Productivity: Why worry?

My post on productivity earlier this month prompted a few questions about the relationship between profit and productivity, and specifically, how a company can increase its profits while productivity is falling.

For example, one on LinkedIn remarked:

Since productivity and profit are so inextricably intertwined, eschewing one for the other would suggest a level of ignorance that will quickly kill both.

Perhaps so, but how quickly depends on all sorts of other things. It is possible to increase profits without increasing productivity. It is even possible to increase profits while productivity falls.

Here is an example which, I hope, might provide a simple explanation.

Let’s say I run a sandwich shop* in a town’s busy business district. I have 5 workers and they can each make and sell 100 sandwiches a day. I sell each sandwich for £2.50, of which 50p is profit. That brings me in £1,250 a day in revenue and £250 a day in profit. I only open on working days, as there wouldn’t be any point on other days. That amounts to around 250 days so my annual profit is £62,500.

That’s not bad, I think to myself, but I know there is more demand out there so, next year, I double the size of my premises and take on another 5 workers. My workers are still making and selling the same number of sandwiches each but the increased turnover means more profit. I have doubled my profit without increasing my productivity.

This is a trick I can only pull off once though. I know there is still more demand so the next year I move again and take on another 5 staff. Now that I have more staff I need a manager so I entrust the job to one of my most dependable workers, Big Barry.

The new workers aren’t quite as good as my long serving ones and, unfortunately, Big Barry’s approach to staff development is to let people work it out for themselves, then shout at them when they get it wrong. As a result, my workers are having to spend quite a lot of time helping the newer people. Despite my and Barry’s best efforts, we never manage to get quite the same level of productivity so we are now only managing 95 sandwiches per worker per day.

Nevertheless, I’m getting more production so I can buy my ingredients more cheaply as I’m using more of them. Consequently, despite a 5 percent increase in staff costs per unit, I can still make 49p profit per sandwich. My profit and revenue per worker has gone down, which is cause for concern but, on the whole, I’m happy. I’m still making nearly £50k more profit than I did last year.

Then I realise I have been missing a trick. I could deliver sandwiches to offices too. I take on another 8 staff to do the delivery but, having read about the gig economy, I decide to make them self-employed, thus saving me some NI and putting the responsibility for transporting the sandwiches onto the staff. Furthermore, I only need to employ them for around 5 hours a day. They come in to help make the sandwiches and they are pretty much done by early afternoon. In terms of hours worked, then, it’s only like having another 5 staff.

However, the effect on production has been catastrophic. I have left Big Barry to deal with the delivery staff, as I think they might be a bit of a handful, and I have promoted Noisy Natalie to be assistant manager. Natalie is one of those small people who fills a room with her personality. Her style is similar to Barry’s but less confrontational. Instead of yelling at people she likes to shout encouragement and play loud dance music. With 23 staff racing around, it’s mayhem. There isn’t really room for everyone and they keep getting in each other’s way. I don’t want to move premises again, though, as it would hike the rent up. It would be good if Barry or Natalie could find a way of making things work in a less frenetic way but neither seems inclined to do so. Some of my older staff mutter about how it was much more fun when there were only a few of us in a shack. A couple of them have left and their replacements are nowhere near as good. Big Barry complains that you just can’t get the staff these days and that all his time is taken up with rostering and paperwork. Sales are down to 85 sandwiches per worker. My productivity has fallen through the floor.

Still, I am paying the new workers less per hour and I haven’t moved premises so my fixed costs have stayed the same. I’m also getting more bulk discounts. Despite my staff costs per unit being around 13 percent more than they were two years ago, I’m still managing to make 48p per sandwich. And would you look at my annual profits? Well over £200k.

As long as I can keep increasing my turnover at a faster rate than I lose profit per unit through falling productivity, I’m laughing.

Rick’s Sandwich bar – revenue and profits

So here I am running a profitable business and creating jobs yet all these economists are having a go at me about productivity. Why?

