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Use and misuse of productivity ratios
O~.IEGq The Int. JI ~,( Mgrnt Set. Vot. 10. N o 6. p p 545 T.o 5~0. 19,,2 Printed in Great Britain
o5~)5-04:',3 52 0'~)5-5-06e,a03.00 0 Pergamon Press Ltd
EDITORIAL Use and Misuse of Productivity Ratios THERE IS NO DENYING the fact that productivity is widely acclaimed as the prime factor that determines the level of prosperity- and standard of living in most countries of the world. Leaving aside a few countries richly' endowed with natural resources, which can generate ample income to sustain even an indolent population in comfort, the economy of most countries and the well-being of their industries depend on how well they can use all their resources--manpower, materials, plants and m o n e y - - t o produce goods and services at an acceptable price and meet d e m a n d at home and abroad. The better the utilization of resources and the greater the output that can be achieved from a given input (provided there is a demand for the output in question), the better off is the enterprise: It can cover its costs, it can improve the remuneration and working conditions of its employees, it can reward its investors, and it can modernize and expand. Productivity is a term that encapsulates the quality of the conversion process from a series of resource inputs to a series of resource outputs, and--subject to satisfactory measurement criteria--it is taken for granted that an improvement in productivity is beneficial and must be relentlessly pursued. The importance of the subject is exemplified by its continuous exposure in the economic and financial press, by inter-firm and international comparisons, by arguments between employers and trade unions, and by pious exhortations from politicians to us all to work harder and more intelligently to improve productivity. The professional literature in this area has also expanded rapidly in recent years, though it has to be admitted that thorough exposes are not as plentiful as would befit such an important subject. This is why a recent book by Paul Mali, entitled 'Improving Total Productivity' (with the long-winded subtitle, 'MBO strategies for business, Government, and not-for-profit organizations') [3] is generally to be welcomed, particularly as it appears to build on a wealth of practical experience. Any attempt to synthesize the lessons learnt from a collection of case studies, involving a variety of enterprises and industries (as well as 'Government and not-for-profit organizations'), is bound to arouse interest. I was certainly interested. First, consider definitions. As Gold points out [i, 2], productivity' is commonly interpreted as physical volume per employee or per man575
Editorial
576
hour. in other words it is equated with productivity of labour. Other inputs, such as materials and capital, are often ignored, and it is generally assumed that if productivity of labour increases, then other measures of performance will benefit as a result. Mali does recognize the wider context in which productivity needs to be viewed: "'Productivity requires resources such as plant capacity, personnel, costs, raw materials, facilities, capital, technology, budgets, supplies and information" and proposes the following definition: "'Productivity is the measure of how well resources are brought together in organizations and utilized for accomplishing a set of results. Productivity' is reaching the highest level of performance with the least expenditure of resources" [-3, pp. 6-7]. As for measurement, he proposes a productivity index in the form of a ratio [-3, p. 21]' productivity index -
output
performance a c h i e v e m e n t
input
resources c o n s u m e d
effectiveness efficiency and elsewhere [3, p. 212] productivity -
o u t p u t _ performance achievement input
resources allocated
actual performance expected performance As a piece of algebraic formulation these definitions do not strictly hold, since 'resources consumed' may not be equal to 'resources allocated', nor is it valid to equate (in the last equation) 'resources allocated" with 'expected performance'. We know, of course, what the a u t h o r is driving at, but the lack of rigour in some of his definitions may adversely affect the whole process of measurement and evaluation. He rightly states that "producticity is a combination of effecticeness and efficiency" and proceeds to distinguish between the two (effecticeness is the degree to which end results are achieved and is output oriented, whereas efficiency is associated with the level of resources used and is therefore input oriented). But a definition that asserts that productivity is the ratio of effectiveness to efficiency (as stated above) is baffling, to say the least, since it implies that for a given level of effectiveness, productivity increases when efficiency declines, and this cannot possibly be what Mali intends to convey. To appreciate the alternative m e t h o d s of measuring productivity, consider first the definition: productivity of factor input X =
output factor input X
O,ne~iLz,
[,o[. 1 0 . . \ ' o . ,5
which highlights the fact that many productivity ratios can be constructed, each relating to a particular disaggregated input, or to a combination of inputs. As for metric, the output mav be measured either in physical terms {such as tons, kilowatts, cars. or other appropriate units of output) or financial terms (revenue, profit or added value). Similarly. the input may be measured in physical or cost terms (tons of material input, manhours, cost of materials, cost of labour. value of fixed assets etc.). Secondly, it is necessary to determine what input and output should be considered, actual or optimal. The simple matrix below shows the possible combinations that guide the selection of criteria: OUTPUT Actual M a x i m u m Actual INPUT Minimum
