PRODUCTIVITY PROFITABILITY B Y M OHAN P. R AO, P H.D. A Simple Method to Link

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1 A Simple Method to Link PRODUCTIVITY to PROFITABILITY B Y M OHAN P. R AO, P H.D. When billions of dollars are invested in technology, business managers would like to know the impact of the investment on the bottom line, not just on employee productivity. A model that can link productivity to profitability would estimate this impact. This article describes a simple profit-linked productivity measurement model introduced about 20 years ago by the American Productivity and Quality Center. The model easily can be implemented using popular spreadsheet software. The author presents the Excel application of the model, its benefits, and possible extensions. 12 SUMMER 2000

2 You invested huge amounts in information technology (IT) to improve your company s bottom line. Then you hired a high-powered research team to determine the impact of your IT investments. The team s conclusion? Technology has improved your employee productivity but may not have improved the bottom line there is no clear relationship between productivity and profitability. None other than a Wharton School research team reached this startling conclusion after studying IT spending in the banking industry. Consider the importance of this conclusion when the financial services industry spent over $50 billion on technology in 1998 alone. 1 But there is a solution to this problem. In 1980, the American Productivity and Quality Center, previously known as the American Productivity Center (APC), developed a simple model that can link productivity to the bottom line. The attraction of this productivity measurement model, better known as the APC model 2 to the business community, is that it uses readily available accounting data and provides performance results in dollars as opposed to abstract indexes. 3 Companies easily can implement the model with the help of popular spreadsheet software such as Microsoft Excel. T HE APC MEASUREMENT S YSTEM I will be presenting the APC model with its implementation in Microsoft Excel. Figure 1 shows a sample application of the APC model based on the original example from the American Productivity Center, and Figure 2 shows cell formulas behind some of the numbers. The hypothetical company I will discuss produces and sells chairs and tables. I have divided all the necessary resources into five categories: material, labor, energy, capital, and miscellaneous. Q UANTITIES, PRICES, AND VALUES? The measurement system evaluates current period performance of the company against base period data. Figure 1 shows the quantities and prices of products (output) and resources (input) for period 1 (the base period) and period 2 (the current period). Multiplication of quantity by price results in the value, which is the sales revenue for products and cost for resources. This company made a gross profit of $37,280 for a gross margin of 26.63%. This basic data, in a few sequential steps, can describe the current period performance in terms of productivity, price recovery, and profitability contributions of each resource. Period 2 Deflated Values Column H of Figure 1 shows period 2 revenues and costs in period 1 prices. This step removes the price effects on both output and input so that period 2 productivity can be measured against period 1 productivity. This step is necessary to calculate the aggregate change ratios in the next columns. Figure 1: Productivity Measurement System Using the APC Model MANAGEMENT accounting quarterly 13

3 Figure 2: Cell Formulas Behind the Measurement System Change Ratios Although calculation of V2/V1, Q2/Q1, and P2/P1 for individual input and output is straightforward, calculating ratios for the totals such as total sales and total labor is more difficult. Q2/Q1 for total sales is the ratio of deflated sales in period 2 to the sales in period 1. (As shown in cell I6 of Figure 2, this ratio is H6/D6. The deflated sales remove the effect of price change, enabling Q2/Q1 to be viewed as a quantity-to-quantity ratio. P2/P1 for total sales is the ratio of sales in period 2 to the deflated sales in period 2. (This ratio is shown in cell J6 of Figure 2 and equals G6/H6. It essentially removes the effect of quantity change by using only period 2 quantities at period 1 and period 2 prices.) The same formula is used for other aggregates. Performance Indexes Productivity index = Quantity change ratio of total output Quantity change ratio of input Woodworker productivity index = I6/I11 = 1.54 Labor productivity index = I6/I13 = 1.57 Total productivity index = I6/I20 = 1.30 Price recovery index = Price change ratio of total input Price change ratio of total input Woodworker price recovery index = J6/J11 = 0.67 Labor price recovery index = J6/J13 = 0.69 Total price recovery index = J6/J20 = 0.88 Profitability index = Value change ratio of total output Value change ratio of total input Woodworker profitability index = K6/K11 = 1.03 Labor profitability index = K6/K13 = 1.09 Total profitability index = K6/K20 = 1.15 Performance Results in Dollars Performance results in terms of productivity and price recovery contributions to profitability in dollars would be more attractive to business managers than indexes. The indexes calculated above can be converted to dollar amounts as shown in the last three columns of Figure 2. Productivity contribution = (Total output Q2/Q1 - Input Q2/Q1) x Input V1 Woodworker productivity contribution = (I6 - I11) x D11 = $18,250 Labor productivity contribution = Sum of productivity contributions of woodworkers and finishers = SUM (O11:O12) = $25,493 Similarly, Total productivity contribution = Productivity contribution of all five categories = O10 + O13 + O15 + O17 + O19 = $32, SUMMER 2000

4 Profitability contributions can be computed similarly. Profitability contribution = (Total output V2/V1 - Input V2/V1) x Input V1 Woodworker profitability contribution = (K6 - K11) x D11 = $1,912 Labor profitability contribution = sum of profitability contributions of woodworkers and finishers = $1,912 + $5,311 = $7,223 Total profitability contribution = sum of profitability contribution of all five categories = $21,495 Price recovery is simply the difference between profitability and productivity contributions. Woodworker price recovery contribution = woodworker profitability contribution - woodworker productivity contribution = Q11 - O11 = $1,912 - $18,250 = ($16,338) Labor price recovery contribution = Q13 - O13 = $7,223 - $25,493 = ($18,270) Total price recovery contribution = Q20 - O20 = $21,495 - $32,269 = ($10,774) VALUE OF THE S YSTEM The measurement system allows management to keep track of changes in productivity and price recovery and their impact on profitability from period to period. Based on the results, one can draw several conclusions about the company s performance in terms of productivity, price recovery, and profitability. These conclusions raise specific questions management may look at to improve the situation. For instance, the results indicate that productivity contributions to profitability are much greater than the losses due to price changes, especially in the labor costs. Overall labor contribution to profitability would have been much worse had there not been a solid productivity improvement. It seems like the cost of labor has increased much more than the prices of tables and chairs. This may raise questions such as, Can we increase the prices of outputs to offset labor cost increases without losing sales? If so, how much do we have to raise if we want the price recovery contribution of labor to be zero instead of -$18,270? Given that woodworker wages have sharply increased from period 1, is it possible to lower the rates? If so, what should the woodworker wage rate be in order for it not to affect price recovery contribution of labor negatively? Similarly, one can conclude that the productivity of electricity is causing profit deterioration. Is electricity being wasted? Or is it due to a change in the manufacturing process? Is it possible to cut down the electricity consumption without affecting the production? If so, what should the electricity consumption be for it not to affect profitability negatively? The answers to some of these questions can be determined by using the Goal Seek and Solver features of Excel. A NSWERS U SING G OAL S EEK AND S OLVER The Goal Seek and Solver features are found in the Tools menu of Microsoft Excel. Goal Seek is the opposite of what-if analysis. Using Goal Seek, we begin with the target value in a dependent cell and determine the corresponding value in the independent cell upon which the target cell is dependent. Both Goal Seek and Solver can change independent cell values, but only Solver can change a range of cells and accept constraints, making it a more powerful feature. It also can be used to solve complex optimization problems that may involve linear or integer programming. What follows is a guide to answering some of the preceding questions. 1. What should the electricity consumption be for it not to affect profitability negatively? As shown in Figure 1, the company is losing $748 because it currently uses 48,000 kwh of electricity. To eliminate this loss, go to the Tools menu, choose Goal Seek, and set cell Q15 (profitability of total energy) to zero by changing cell E14 (quantity of electricity) as shown in the dialog box below. After clicking on the OK button, the answer in cell E14 is 44,261 kwh. Therefore, consumption should be cut by roughly 4,000 kwh to not impact company profitability negatively. MANAGEMENT accounting quarterly 15

