how actions will impact productivity in the long-term.
RESOURCES PRODUCTIVITY EXAMPLE
A resources company can be analyzed in the same way. It’s productivity is a ratio of total output value to total input costs. As a commodity business, almost all resources are commodities, a resources company automatically struggles to compete at the output value level.
It can do a few things to increase output value but not much.
First, it can improve mining techniques to extract more valuable ore from a ton of rock. For example, rather than extracting 1 ounce of gold from a ton of rock, it could try to extract 1.2 or 1.5 ounces from the same weight of rock using better crushing and chemistry.
Second, it can operate in commodities with higher prices and lower extraction costs. There is not much else it can do. The prices are set by the market and attempts to manipulate the market generally do not go down well with the U.S. Justice Department.
Exhibit 4: Productivity options resources company
That leaves the total input costs side. Fixed costs tend to be very high in mining. It takes years to bring a mine to the point of production and even highly automated mines have high costs. Even so, this is the only lever the company can manipulate.
It must find ways to lower fixed and variable costs. So, a COO at a resources company will try to raise total output value by increasing production volume and the quality of the ore mined, but much remains out of his control since prices are set in the market. Knowing how much to push the lever requires strong business judgment.
He really needs to focus on driving down costs at all times, even when he is trying to increase production volume.
Exhibit 5: Saudi Oil Productivity Example
Given the cyclical nature of resources, having the lowest cost position is key. And this is hard to achieve. When demand is rising and prices for commodities subsequently surge, companies ignore lowering costs since high prices can mask poor cost containment.
Under pressure to benefit from the higher commodity prices, management typically focuses on output versus cost containment. So as prices climb with demand, companies tend to score big profits but on the back of creeping costs. When prices fall, those with a high-cost base suffer.
It is not easy to quickly lower costs. In fact, as prices fall, demand typically falls, and companies must fight for market share just to stay in business. One way to do this is to charge clients less for the commodity. This is hard to do when you are a high-cost producer but easier to do if you are the lowest-cost producer. The lowest-cost producer can offer prices that are lower than the production costs of competitors but higher than their own production costs.
They, therefore, lower their profit per ton/ounce/barrel but offset this with high market share gains. Eventually, the higher-cost producers close facilities, shut down, or are acquired.
This article is adapted from Succeeding as a Management Consultant, 2nd Edition.
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