In cell 1 we consider the ctctugll output relg~rino to an actt~al input. Such a ratio on its own tells the analyst little about performance, since he is unable to state whether the ratio is good or bad. He therefore needs to compare it with a standard in order to make such a judgement. This standard may be provided by: - - a ratio relating to a previous time period, - - a ratio relating to a similar activity carried out at the same time elsewhere (in the enterprise or outside), or to the industry as a whole (this is the essence of inter-firm comparisons), - - a ratio of the m a x i m u m output that can be obtained for a given level of input (cell 2 in the matrix), - - a ratio of the minimum input needed to produce the actual level of output (cell 3 in the matrix). Thus, an evaluation of performance may be based on a comparison of ratio 1 with itself (for other time periods or other operations) or with ratio 2 or with ratio 3. This explicit formulation helps us to understand the many ramifications of the measurement process and it is, unfortunately, missing from Mall's book, though he does implicitly recognize them in the variegated list of ratios that may be considered in several circumstances. As for the optimum output or input in cells 2 and 3, Mali strongly advocates the use of MBO (Management by Objectives) which--despite the shortcomings of its subjective nature--is a widely used tool in corporate planning and evaluation. What it boils down to is a comparison of actual outpltt ~'ith optimol ozltpttt (often referred to as the capacity of a
577
Editorial
57,3
plant with given resource i n p u t s / o r optimal input with actual input, as is clear from the following" Index 1 Index 2
(actual output)/(actual input) maximum output)'(actual input) actual output maximum outpt.t
actual output capacity
= capacity utilization, Index 1 Index 3
(actual output)/(actual input) (actual output)/(minimum input) minimum input actual, input
The interesting facet of this approach is that although the definition of productivity starts with a ratio of output to input, a comparison of index 1 with index 2 involves a ratio of output to output and that of index 1 with index 3 a ratio of input to input. Furthermore, for any particular input it is possible for the two comparisons to yield different results, even when MBO is used to specify both optimal inputs and outputs. A recognition of such an outcome by Mali, and its implications illustrated by practical case studies, would have been appropriate. The importance of measurement leads Mali to identify five categories of ratios: overall indices, objective ratios, cost ratios, work standards and time-standard ratios. With 24 in each category, his list covers 120 ratios, although the reader is warned that these are merely examples and that "an endless variety is possible". It is the case, however, that when faced with such a perplexing variety, the analyst would welcome some guidance. Surely, not all ratios are of equal importance. Some are likely to be more significant than others in their potential effect on certain global measures of performance, such as profit, return on investment or total unit cost. The elaborate structure proposed by Gold to show how productivity ratios are linked to these overall measures [2] is sadly lacking in Mali's treatise, nor is there any explicit discussion of the intricate network of relationships between productivity measures and the fact that one can be improved at the expense of another. As Gold points out, increased productivity of one factor input (such as labour productivity) does not automatically result in decreased unit cost and may not in itself be desirable. It is only through a systematic examination of the relevant network of relationships that the consequences of changes in operating methods and factor prices can be properly assessed. Curiously' enough, there is no mention by Mall of Gold's work.
Omeqa. Vol. I0, .\o. 6
That measures in isolation can be too parochial, even whimsical. and hence of rather questionable relevance, is demonstrated by some of the ratios in Mali's own list. Consider, for example, the following [3, pp. 8 8 - 8 9 ] Inventory 1. is one of his cost ratios, though it is none too Advertizing costs clear what relationship there might be between the numerator and the denominator. The ratio can presumably be increased by increasing inventory levels and reducing advertizing expenditure, but why should this be interpreted as an improvement in performance? 2.
3.
4.
5.
Recruits selected
is a proposed measure in the governmental sector. Costs but recruiting costs per employee are usually minute compared with the subsequent costs of employment, so that it may in fact be beneficial to increase recruitment costs to improve the quality of intake, rather than e m b a r k on a cost cutting exercise. Students graduating . is suggested in the field of education, though Annual costs again no reference is made to quality, which is obviously of prime importance, even if it is difficult to measure objectively. Clearly. it is possible to reduce the cost of education per student by providing inferior facilities, though whether this would be desirable is another matter. Graduates
is another ratio in the field of education, proposed as Curriculums a work standard, though its likely purpose is somewhat obscure. Research reports
is a cost ratio cited in the field of "'health and Allocated budget human services". The naive notion that the number of research reports can in any way be a sensible measure of output is perhaps symptomatic of the degree of crudity with which some ratios can be constructed. A change in the value of such a ratio can hardly be indicative of a change in the utility, efficiency, or even the level of activity of the department concerned.