One problem with my business model is that it leaves little room for giving my workers much of a pay rise. The more I rely on a plentiful supply of relatively cheap labour to grow my business, the less likely I am to be able to pay them more. Even a small pay rise for my 15 regular workers might wipe out my profit margins.

The other problem is that I am not doing anything to increase the skills of my workers. They are doing the same thing every day and I’m trusting time and experience to help them improve.

If I improved the processes in my shop and provided better equipment, I would be able to produce more sandwiches with the same amount of people. With a bit of training, my workers would improve the quality and quantity of their work more quickly. Sending Barry  and Natalie on a supervisors’ course might be a good start, for them and for the rest of the staff.

Any or all of these things would help me to sell more sandwiches without increasing the number of staff I have. This would give me more money to invest or to share with my workers.

The low-wage economy creates a Catch-22. The cheaper it is to get staff, the easier it is for me to expand my business by taking more people on and the less likely I am to worry about how much they are producing. But the longer I go on relying on cheap labour, the more difficult it becomes for me to do any of the good things the experts say I should. The less profit I am making per worker, the more it will cost me to give my staff a pay rise or to invest in their development.

Economists are worried about my business model because, although I am making a profit, I’m not doing much to increase overall per capita GDP or to improve the country’s skill base. As Paul Krugman famously put it:

Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

Since the Second World War, the UK has experienced an unprecedented growth in living standards. Unless productivity improves, the rate of that improvement will slow down or even stop. The next generation won’t be better off and might even be worse off than their parents

Added to that, we face rising demands on public finances. Ultimately the UK’s public deficit is a productivity and labour market problem. If we are to maintain our public services in the face of increasing cost pressures we need to increase tax revenue, which means increasing per capita GDP.

Which is why economists, central bankers and treasury civil servants are so worried about flatlining productivity and why they are encouraging firms to understand and improve it. At least some of the cause of the productivity slowdown lies Britain’s workplaces and there is evidence that much of the problem lies in our small and medium-sized companies.

Research by the New Policy Institute found that, for all but the largest UK companies, turnover per worker in 2015 was less, in real terms, than it was in 2002.

Nevertheless, despite declining productivity, many of these firms will still be making profits. As Andy Haldane pointed out, not all of the long tail of poor productivity businesses are the zombie firms being kept alive by cheap interest rates. Some of them are making profits. It may even be that some firms have set themselves up to take advantage of low labour costs.

What might be good in the short-term for the individual business owner isn’t necessarily good for the wider economy in the longer term. This is what Mike Haynes called unproductive entrepreneurship and ultimately it causes a drag on the whole economy.

It may be that the increase in the minimum wage and restrictions on the number of migrant workers will force a lot of companies to reassess the way they use their people. Rising pay costs and a labour shortage might, therefore, be the catalyst for an improvement in productivity. This, though, will require significant investment both in people and technology, something for which British business has shown little enthusiasm in recent years.

Which brings me back to the question I raised in my previous post. A lot of businesses might not know they are low productivity firms. Even if they did, would it bother them if the profits were still coming in? Unless something comes along to give them an incentive to change, why worry?

 

* Some sandwich shop owners will, no doubt, look at these profit margins and say “chance would be a fine thing”. I’m also not suggesting that sandwich shops are riven with poor and exploitative managers. This is meant simply as an example to illustrate a point, therefore I have tried to keep the numbers simple.

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14 Responses to Productivity: Why worry?

  1. John says:

    You need to apply the theory of diminishing marginal returns to your model.
    You cannot keep on cramming-in more and more workers and more and more activity into the same space. Eventually, they will all start to get in each others way and a point will be reached at which the rate of marginal returns per added item of labour or capital will diminish negatively.
    As for enhancing productivity through extra training and investment in new technology, this is something that British industry and employers have failed to do for decades, if not centuries.
    This is why some previously mighty industries have ceased to exist in the UK.
    People can always talk about labour strikes but how many realise we have been living under a capital strike for many many many years now?
    The banks and financial institutions have not helped in this regard – preferring to play casino on the global commodity, shares and currency markets – but neither have many firms who simply sit on huge piles of cash and do nothing with it or shovel it all out as shareholder dividends.
    I hope Corbyn wins the general election and that John McDonnell introduces window guidance to steer the UK economy in the right direction. It worked well for the Japanese and Chinese.
    The UK economy is far too important to leave to the vagaries of an ill-performing “market”.

