Wednesday, February 23, 2011

What Is Productivity? What Is Efficiency?

Back in 1997, I wrote a 15-page white paper synthesizing concepts I'd read in various publications on economics, including some of Joseph Schumpeter's seminal papers from the 1920s. The short version of the paper enabled my mentor, Gerry Weiss, to get me a meeting with an influential, well-known former money center bank CEO to discuss the concepts and my resulting research as it applied to corporate performance, both internally for resource allocation, and externally for equity portfolio management.

I found that prior economic literature had, for the most part, failed to distinguish between productivity and efficiency. So I wrote, in part,

"The critical difference between efficiency measures (called “volume efficiencies” in this paper instead of the popular term “productivity”) and productivity measures (called “resource value productivities” in this paper) is that the numerator of the latter are value-denominated, whereas the former are unit-denominated. Thus, volume efficiency measures can’t provide any information regarding the value of what was done more or less efficiently. By splitting what has come to be misnamed productivity into two properly different concepts, some of the confusion regarding the modern behavior of volume efficiency can be better understood."

Imagine my surprise, therefore, that 12 years later, the Wall Street Journal published an editorial in last Wednesday's edition by two McKinsey consultants addressing some of the same concepts. Except that they still didn't get it quite right.

Here's what James Manyika and Vikram Malhotra wrote in their editorial Productivity and Growth: The Enduring Connection,

"Productivity can come either from efficiency gains (i.e., reducing inputs for given output) or by increasing the volume and value of outputs for any given input (for which innovation is a vital driver.)"

The McKinsey guys are close to getting it right, but they still fail to properly split volume efficiency phenomena from the very different notion of creating more value for a level of output.

Further, from reading their article, it's clear that they still mistakenly deal in averages across an economy. They also misleadingly connect productivity and growth, as if one will drive the other.

Truth is, as I found in my proprietary research over a decade ago, the highest resource productivity gains aren't typically associated with raw growth in value for shareholders.

The actual relationships are much more complicated, but I can't discuss them here. It's proprietary.

But I can tell you this. McKinsey's contention that productivity is some amorphous concept which can be grown or driven higher across an economy to spur economic growth is wrong. That's not how Schumpeterian dynamics works. It has more to do with higher value-added solutions displacing older ones in an economy, not simply flogging older competitors' operations to somehow run leaner and faster. Those activities won't create more consumer value.

You might be able to measure these concepts across an economy. But that doesn't mean they are managed or occur at that level.

However, I'm quite sure Manyika's and Malhotra's puff piece in the Journal is just the public facet of a well-orchestrated push, complete with Powerpoint presentations, that's being delivered to every potential client. It makes for good face time and high-spot meetings with CEOs to suggest some new project for, naturally, McKinsey, to measure various aspects of the firm's efficiency and productivity.

For those CEOs and senior executives who can't think for themselves, it will sound very seductive. It reminds me of something Bob Gach, a partner at Andersen Consulting years ago when I worked there, used to say. He didn't like Morgan Stanley, his lead client, very much. He said they were a bad client because they knew too much. Ideally, he contended, a client had to be smart enough to know they needed help, but, unlike the old Salomon, Goldman or Morgan Stanley, not so smart as to know they could do most of the job themselves. That probably also describes the ideal McKinsey client.

From that perspective, this new spin on productivity sounds good, doesn't it? Won't actually help the companies, but it should help the McKinsey partners.


CCz said...

Great post.
Politicians, academics, managers, all think the same to improve productivity one has to reduce costs, reduce wages, increase volume. I believe it is a reminder of the time when demand was bigger than supply.
My life changed when I read “Managing Price, Gaining Profit” from Michael V. Marn & Robert L. Rosiello, HBR Sept 1992, and I understood the leverage power of price.
In a capitalist economy where supply is bigger than demand there is only one way to increase price - increase value.

CCz said...

You wrote "they still mistakenly deal in averages across an economy."
I learned with one of the 2010 Nobel Prize winner, Mortensson, the incredible fact that there is more productivity dispersion within an economic sector than productivity dispersion between economic sectors. Almost no one see the implications of that for goverments and public policies.

C Neul said...

Thanks for your comments.

Unfortunately, the concept of "demand was bigger than supply" isn't technically correct.

Demand and supply are unequal at many price levels, equal at the market price.

Your remark about dispersions of productivity is an instructive one. Thanks.