6. Admission cost per patient per week in a hospital is quoted in a case study where additional office machinery helped to reduce staff and thereby total admission costs i-3, pp. 57-58]. However, a great deal depends on what is meant by 'admissions'. It is possible, of course, to reduce processing at the admission stage by deferring some of the work for completion at a later period, with the result that the cost per admission is reduced but the total work load remains unchanged.
579
i80
Editorial
There are other examples, but these suffice to support two arguments alluded to earlier: First. although in theory an infinite number of ratios is possible, in practice only sensible' control ratios ('sensible" in a managerial context) need to be considered: second, it is usually not difficult to conceive of ways for improving a particular ratio at the expense of one or several others and it is therefore not immediately obvious that the overall outcome would be desirable. All this tends to overshadow some of the positive aspects of Mall's patter. He is particularly good on check lists, which can come in handy for the practitioner as he gets immersed in the intricacies of a particular investigation. His proposal that productivity audits should be conducted from time to time is a useful reminder that when executives are embroiled in the day-to-day running of their operations, they are generally incapable of standing back and evaluating performance in a wider context. He rightly insists that productivity measures need not be confined to the manufacturing environment but can often be designed for a variety of service activities. What is missing, though, is a proper analytical framework, an attempt to bring together the various control tools through a network of relationships to provide a penetrating insight into the way that an enterprise functions (for example, in the way proposed by Gold 1-2]), so that the causes of changes in past performance and the possible consequences of managerial actions can be ascertained. SAMUEL EILON
Chief Editor REFERENCES 1. EILON S. GOLD B & SOl!SAN J (1976) Applied Productivity Analysis jot Industry. Pergamon Press. Oxford. 2. GOLD B (1973) Technology, productivity and economic analysis. Omega 1(1), 5-24. 3. MALl P (1978) hnprocing Total Producticity. John Wiley. New York.
o5~)5-04:',3 52 0'~)5-5-06e,a03.00 0 Pergamon Press Ltd
EDITORIAL Use and Misuse of Productivity Ratios THERE IS NO DENYING the fact that productivity is widely acclaimed as the prime factor that determines the level of prosperity- and standard of living in most countries of the world. Leaving aside a few countries richly' endowed with natural resources, which can generate ample income to sustain even an indolent population in comfort, the economy of most countries and the well-being of their industries depend on how well they can use all their resources--manpower, materials, plants and m o n e y - - t o produce goods and services at an acceptable price and meet d e m a n d at home and abroad. The better the utilization of resources and the greater the output that can be achieved from a given input (provided there is a demand for the output in question), the better off is the enterprise: It can cover its costs, it can improve the remuneration and working conditions of its employees, it can reward its investors, and it can modernize and expand. Productivity is a term that encapsulates the quality of the conversion process from a series of resource inputs to a series of resource outputs, and--subject to satisfactory measurement criteria--it is taken for granted that an improvement in productivity is beneficial and must be relentlessly pursued. The importance of the subject is exemplified by its continuous exposure in the economic and financial press, by inter-firm and international comparisons, by arguments between employers and trade unions, and by pious exhortations from politicians to us all to work harder and more intelligently to improve productivity. The professional literature in this area has also expanded rapidly in recent years, though it has to be admitted that thorough exposes are not as plentiful as would befit such an important subject. This is why a recent book by Paul Mali, entitled 'Improving Total Productivity' (with the long-winded subtitle, 'MBO strategies for business, Government, and not-for-profit organizations') [3] is generally to be welcomed, particularly as it appears to build on a wealth of practical experience. Any attempt to synthesize the lessons learnt from a collection of case studies, involving a variety of enterprises and industries (as well as 'Government and not-for-profit organizations'), is bound to arouse interest. I was certainly interested. First, consider definitions. As Gold points out [i, 2], productivity' is commonly interpreted as physical volume per employee or per man575
Editorial
576
hour. in other words it is equated with productivity of labour. Other inputs, such as materials and capital, are often ignored, and it is generally assumed that if productivity of labour increases, then other measures of performance will benefit as a result. Mali does recognize the wider context in which productivity needs to be viewed: "'Productivity requires resources such as plant capacity, personnel, costs, raw materials, facilities, capital, technology, budgets, supplies and information" and proposes the following definition: "'Productivity is the measure of how well resources are brought together in organizations and utilized for accomplishing a set of results. Productivity' is reaching the highest level of performance with the least expenditure of resources" [-3, pp. 6-7]. As for measurement, he proposes a productivity index in the form of a ratio [-3, p. 21]' productivity index -
output
performance a c h i e v e m e n t
input
resources c o n s u m e d
effectiveness efficiency and elsewhere [3, p. 212] productivity -
o u t p u t _ performance achievement input