  2. A brilliant post – I loved the example, which makes some rather abstract concepts very easy to grasp.

    Thank you!

  3. Stewart says:

    I think there’s a very simple test for businesses to assess whether they are a low productivity firm: if you’re worried about the effect on your business of increases in the national minimum/living wage, then you’re a low productivity firm, and your firm is part of the problem.

  4. SimonF says:

    It seems to me that the problem here is that Rick isn’t facing enough competition. A tightening of labour supply will help, but how much if free movement keeps supplying more? (I don’t have a problem with free movement so lets not start that argument), Raising the minimum wage might help but its the same for Rick’s potential competition so their incentive to improve productivity rather than pass on the cost is reduced.

    What’s stopping more efficient sandwich makers entering the market should be one of the questions that economists and policy makers should be asking? I know we keep being told that its regulation, but nobody can point to a single regulation that is killing an industry. There’s a reason for that, regulations are like throwing small pebbles in to a stream, each one is inconsequential but eventually the sum will affect the course of the stream. And no, I’m not advocating zero regulation, especially in the food industry,but perhaps there are some barriers to entry that need to be looked at as they give Rick an advantage and remove his incentive to invest.

    The Man From The Ministry may or may not be able to help Rick improve his productivity but until he has an incentive in the form of a serious amount of competition, not just for his customers but also, and just as importantly, his best staff, why should he bother? Perhaps the Man From The Ministry should be actively promoting competition to enter the market, that might get Ricks attention?

    • bill40 says:

      SimonF,
      More competition is sometimes a part of the problem also. How does it help if I compete with Rick and my staff is made up of poorly paid illegal immigrants? Or how about I don’t care how much money I make from sandwiches as the business is a front for laundering drug money.

      These are not extreme examples and have happened regularly although’ I’ll whisper this quietly, regulation has helped. The problem is exactly as John states above, appalling management and a banking system that is a parasite on the real economy.

    • Dipper says:

      Rick also has to compete with branches of an American sandwich operation. The Bahaman-based corporation charges the UK operation for use of the logo and management services. The UK operation makes very little money and so pays no UK tax.

  5. richardprichard says:

    “turnover per worker in 2015 was less, in real terms, than it was in 2002”
    This is a really helpful article, but I’m still struggling slightly with this productivity malarkey. My hypothesis is that competition between companies has become more overt, which pushes prices down, which reduces turnover per worker. It reduces profit per worker too, because some sales at low margins are better than no sales at decent margins. What is wrong with my hypothesis? How can we know that this is a productivity issue ?

  6. Dipper says:

    The infamous EU Sandwich regulations mean Rick has to appoint someone to personally approve each aspect of Sandwich production. I guess the question of whether this increases Rick’s productivity or decreases it will be resolved by whether or not the regulations put some smaller operators out of business and mean Rick can charge more for his sandwiches.

  7. rogerh says:

    Presumably French or German sandwich shops work in a similar way to British ones. Surely those who manage such businesses know they have ‘low productivity’ but what can they do about it? Viable sandwich making machines are not available. Natural selection has led to on-site making using cheap labour. Other differences such as style or filling may work in more expensive areas but cheap is usually a good way to go.

    As with sandwich shops so with many other smaller businesses. Therein lies the rub, how to make the nation highly productive. Well, so far we have produced more lawyers/head and more accountants/head than any other EU nation. These are all highly skilled workers and yet overall productivity is low. Other attractive jobs that have come to prominence include TV presenter, talk show host, politician, lobbyist, consultant, regulator and pseudo regulator and blogger. The trouble with these jobs is the low leverage. Indeed taken altogether we might see the work of one group cancels out the work of another, overall the leverage turns out negative. Contrast this with manufacture, the wages paid to a worker are multiplied many times by machinery and systems and show an overall positive leverage.

