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About this lesson

Productivity is a term used to indicate improved efficiency which results in more output for the same input.

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Quick reference

Productivity

Productivity is a term used to indicate improved efficiency which results in more output for the same input.

When to Use Productivity

Productivity measures are used when companies are in a cost-cutting mode.  Productivity can be applied to the entire business cost structure or it can be focused on a particular type of cost, such as variable cost. 

Instructions

Productivity is a term that is used frequently in business to indicate improved efficiencies.  Within the finance community there is a specific way to calculate productivity.  This productivity calculation removes the effects of inflation and deflation.  It focuses on whether the organization was able to do more output with the same input. (or same output with less input).  This calculation focuses on the output for a given amount of resources.

  • The productivity ratio calculation starts with an output ration that is sales divided by costs.  At the business level, this is all of the sales for product and services (remove unusual items from the revenue) and all of business costs for some time period. 
  • The change in productivity is determined by calculating the change in ratios from year to year.  Positive productivity has occurred if that ratio is larger than the previous year.  Negative productivity occurred if the ratio is smaller than the previous year.
  • While the productivity ratio calculation at a business level includes all costs, a variation that is often calculated will only use the variable costs.  When the ratio is calculated in that manner, it is known as Variable Cost Productivity.
  • Because the calculation are comparing year to year, a factor is used to adjust for inflation or deflation.
    1. Therefore if your product used oil, you wouldn’t automatically be credited for positive productivity when the price of oil dropped and negative productivity when it went up.  To get positive productivity, you would need to reduce the amount of oil used.  That is reduce the amount of resource required.
    2. Finance will provide the factor based upon their analysis.  They may have different factors for different commodities or categories of sales and costs.
  • The calculation is a three step process:
    1. Adjust current year sales and cost information back to last year’s standards. Adjust for price inflation and deflation.
    2. Determine the ratio of sale/cost for last year and the current year – using the adjusted values.
    3. Calculate the percentage change in the ratio.
  • Many companies calculate this monthly using a rolling 12 month window (i.e. the most recent 12 months, regardless of which fiscal year the month was in.)

 