resources allocated
actual performance expected performance As a piece of algebraic formulation these definitions do not strictly hold, since 'resources consumed' may not be equal to 'resources allocated', nor is it valid to equate (in the last equation) 'resources allocated" with 'expected performance'. We know, of course, what the a u t h o r is driving at, but the lack of rigour in some of his definitions may adversely affect the whole process of measurement and evaluation. He rightly states that "producticity is a combination of effecticeness and efficiency" and proceeds to distinguish between the two (effecticeness is the degree to which end results are achieved and is output oriented, whereas efficiency is associated with the level of resources used and is therefore input oriented). But a definition that asserts that productivity is the ratio of effectiveness to efficiency (as stated above) is baffling, to say the least, since it implies that for a given level of effectiveness, productivity increases when efficiency declines, and this cannot possibly be what Mali intends to convey. To appreciate the alternative m e t h o d s of measuring productivity, consider first the definition: productivity of factor input X =
output factor input X
O,ne~iLz,
[,o[. 1 0 . . \ ' o . ,5
which highlights the fact that many productivity ratios can be constructed, each relating to a particular disaggregated input, or to a combination of inputs. As for metric, the output mav be measured either in physical terms {such as tons, kilowatts, cars. or other appropriate units of output) or financial terms (revenue, profit or added value). Similarly. the input may be measured in physical or cost terms (tons of material input, manhours, cost of materials, cost of labour. value of fixed assets etc.). Secondly, it is necessary to determine what input and output should be considered, actual or optimal. The simple matrix below shows the possible combinations that guide the selection of criteria: OUTPUT Actual M a x i m u m Actual INPUT Minimum
In cell 1 we consider the ctctugll output relg~rino to an actt~al input. Such a ratio on its own tells the analyst little about performance, since he is unable to state whether the ratio is good or bad. He therefore needs to compare it with a standard in order to make such a judgement. This standard may be provided by: - - a ratio relating to a previous time period, - - a ratio relating to a similar activity carried out at the same time elsewhere (in the enterprise or outside), or to the industry as a whole (this is the essence of inter-firm comparisons), - - a ratio of the m a x i m u m output that can be obtained for a given level of input (cell 2 in the matrix), - - a ratio of the minimum input needed to produce the actual level of output (cell 3 in the matrix). Thus, an evaluation of performance may be based on a comparison of ratio 1 with itself (for other time periods or other operations) or with ratio 2 or with ratio 3. This explicit formulation helps us to understand the many ramifications of the measurement process and it is, unfortunately, missing from Mall's book, though he does implicitly recognize them in the variegated list of ratios that may be considered in several circumstances. As for the optimum output or input in cells 2 and 3, Mali strongly advocates the use of MBO (Management by Objectives) which--despite the shortcomings of its subjective nature--is a widely used tool in corporate planning and evaluation. What it boils down to is a comparison of actual outpltt ~'ith optimol ozltpttt (often referred to as the capacity of a
577
Editorial
57,3
plant with given resource i n p u t s / o r optimal input with actual input, as is clear from the following" Index 1 Index 2
(actual output)/(actual input) maximum output)'(actual input) actual output maximum outpt.t
actual output capacity
= capacity utilization, Index 1 Index 3
(actual output)/(actual input) (actual output)/(minimum input) minimum input actual, input
The interesting facet of this approach is that although the definition of productivity starts with a ratio of output to input, a comparison of index 1 with index 2 involves a ratio of output to output and that of index 1 with index 3 a ratio of input to input. Furthermore, for any particular input it is possible for the two comparisons to yield different results, even when MBO is used to specify both optimal inputs and outputs. A recognition of such an outcome by Mali, and its implications illustrated by practical case studies, would have been appropriate. The importance of measurement leads Mali to identify five categories of ratios: overall indices, objective ratios, cost ratios, work standards and time-standard ratios. With 24 in each category, his list covers 120 ratios, although the reader is warned that these are merely examples and that "an endless variety is possible". It is the case, however, that when faced with such a perplexing variety, the analyst would welcome some guidance. Surely, not all ratios are of equal importance. Some are likely to be more significant than others in their potential effect on certain global measures of performance, such as profit, return on investment or total unit cost. The elaborate structure proposed by Gold to show how productivity ratios are linked to these overall measures [2] is sadly lacking in Mali's treatise, nor is there any explicit discussion of the intricate network of relationships between productivity measures and the fact that one can be improved at the expense of another. As Gold points out, increased productivity of one factor input (such as labour productivity) does not automatically result in decreased unit cost and may not in itself be desirable. It is only through a systematic examination of the relevant network of relationships that the consequences of changes in operating methods and factor prices can be properly assessed. Curiously' enough, there is no mention by Mall of Gold's work.