    The snag is that a service economy may well have definite limits. Indeed as the level of education and sophistication rises so fewer and fewer want to take up mundane service jobs and seek to climb up the pile. In doing this we accrete more bureaucracy and complication and fancy titles and low productivity.

  8. william sutton says:

    As very much a layman in this area, maybe someone could explain the following – I’m looking at the the very recent ONS report on international comparisons of productivity. In Fig.2 (GDP per worker for G7 countries) the UK figure is roughly the same as Canada, 10% below Germany, 12.7% below France and…drum roll……13.1% below that of Italy. My conclusion is, either measures of productivity are simply wrong, or meaningless, or else we should all be moving to Italy to take advantage of that booming economy over there.

  9. Blissex says:

    «So here I am running a profitable business and creating jobs yet all these economists are having a go at me about productivity. Why? One problem with my business model is that it leaves little room for giving my workers much of a pay rise.»

    Pay rises are “Inflationary” according to neoliberal Economists, while profits are not “inflationary”. Also most commentary on the economy, by Economists or columnists, etc., is from the point of view of investors, not workers.

    «The more I rely on a plentiful supply of relatively cheap labour to grow my business, the less likely I am to be able to pay them more. Even a small pay rise for my 15 regular workers might wipe out my profit margins.»

    Most employers are marxists to a fault, and reckon that only by appropriating the worker surplus they can make a profit; some time ago Nassau Senior was arguing that reducing work hours would kill business because all profit is made in the last hour of each workday.

  10. Blissex says:

    «A lot of businesses might not know they are low productivity firms. Even if they did, would it bother them if the profits were still coming in? Unless something comes along to give them an incentive to change, why worry?»

    Some decades ago the ruthless but clever Singapore government worried that Singapore would become the “sandwich shop” of the world, with easy profits for Singapore businesses fueled by immigration of cheap Malay “guest workers”.

    Their solution was to roughly double wages for Singapore citizen by decree (gradually but quickly), to force low-productivity businesses to close down in Singapore and push a switch to higher-productivity businesses, to avoid the “middle income trap”. I guess part of the goal was to discourage the immigration of cheap malay workers, to preserve the majority-chinese character of Singapore.

    In the short term there was quite a bit of pain, but strategically the move worked very well, also because Singapore is small and the government invested a lot in subsidizing education and making Singapore attractive as a regional headquarters city, therefore with staff rather than line jobs.

    The UK governments of the past decades seem to have chosen the opposite strategy, I suspect in part because a weak working class struggling to survive day to day in low-pay jobs and made in large part of non-voting immigrants has been a strategic political goal for both the Conservative and New Labour elites, as it has been in the USA bipartisan consensus.

  11. nicktemple1 says:

    Thanks Rick – first off, good luck with the sandwiches.

    Secondly, there is another aspect worth bearing in mind: some businesses deliberately employ more people (or even the maximum number of people) for their turnover, not fewer. These might particularly include social enterprises whose mission is to employ people with learning disabilities or those coming out of offending; or those with dedicated training & apprenticeship programmes; and so on. This is where profit alone isn’t a good enough measure – the wider value of helping someone marginalised from the labour market back into work isn’t recognised by the binary productivity measure, so won’t be incentivised. But actually, for the economy as a whole, it will be beneficial. And plays to your points on tax take, skills, labour market etc – but productivitiy, as it is currently thought of, won’t get us there.

    • John says:

      Presumably, other national economies have similar arrangements for social enterprises as here.
      Yet, they manage much higher levels of productivity than are achieved here in the UK.
      This suggests a “capital strike” by banks and companies in this country – not seen elsewhere.
      In short, not investing in better capital equipment is a deliberate policy of banks and companies.
      As long as this under-investment in new technology continues so too will low levels of productivity.

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