1. Why is productivity important?
2. What is Free Lunch Productivity?
3. Who came up with the idea of Total Factor Productivity to measure productivity at the company level (Free Lunch Productivity)?
4. What is the connection to USA Today?
5. There are many productivity benchmarks, and all have their shortcomings. Why is FLP any better than others?
6. This benchmark measures TFP change. So a company can improve significantly on TFP in the course of 5 years, but overall it may still underperform in its industry. So how can you make any analysis of the nominal productivity?
7. How is FLP actually computed?
8. Can you explain the actual FLP change equation?
9. Where does the 0.4 come from?
10. More Questions?
Q. Why is productivity important?
Because how productive individuals, businesses and countries are, determines how wealthy and how prosperous they become. Income per person, or value added per worker, is a key driver of profit, living standards and wealth creation.
Q. What is Free Lunch Productivity?
Most productivity measures focus on a single resource: for instance, output per worker or per labor hour, or profit per dollar of shareholders' capital, are measures of productiveness for labor or for capital.
But often we would like to have an overall measure of productivity that measures how productive labor and capital are together. That is what Free Lunch Productivity (FLP) measures.
Q. Who came up with the idea of Total Factor Productivity to measure productivity at the company level (Free Lunch Productivity)?
Professor Shlomo Maital from MIT, TIM . See: History of Total Factor Productivity and Free Lunch Productivity (link)
Q. What is the connection to USA Today?
Four years ago, the largest-circulation newspaper in the United States, contacted Prof. Shlomo Maital, and asked for help in computing FLP growth numbers for America's largest 100 firms. Since then, for the past four years, Maital has been working with Del Jones and Barbie Hansen on an annual two-page spread published in USAToday, showing the year-to-year change in TFP for the Fortune 100 companies.
Q. There are many productivity benchmarks, and all have their shortcomings. Why is FLP any better than others?
Correct, in principle any way of measuring productivity has its shortcomings. But in this research, the FLP calculations have been applied in the same way to all companies. So it provides an insight as to how firms compare, from an IT productivity perspective.
Q. This benchmark measures TFP change. So a company can improve significantly on TFP in the course of 5 years, but overall it may still underperform in its industry. So how can you make any analysis of the nominal productivity?
To deal with this issue, this benchmark uses the average of FLP change and value add per employee. FLP change shows how the company in question has progressed. Value add per employee shows how productive they are nominally in comparison to their peers in their industry.
Q. How is FLP actually computed?
Pretty simple, actually. Take a measure of 'output' -- for a whole economy, Gross Domestic Product (GDP); for an individual firm, 'value added' (sales revenues minus cost of raw material inputs). Divide it by a number representing 'labor plus capital tools' -- or, a package including labor and the capital it uses. The result: a single number, measuring output, or value added, per unit of labor and capital taken together. This number can be tracked year-to-year, and the % changes in it measured, to measure progress and growth in productivity, and to compare it across companies and across countries.
Q. Can you explain the actual FLP change equation?
Sure. Consider XYZ Inc. Here are its numbers:
| |
2002 |
2001 |
% change |
| Sales |
$110M. |
$100M. |
10% |
| Cost of Raw Materials |
30M. |
25M. |
|
| = Value Added |
$80M. |
$75M. |
6.7% |
| Labor (no. of employees) |
250 |
250 |
0% |
| Value added per employee |
$440,000 |
$400,000 |
+10% |
| Shareholders' Equity (Capital) $B |
$102M. |
$100M. |
2% |
| Capital per employee |
$408,000 |
$400,000 |
+2% |
a) Take the % change in output, or in value added per employee
+10% this is a measure of labor productivity; the question is, why did labor productivity rise by 10%?; was it because of 'capital deepening' -- each worker had 2% more capital during the year than during the year before (i.e. more software, machines, computers, IT, etc.)? or was it because of non-capital factors, such as management, motivation, efficiency, product innovation, etc.
b) To find the answer: subtract from the %change in value added per worker, the contribution of 'added capital per worker' to labor productivity:
- 0.4 times (2%)
the 0.4 is the 'weight' or 'contribution' of capital to labor productivity; and the +2% is the % change in capital per worker.
So -- the fact that the workers' capital rose during the year by 2% added 0.4 x 2 = 0.8% to their productivity. What is left over, after subtracting this from the -8.3%, is the % change in total factor productivity:
10% - 0.8% = 9.2 %
Conclusion: XYZ Inc. managed to boost its sales, production, and productivity, not by using costly shareholders' capital but mainly by 'free lunches' -- increasing the motivation, efficiency, and energy of workers, and the attractiveness in the marketplace of its products.
Often, strong TFP numbers reflect innovative products that find market success.
Q. Where does the 0.4 come from?
Free Lunch Productivity, is a ratio between output or sales revenue and a 'package' of inputs (labor and capital). The package of inputs is a geometrically weighted average:
L^(.6) * K^(.4), where L is the number of employees and K is the value of the firm's capital, or assets.
The exponents represent the fraction of the firm's value added contributed by labor (0.6 or 60%) and by capital (0.4 or 40%) -- taken as the average for the economy as a whole. We use the economy-wide average, since the data needed to compute this parameter for each firm is normally not publicly available.
However, if you have access to your company's data (wage costs, including social benefits, pension contributions, etc., as a fraction of the firm's total value added, measured as sales revenue minus cost of raw material components), you can compute this parameter rather than assume it is equal to the economy's average.
Free Lunch Productivity is: Q/ L^(.6) K^(.4) where Q is sales revenue or value added.
The % change in TFP is: % change in Q/L minus 0.4 (% change in K/L)
This shows how the 0.4 parameter enters into the FLP equation.
Q. More Questions?
Please contact Miriam@tim.co.il
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