Omeqa. Vol. I0, .\o. 6
That measures in isolation can be too parochial, even whimsical. and hence of rather questionable relevance, is demonstrated by some of the ratios in Mali's own list. Consider, for example, the following [3, pp. 8 8 - 8 9 ] Inventory 1. is one of his cost ratios, though it is none too Advertizing costs clear what relationship there might be between the numerator and the denominator. The ratio can presumably be increased by increasing inventory levels and reducing advertizing expenditure, but why should this be interpreted as an improvement in performance? 2.
3.
4.
5.
Recruits selected
is a proposed measure in the governmental sector. Costs but recruiting costs per employee are usually minute compared with the subsequent costs of employment, so that it may in fact be beneficial to increase recruitment costs to improve the quality of intake, rather than e m b a r k on a cost cutting exercise. Students graduating . is suggested in the field of education, though Annual costs again no reference is made to quality, which is obviously of prime importance, even if it is difficult to measure objectively. Clearly. it is possible to reduce the cost of education per student by providing inferior facilities, though whether this would be desirable is another matter. Graduates
is another ratio in the field of education, proposed as Curriculums a work standard, though its likely purpose is somewhat obscure. Research reports
is a cost ratio cited in the field of "'health and Allocated budget human services". The naive notion that the number of research reports can in any way be a sensible measure of output is perhaps symptomatic of the degree of crudity with which some ratios can be constructed. A change in the value of such a ratio can hardly be indicative of a change in the utility, efficiency, or even the level of activity of the department concerned.
6. Admission cost per patient per week in a hospital is quoted in a case study where additional office machinery helped to reduce staff and thereby total admission costs i-3, pp. 57-58]. However, a great deal depends on what is meant by 'admissions'. It is possible, of course, to reduce processing at the admission stage by deferring some of the work for completion at a later period, with the result that the cost per admission is reduced but the total work load remains unchanged.
579
i80
Editorial
There are other examples, but these suffice to support two arguments alluded to earlier: First. although in theory an infinite number of ratios is possible, in practice only sensible' control ratios ('sensible" in a managerial context) need to be considered: second, it is usually not difficult to conceive of ways for improving a particular ratio at the expense of one or several others and it is therefore not immediately obvious that the overall outcome would be desirable. All this tends to overshadow some of the positive aspects of Mall's patter. He is particularly good on check lists, which can come in handy for the practitioner as he gets immersed in the intricacies of a particular investigation. His proposal that productivity audits should be conducted from time to time is a useful reminder that when executives are embroiled in the day-to-day running of their operations, they are generally incapable of standing back and evaluating performance in a wider context. He rightly insists that productivity measures need not be confined to the manufacturing environment but can often be designed for a variety of service activities. What is missing, though, is a proper analytical framework, an attempt to bring together the various control tools through a network of relationships to provide a penetrating insight into the way that an enterprise functions (for example, in the way proposed by Gold 1-2]), so that the causes of changes in past performance and the possible consequences of managerial actions can be ascertained. SAMUEL EILON
Chief Editor REFERENCES 1. EILON S. GOLD B & SOl!SAN J (1976) Applied Productivity Analysis jot Industry. Pergamon Press. Oxford. 2. GOLD B (1973) Technology, productivity and economic analysis. Omega 1(1), 5-24. 3. MALl P (1978) hnprocing Total Producticity. John Wiley. New York.