Productivity: What Is It And How Do I Measure It?
Productivity growth is frequently praised by governments, business community, and the media. Both as proof of a healthy economy and as a solution to generally improving standards. Yet there is little agreement on what productivity actually is and means.
To accountants and economists, productivity is the efficiency of the economy in converting inputs, (the material, labor, and capital), into output, (the actual products and services sold). Productivity grows when output grows faster than inputs. This results in making the existing productive inputs more efficient. Now, productivity does not measure the value we attach to the outputs. It only measures how efficiently we use our assets to produce the outputs.
Productivity at the company level.
The application and generation of technological and organizational knowledge, also called innovation, are the main contributors and drivers of productivity growth at the company level. The choice of technology and how the production is organized, which are management decisions, play a crucial role in productivity performance.
Firms can improve their productive efficiency in three ways:
Technological progress and organizational change - firms adopt or develop new technologies, such as software, and/or organizational structures that are new to the firm.
Improvements in technical efficiency - increases in output can be achieved, at a given level of input, from better and greater use of existing resources.
Increasing returns of scale - as the size of the firm expands, its unit cost of input items and processes of production can fall as it becomes more advantageous to adopt existing technologies from outside of the firm's current assets. These would include such things as machines that have a higher capacity of production per hour then current machines or software that to hone more strategic and accurate movement.
Great, but how do we measure our current productivity? You ask.
Productivity is measured as a ratio of a unit of outputs to a unit of inputs used in the production of goods or the delivery of services. Productivity is estimated by subtracting the growth in inputs from the growth in output, it is residual. Ok, so this is the economic definition of productivity. So now what? How is it measured in the real world and at the company level?
The most common productivity measure used by small and medium businesses is the Labor Productivity method.
Labor Productivity (LP) measures the growth in valued added unit output (finished products or services) per unit of labor used. This is the simplest and therefore the one most used by small and medium sized firms. And even here you have choices for what the units are. Most will use the labor revenue and labor cost. We will show how to calculate this in just a moment, below.
The formulas for calculating Labor Productivity. The formula will show a calculation for year to date (YTD), but happily the same formula is used for the calculation for a single month to date (MTD). Just replace the YTD numbers with the MTD numbers. Here we are using a dollar as a unit for measurement. Also the labor numbers used are those of direct labor employees and subcontractors, not administrative or other employees.
The four steps are as follows, with an example following below:
1.First calculate the average labor revenue per month.
The sum of all your YTD labor revenue ÷ # of months YTD = average labor revenue per month. (If you don’t keep track of your labor revenue separately in your accounting process, add up the labor billed each month and keep those numbers on a spreadsheet. You can use a second spreadsheet in the workbook to calculate these formulas
2.Then... Calculate your average labor Cost Hours per month
The sum of all your YTD labor costs, including any subcontractor labor ÷ # of months YTD ÷ Your average hourly wage = avg labor Cost Hours per month
(Using only the cost of Direct Labor Employees and the amount you pay your contractors for their labor, not materials or anything else. Your subcontractors should have separate line items or total for the labor they are billing. If not, get them to do so.)
3. And then… Calculate the number of Billable Employee Equivalents
Avg Cost Hours per month (#2 above) ÷ 173.33 (avg work hours for an employee in a month, [2080 a year ÷ 12]) = # of Billable (fulltime) Employee Equivalents (BEE’s)
4.Lastly…Calculate the average labor revenue per employee (our LP #)
Avg labor revenue per month (#1) ÷ # of BEEs (#3) = YTD Labor Productivity per Employee.
Examples (using July)
1. Avg Labor Revenues per month YTD
Labor Revenue YTD # of Months YTD Avg Labor Revenue per Month
$341,505.00 ÷ 7 = $48,786.43
2. Avg Labor Cost Hours per month YTD
Labor Costs YTD # of Months YTD Avg Hourly Wage Avg Labor Cost Hours
$118,397.09 ÷ 7 ÷ 14.00 = 1,208.13
3. Number of Billable (fulltime) Employee Equivalents per month YTD
Avg Labor Cost Hours Avg Work Hours Billable Employee Equivalents
per month (#2) per Month (173.33) (BEEs)
1,208.13 ÷ 173.33 = 6.97
4. Labor Revenue per Direct Labor Employee per month YTD
Avg Labor Revenue per Month (#1) BEE’s (#3) Avg Labor Revenue Per Employee
per month YTD
$48,786.43 ÷ 6.97 = 6,999.358
When that last number moves up or down it is an indication of increased or decreased productivity.
While there is a second method for calculating productivity, the Multi-Factor Productivity (MFP) method, it is way too complicated and time consuming for the average small business to use. For instance the U.S Department of Labor uses a supercomputer to calculate the MFP and the large number of data points and numerous steps are just too cumbersome to even include in this blog, in fact this blog is already too long. Thanks for sticking with us till this point.
One final note: There are software programs that will do the Labor Productivity calculation for you and they do many other business benchmarks to help you know how your business is doing. Some will even compare your business to data of the average for your industry. We know of a software platform that offers this information (wink, wink).
For instance the formulas above are taken from such an application. Vital Management was originally designed for custom integrators however it is now used by many different companies in many different industries to offer more than what can be learned from a P&L or balance sheet.
Go to BI4CI.com to see how they do it. As an alternative, go to Cairnstack.com or contact us at 303-862-3000 for more information.
Sources: PC News, May 2015, Australian edition;
J Fordon, S Zhao, P Gretton: On productivity, Concepts and Measurement
Bi4Ci.com founders; Paul Starkey and Steve Firzst.