5 2. What should the woodworker wage rate be in order for it not to affect price recovery contribution of labor negatively? As shown in the following dialog box, set cell P13 (price recovery contribution of labor, currently -$18,270) to zero by changing cell F11 (price of woodworker). Clicking the OK button reduces the value of cell F11 from $18.00 to $ What should the increased prices of tables and chairs be to offset the current -$18,270 price recovery contribution of labor? Because we want to change the price of more than one product in this case, we need to use Solver instead of Goal Seek. As shown below, set the target cell, P13 (price recovery contribution of labor), to zero by changing cells F4:F5 (price of tables and chairs in period 2), subject to the constraint F5 =7* F4. Without this constraint, Solver may use its own (often bad) judgment and increase the price of chairs from the current $65 to $92 and the price of tables from the current $450 to only $453. We use the constraint F5 =7*F4toretain the ratio of the price of a table to the price of a chair for all increased prices. Solver also can create a separate Answer Report worksheet showing the original and changed values without making any changes to the original worksheet. The Answer Report shows the new price of chairs and tables to be $78.64 and $550.47, respectively, for a labor price recovery contribution of zero. A N I MPORTANT AND F LEXIBLE TOOL As you can see, a simple APC model links productivity to profitability. Productivity measurement is important for diagnosing problem areas and contemplating corrective actions. Good productivity management requires a productivity measurement system that managers will use easily and frequently. Financially oriented business managers find the APC model and its implementation in spreadsheet software easy to understand and use, thus encouraging more widespread and thorough attention to productivity results and enabling better productivity analysis. Numerous extensions can be made to the basic system. A spreadsheet-based system can be used to generate optimal standards as opposed to actual nonoptimal base-period data, 4 and the results can be accessed from other software, such as expert systems, that can interpret the results, determine causes, and recommend solutions. 5 Because spreadsheet software is popular and economical, business managers will be eager to develop this application and use it effectively. Mohan P. Rao, Ph.D., CFPIM, is an associate professor of Computer Information Systems at the University of Texas-Pan American, Edinburg, Texas. He can be reached via at rao@panam.edu. 1 Orla O Sullivan, Technology spending s uncertain payback, United States Banker, September 1998, pp John G. Belcher, Jr., The Productivity Management Process, American Productivity Center, Houston, Texas, David M. Miller and Mohan P. Rao, Analysis of Profit-Linked Total-Factor Productivity Measurement Models at the Firm Level, Management Science, June 1989, pp Mohan P. Rao, Optimal Base-Period Data for Productivity Measurement, International Journal of Operations & Production Management, August 1993, pp Mohan P. Rao and David M. Miller, A Formal Methodology for Productivity Analysis Using Knowledge-Based Technology, in Productivity Management Frontiers-II (Ed. Sumanth et al.), 1988, pp FURTHER READING Epstein, Marc J., and Jean-François Manzoni. The Balanced Scorecard and Tableau de Bord: Translating Strategy into Action. Management Accounting, August 1997, pp Grifell-Tatje, E., and C.A. Knox Lovell. Profits and Productivity. Management Science, September 1999, pp Kaplan, Robert S., and David P. Norton. The Balanced 16 SUMMER 2000