Hints and Tips

  • This is not the same as cost increases or cost savings due to price adjustments either with customers or suppliers.  Those effects are removed from this analysis but do affect the financial reports and statements.
  • The analysis is done in this manner to evaluate managers and determine if they were actually more efficient or just lucky.  Generally, the operational managers cannot control pricing, but they can control usage, scrap, and other factors that add cost.
  • Note that a cost reduction would provide positive productivity using this measure only in the year when it went into effect. After that, the effect is already in the numbers from the previous year, so there would be no further improvement in the productivity ratio, although the cost savings would continue year after year.  Therefore to get positive productivity, changes must be made every year to reduce the utilization of resources.
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  • 00:03 Hi, this is Ray Sheen.
  • 00:05 Let's talk about productivity.
  • 00:07 Now this term is used often in business discussions,
  • 00:10 let's find out what it means in financial terms.
  • 00:15 We will look at a financial calculation known as a productivity ratio.
  • 00:19 The productivity ratio is a measure of improvement in cost effectiveness for
  • 00:22 a business unit.
  • 00:23 Many companies will have productivity goals and
  • 00:25 targets that are used as measures for business success.
  • 00:28 Operational managers are charged with achieving these goals.
  • 00:32 An immediate question that comes to mind is, which costs are to be included, and
  • 00:36 how are the calculations done?
  • 00:37 The productivity ratio calculation normally will include all of
  • 00:40 the sales revenue from product and service sales, and
  • 00:43 all the business operating cost over some time period.
  • 00:47 The calculation normally includes one year's worth of cost and sales.
  • 00:51 Many companies will recalculate their ratio monthly,
  • 00:54 using the most recent 12 month of sales and cost data.
  • 00:58 Some companies will also calculate variable costs productivity.
  • 01:01 In this case, they still use all of sales, but
  • 01:04 instead of all operating costs, they only use the variable costs.
  • 01:09 A ratio is created of sales divided by cost for the current point in time,
  • 01:12 and another one from one year ago.
  • 01:15 The productivity value is the percentage of change in the two ratios.
  • 01:20 A higher value, that is more sales over the same cost, is positive productivity.
  • 01:25 And a lower value is negative productivity.
  • 01:28 Let's talk a little bit more about the calculation.
  • 01:30 Because there is a tricky element to it.
  • 01:32 The calculation is done in a three step process.
  • 01:34 The first step is the tricky step.
  • 01:37 The Productivity Ratio is measuring the change in efficiency.
  • 01:41 Therefore it needs to remove the effects of price inflation and
  • 01:44 deflation that is occurring in the market.
  • 01:46 The company is not able to control those items.
  • 01:49 For instance, if your product uses oil, and
  • 01:51 the price of oil goes down, you don't get credit for a productivity improvement.
  • 01:55 You have nothing to do with the price of oil.
  • 01:58 If instead you reduce the amount of oil used by 20%, you would get credit for
  • 02:02 productivity, regardless whether the price of oil goes up or down.
  • 02:07 So the first step is to take out the inflation and deflation effects.
  • 02:10 These effects apply to the cost of labor and materials, and
  • 02:14 it also applies to the price of your product.
  • 02:16 All of the sales an cost values are adjusted
  • 02:19 to an equivalent of last years value.
  • 02:22 Finance will provide the adjustment factors to use for
  • 02:25 the different categories of cost.
  • 02:27 Step two is to set up the sales over cost ratios.
  • 02:30 Two ratios are needed.
  • 02:32 The sales over cost from last year and
  • 02:34 the adjusted sales over the adjusted cost from this year.
  • 02:38 Make sure you include the correct categories of sales and costs.
  • 02:42 The third step is to determine the percentage change from last year's sales
  • 02:45 over cost ratio, to this year's sales over cost ratio.
  • 02:49 Let's look through an example.
  • 02:51 Okay, in this example you can see we have the values for sales, operating expenses,
  • 02:56 and COGS for last year and this year.
  • 02:59 We also have adjustment factors that finance has given us for
  • 03:03 each of those categories.
  • 03:04 Incidentally, you might disagree with the factors from finance, and
  • 03:08 in my experience, you can go to finance with data,
  • 03:11 show them what the current adjustment factor should be.
  • 03:13 They'll listen politely, and then tell you to use their adjustment factors anyway.
  • 03:17 So let's do step one.
  • 03:18 We adjust this year's $28 million sales with a factor of 1.037 and
  • 03:23 end up with the adjusted sales of just over $27 million.
  • 03:27 We adjust the $10 million of operating expense with a factor of 1.006,
  • 03:32 and get an adjusted expense $9,940,000 and change.
  • 03:36 We adjust the $13,850,000 of COGS with a factor of 1.022 and
  • 03:41 get an adjusted COGS of 13,551,000.
  • 03:43 Now step two. We build the sales over-cost ratios.
  • 03:51 Last year's sales were $25 million.
  • 03:53 When we add the operating expense of COGS of last year, we get $22,350,000.
  • 03:59 This ratio comes out to be 1.119.
  • 04:01 For this years ratio we need to use the adjusted numbers.
  • 04:07 The adjusted sales are just over 27 million.
  • 04:11 Adding the adjusted operating expense and COGS together, we get 23,492,000.
  • 04:18 This gives us a ratio of 1.149.
  • 04:20 Now, for step three.
  • 04:23 We look at the percentage change from 1.119 to 1.149.
  • 04:27 This comes out to 2.7%.
  • 04:31 Therefore, the business was 2.7% more productive.
  • 04:35 The math is not complex.
  • 04:36 The key to the calculation is to get your totals and get the adjustment factors.
  • 04:40 The key to productivity, is to increase sales without increasing resources.
  • 04:45 Notice in this example, our costs are up, but our productivity is up also.
  • 04:53 As you can see, productivity,
  • 04:55 at least in financial terms, is based upon becoming more efficient.
  • 04:59 It's an application of that time-worn phrase, do more with less.

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