Total Factor Productivity: A Two Dimensional Matrix

Total Factor Productivity is an important concept in economics. It connotes the fact that factors other than capital and labour contribute to the output of an economic system. Total Factor Productivity (TFP) is the portion of output not explained by the amounts of inputs used in production. As such, its level is determined by the amount of inputs used in production, and by how efficiently and intensely the inputs are utilized in production. TFP growth is usually measured by the Solow Residual. An equation of Cobb-Douglas form is used to explain total output as a function of total factor productivity and the capital and labour productivity. While some economists believe that TFP is a key driver of economic growth, others believe that it is subject to annual variations and suffers from imperfect measurements.

The Conference Board in its Productivity Brief 2015 suggests that TFP growth is the result of a combination of improvements in efficiency (meaning, fewer inputs are needed for a given output) as well as technology and innovation (meaning, more output is achieved from a given input). It considers financial capital in terms of machinery, equipment and structures. It considers human capital in terms of skills and management competencies. Adding technology and innovation to this capital combination, it expects increase in output per worker hour. If jobs expand together with higher productivity there would be a growth in total output. The data presented by The Conference Board present a declining or flat growth situation in TFP, across the developed markets as well as emerging markets. It concludes that unless productivity growth picks up, key indicators of economic health would not pick up, affecting societal welfare.

Macro or micro?

National economic management is in the hands of policy makers in the Governments. They typically attempt to draw up policies at macro level that stimulate and attract national and international investments and support expansion of micro-level industrial, business and economic activity. Industries and businesses do require policy stimulation and support but probably there is a lot that can happen at micro level itself through higher productivity. The trickle-down effect of policy stimulation and bottom-up impact of productivity improvement would be synergistic. In fact, without the latter (of productivity improvement) inflow of capital arising from policy stimulation would cause further exacerbation in productivity scenario. Without productivity drivers in the economy flow of capital, even if stimulated by policy framework, could eventually ebb. The linkages between macro and micro are as important as discrete macro and micro improvements. This is particularly important for India given the legacy of socialist policies, inevitability of mixed economy and importance of domestic and foreign investments.

Industry gets organized in public sector (or Government owned sector), private sector (or citizens, individually or collectively, and in joint sector (Government and people ownership). There is also the concept of public-private partnership. Although all of these are organizational entities, they are considered to vary significantly in respect of productivity practices, which are in turn linked to management approaches. The common view is that public sector is sought to be influenced by the Governments while private sector seeks to influence the Governments. The former, it is felt in some quarters, is a convenient instrument for economic stimulation and job creation while, likewise in some quarters, the latter is arraigned as an opportunistic instrument for market capitalization and rent seeking. The joint sector and public-private partnerships are stuck in the middle, often gridlocked with ownership differences. The polemical perceptions should not be allowed to influence a genuine focus on total factor productivity which is essential for any organization (and economy), regardless of organizational nature or ownership (or economic policies).

Pan-organizational

Within the limits of what is humanly possible and within the perspectives of work-life balance, the greater the output that is achieved from certain inputs, productivity movement is supported. This, in turn, helps economic growth. This is applicable for all organizations. The totality with which a policy issue is considered and the speed with which the policy thought is converted into executive action defines productivity of national governance. The comprehensiveness with all inputs are aggregated and the competitiveness with which the aggregate is converted into a product or service for the customer defines the productivity of industrial management. The productivity of governance is impacted by certain democratic structures and processes, be it in US and Japan or India and China. The productivity of industry may be impacted by policy framework but is largely within organizational control.

Unfortunately, over the last several years, productivity as a concept is overshadowed by competitiveness. Individual and system productivities are considered to be of lower significance than businesses competitiveness; and competitiveness is defined in terms of either product differentiation or cost leadership. The emergence of concepts of competitiveness is welcome but the dilution of focus on productivity is not so helpful. Productivity has a strong connotation of intrinsic efficiency improvement in an absolute sense while competitiveness has a connotation of getting better of another in a relative manner. While the concept of competitiveness may be helpful at an overall business level, organizational management has to continue to be focused on productivity. There have, of course, been criticisms of productivity that it lacks a business perspective and could lead to sub-optimization of the total system even if the sub-systems are productive. One can safely premise, however, that without productivity there cannot be competitiveness.

Productivity matrix

Productivity is all about efficiency and effectiveness. The concept itself needs to be deployed efficiently and effectively for the concept to deliver results in today’s scenario. True and authentic productivity analysis becomes possible when it is viewed as a matrix of value chain management and total factor deployment. A worker being productive on a manufacturing line in terms of components produced in a given unit of time would not help in the system productivity if the product is not packaged well or is not transported safely and delivered on time. Managing the value chain on an end to end basis would be of no avail if factors of productivity in each constituent are not taken into account to develop effective input-output metrics. Some firms view this need (if at all they recognize the concept) as more relevant for integrated companies which control all activities of the value chain. Firms also consider outsourced activities to be adequately measured in terms of productivity just through their cost competitiveness.

The fact, however, is that productivity matrix is relevant for all activities and for all firms. A highly research oriented innovation-dependent firm as well as an operations oriented manufacturing-driven firm would benefit by the concept of productivity matrix. In the former, at a gross level, more inputs may seem to lead to better output because the probability of an innovative discovery would improve with more work streams. However, in each work stream experimental productivity is vital. On the other hand, in repetitive work environment smooth flow, seamless coordination and freedom from defects support productivity. Productivity does not mean error-proof activities; rather it means discovering the cause of errors and enhancing output. Measurement systems for finished products ensure product quality but they would not assure zero defects. Understanding the output profile, in terms of quality and productivity, of the material supplier would, on the other hand, ensure productivity. Quality and productivity are interrelated. High quality leads to high productivity while just a rate of production without quality assurance would lead to poor final output.

Matrix measurement

Total factor productivity would work only if inputs and outputs at each stage of the value chain are fully understood and measured. There are more inputs than labour, capital and technology as commonly understand; nor are all the inputs linear and variable. Usually the three common inputs of labour, plant & machinery and technology are expressed in common financial terms and used as denominator. It is possible to granulate the inputs into sub-classifications such as direct labour, indirect labour, permanent employees, contract employees, energy, other utilities, land, building, equipment, direct materials, indirect materials, long term capital, short term capital, investments in R&D and so on. The granulation becomes relevant to compare and contrast productivity measurements across industries, firms and time. Adjustment for parity helps managements understand true operational productivity.

There are other process related variables as well, which impact productivity. In governance, the discussion and decision making structures (for example, ministerial versus bureaucratic or individual versus committee) impact productivity. On a shop floor, the feeder systems for materials and components (centralized versus decentralized versus delivered on spot or taken from store) determine the level of productivity. In a research laboratory, the access to global intellectual property databases and the availability of patent evaluation and patenting infrastructure determine the level of productivity. With respect to human capital the processes adopted and time invested for writing down operating procedures and training people in them determine the level of productivity. While all these are doubtless captured in financials, gross indexes convey little direction for improvement.

Organizing for TFP

Most productivity departments in firms are confined to shop floor as industrial engineering or productivity improvement departments. More recently operational excellence has come up as a more contemporary nomenclature. Yet, a preoccupation with manufacturing remains the unchanged focus. As discussed in this blog post, productivity is a much more comprehensive concept covering the total value chain with multiple factors in each stage of the matrix. A total factor productivity department needs larger organizational appreciation and leadership commitment. Economists are rightly intrigued to capture what is not covered in total factor productivity; it is time that industrialists, businessmen and administrators begin to get intrigued about and interested in what is yet to be covered for measurement of total productivity.

Posted by Dr CB Rao on June 27, 2015