6 Background on PERFORMANCE MEASURES Profit margins and productivity are the most important performance indicators for CEOs in their strategic decision making, according to Industry Week s 27th annual survey of CEOs. 1 Performance measurement has gained some importance in recent years because of the Balanced Scorecard. 2 Tableau de bord 3 and Objectives Matrix 4 are similar to the Balanced Scorecard although the Scorecard outlines four specific perspectives and categorizes measures into them. The Scorecard does not attempt to link productivity to profitability, and it uses both financial and nonfinancial measures. But according to a recent survey of U.S. and Canadian companies, there is a significant gap between attaching importance to a measure, actually collecting data for it, and, if this is done, using the measure for planning and evaluation. 5 Financial measures seem to be given more importance and used most often. Productivity measures can be classified into partial productivity measures and total productivity measures. 6 An example of partial productivity is labor productivity, which is a ratio of total output or sales revenue per worker or worker-hour. Likewise, total productivity measure is a ratio of an index of all outputs to the index of all inputs. Total productivity measures are more suitable for firm-level performance measurement. Some are referred to as profit-linked total-factor productivity measurement models because they link productivity to profitability, 7 and others are multifactor productivity measurement models. 8 Two additional models are the Profitability = Productivity + Price Recovery (PPP) model introduced by Miller, 9 which uses a deflating method different from the APC model, generally uses more than two-period data, and produces results in terms of dollar contribution of productivity toward profitability. 10 More recently, Grifell-Tatje and Lovell introduced a model that decomposes profit change into productivity effect, activity effect, and price effect. 11 Productivity effect further decomposes into technical change and operating efficiency, whereas activity effect decomposes into product mix, resource mix, and scale effect. They illustrate this decomposition with an empirical application to the Spanish banking industry. 1 T. Stevens, Chief Among us: 27th Annual CEO Survey, Industry Week, November 1998, pp R.S. Kaplan and D.P. Norton, The Balanced Scorecard Measures That Drive Performance, Harvard Business Review, January-February 1992, pp ; R.S. Kaplan and D.P. Norton, Putting the Balanced Scorecard to Work, Harvard Business Review, September-October 1993, pp ; R.S. Kaplan and D.P. Norton, Using the Balanced Scorecard As a Strategic Management System, Harvard Business Review, January- February 1996, pp Marc J. Epstein and Jean-François Manzoni, The Balanced Scorecard and Tableau de Bord: Translating Strategy into Action, Management Accounting, August 1997, pp James L. Riggs, Monitoring with a Matrix That Motivates As It Measures, Industrial Engineering, January 1986, pp Bonnie P. Stivers, Teresa Joyce Covin, Nancy Green Hall, and Steven W. Smalt, How Nonfinancial Performance Measures Are Used, Management Accounting, February 1998, pp Charles E. Craig and R. Clark Harris, Total Productivity Measurement at the Firm Level, Sloan Management Review, Spring 1973, pp John G. Belcher, Jr., The Productivity Management Process, American Productivity Center, Houston, Texas, 1984; David M. Miller, Profitability = Productivity + Price Recovery, Harvard Business Review, May-June 1984, pp ; David M. Miller and Mohan P. Rao, Analysis of Profit-Linked Total-Factor Productivity Measurement Models at the Firm Level, Management Science, June 1989, pp D. Scott Sink, Thomas C. Tuttle, and Sandra J. DeVries, Productivity Measurement and Evaluation: What Is Available? National Productivity Review, Summer 1984, pp Miller, Miller and Rao, E. Grifell-Tatje and C.A.K. Lovell, Profits and Productivity, Management Science, September 1999, pp Scorecard Measures That Drive Performance. Harvard Business Review, January-February 1992, pp Kaplan, Robert S., and David P. Norton. Putting the Balanced Scorecard to Work. Harvard Business Review, September-October 1993, pp Kaplan, Robert S., and David P. Norton. Using the Balanced Scorecard As a Strategic Management System. Harvard Business Review, January-February 1996, pp Miller, David M. Profitability = Productivity + Price Recovery. Harvard Business Review, May-June 1984, pp Riggs, James L. Monitoring with a Matrix That Motivates As It Measures. Industrial Engineering, January 1986, pp Sink, D. Scott, Thomas C. Tuttle, and Sandra J. DeVries. Productivity Measurement and Evaluation: What Is Available? National Productivity Review, Summer1984, pp Stevens, Tim. Chief Among Us: 27th Annual CEO Survey. Industry Week, November 1998, pp Stivers, Bonnie P., Teresa Joyce Covin, Nancy Green Hall, and Steven W. Smalt. How Nonfinancial Performance Measures Are Used. Management Accounting, February 1998, pp MANAGEMENT accounting quarterly 17