Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Many managers believe that increasing productivity will improve financial performance, but companies spend billions each year to improve productivity without receiving any financial benefit to the bottom line. The purpose of this paper is to explain why productivity improvements do not automatically produce financial benefits, and how the desired benefits can be obtained. According to Yu-Lee the problem is a lack of understanding of the relationships between capacity, productivity, and financial improvements. The solution requires developing a clear and concise definition of productivity, and a proper concept of cost dynamics.
Yu-Lee defines two main types of capacity. These include static capacity and dynamic capacity. Static capacity is represented by inputs such as space, labor, equipment, information technology, and materials. Dynamic capacity is represented by output1. Cost reduction projects target static capacity, i.e., input, while operational improvements emphasize dynamic capacity, i.e., output. Yu-Lee makes a distinction between dynamic capacity and realized dynamic capacity, or just realized capacity. Dynamic capacity is essentially potential output, while realized capacity refers to actual output. From these definitions it is clear that productivity and capacity are closely related. Capacity is defined in terms of inputs and outputs, and productivity is defined in terms of output per input. But that leads to a problem.
The Cost Dynamics of Capacity
From Yu-Lee's perspective (or the explicit cost dynamics, ECD perspective2), cost is defined by the dollars that flow out of the entire company. Cost allocation as used in traditional accounting (or any other accounting approach such as activity-based costing) is not part of the ECD approach. Calculating cost per unit, or cost per input simply confuses the issue and leads to decisions to reduce cost that actually increase cost. There are only two ways to reduce cost. Purchase less capacity, or pay less for the current amount of capacity.
Anatomy of Productivity
As indicated above productivity is defined as follows:
1. Realized Productivity = Realized Capacity ÷ Static Capacity
2. Potential Productivity = Dynamic Capacity ÷ Static Capacity
3. Capacity Utilization = Realized Capacity ÷ Dynamic Capacity
4. Realized Productivity = (Potential Productivity)(Capacity Utilization)
Improving potential productivity involves either:
1. increasing dynamic capacity, i.e., potential output, or
2. reducing static capacity needed, i.e., reducing actual input without reducing potential output.
Improving realized productivity involves either:
1. increasing realized capacity, i.e., actual output, or
2. reducing static capacity, i.e., actual input without reducing actual output.
Ensuring Financial Benefit
Improvements in realized productivity (actual output per actual input) generate additional capacity, but do not necessarily generate improvements in financial performance. Obtaining financial benefit from the capacity improvements requires carrying the improvement to the bottom line. Financial benefits are generated when the needed capacity is reduced, (i.e., cost reductions from decreases in required space, labor, equipment, information technology, and materials), or when the company does more with the extra capacity that generates increased revenue.3
1 In accounting, capacity is usually defined in terms of output. For example, see my Note on Denominator Activity Levels; Brausch, J. M. and T. C. Taylor. 1997. Who is accounting for the cost of capacity? Management Accounting (February): 44-46, 48-50. (Summary); and Debruine, M. and P. R. Sopariwala. 1994. The use of practical capacity for better management decisions. Journal of Cost Management (Spring): 25-31. (Summary).
2 For more on Explicit Cost Dynamics see:
Yu-Lee, R. T. 2002. Target costing: What you see is not what you get. Journal of Cost Management (July/August): 23-28. (Summary).
Yu-Lee, R. T. and C. Haun. 2006. Create bullet-proof value propositions. Industrial Management (May/June): 25-30. (Summary).
3 For another paper related to productivity, see Hayzen, A. J. and J. M. Reeve. 2000. Examining the relationships in productivity accounting. Management Accounting Quarterly (Summer): 32-39. (Summary). For the economic theory view of the relationship between productivity and cost see Martin, J. R. Not dated. Chapter 11: Conventional Linear Cost-Volume-Profit Analysis. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. http://maaw.info/Chapter11.htm
To Compare Explicit Cost Dynamics to The Theory of Constraints see:
Goldratt, E. M. 1990. What is this thing called Theory of Constraints. New York: North River Press. (Summary).
Goldratt, E. M. 1990. The Haystack Syndrome: Sifting Information Out of the Data Ocean. New York: North River Press. (Summary).
Goldratt, E. M. and J. Cox. 1986. The Goal: A Process of Ongoing Improvement. New York: North River Press. (Summary).