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.