Labor productivity gets trumped by ROI

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Businesses make investment decisions mostly to maximize returns. Labor productivity is not central to investment math, yet too many monetary economists assume it is. This misunderstanding can lead to disconnects between central bankers and businesses on interest rates.

 

Setting the stage

“Work smarter, not harder” is a practical way to think about labor productivity. Yet, just as there is a precise definition of an NFL football, labor productivity has several specific meanings:

  • Labor productivity is units produced divided by labor hours worked. This is taught in business schools and used in companies. It is also used by the U.S. Bureau of Labor Statistics (BLS) in their industry labor productivity data when the needed survey data is available from companies via the Census Bureau. Otherwise, the BLS uses industry value-added adjusted for price level change. This industry data view is “bottom-up.”
  • Labor productivity for major sectors of the economy is estimated “top-down.” It starts with GDP, subtracts out government, government enterprises (think Freddie and Fannie), households, and nonprofits. The residual is the private business sector. Farming can also be subtracted to separate the improvement in farm productivity in the post-WWII decades. Nonfarm private business sector labor productivity is often the news headline.

In other words, official footballs are different depending on the purpose, as defined by those leagues.

In businesses, improving labor productivity by cutting labor hours worked relative to production is not the same as maximizing profit.

  • Labor productivity improvement is important within a given set of quality objectives and resource mix of equipment, buildings, and materials — whether a manufacturing shop floor or hospital wing.
  • Decisions to invest can change that mix of resources in pursuit of those quality objectives. These decisions are based on a measure of return. Ultimately, that return will be income net of taxes and financial capital costs divided by the investment required. For a proposed investment, returns are estimated and adjusted for the risk of achieving the return — net present value.

Labor productivity is far from what businesses maximize

  • Return on investment includes labor costs (wages and benefits), rather than labor hours.
  • Labor productivity doesn’t include all the strategic and tactical reasons for an investment decision, cost of labor (including changes in worker age and skill), asset (including tax and weighted average cost of capital), materials, energy, and implications for partners (up and down-stream), and quality.

In other words, looking for a football in a baseball game makes no sense.

When the ROI decision is considered in actual companies — oil & gas, airlines, hospitals, fast food, hotels, transportation and warehousing, retail, and more – considerations beyond labor productivity quickly multiply. Further, competitors with different resources mixes can make decisions with opposite results for labor productivity.

Good business reasons for flat or falling labor productivity

“Following the money” illustrates why a business would prefer to maximize return instead of labor productivity.

  • If the profit margin on goods produced is greater than the change in the units sold or deflated sales used by the BLS, then the benefit to the business will be greater. This is a part of the debate about whether price level change is overstated and Gross Domestic Product is understated.
  • If younger or lower skill workers at lower wages are used, then labor hours can rise, but costs will rise less or fall. For example, in hospitals when lower skill and wage workers are substituted for doctors and Registered Nurses with Bachelor of Science in Nursing degrees.
  • If more labor hours improve asset utilization

Asset utilization has several flavors:

  • Extra shift – whether a restaurant or bowling alley is open longer hours when customers are fewer or a “red-eye” flies with lower fares and passengers, labor productivity is lower but the return is improved. This is what your helpful managerial finance, managerial accounting, or microeconomics professor once explained to you — marginal benefit exceeding marginal cost. This is especially the case when there is a fixed worker requirement, such as flight or restaurant crew size, regardless of sales.
  • Deadlines – when equipment creates a bottleneck and there are delivery deadlines, then extra workers can team to get work in and out of the bottleneck machine faster. Thus, the machine utilization goes up and deadlines are achieved. This also happens when businesses view buying more capacity as too risky.
  • Turnaround – a broader case of “deadline,” this a “job shop” optimization problem, seen by consumers in restaurants, hotels, and airlines – more workers can increase the utilization of an asset, especially when demand isn’t consistent (such as restaurant busy hours). Unless a restaurant has the ability to tightly schedule customers to increase meals served and revenue (like at a popular theme park restaurants), they must do the best they can with customers who come in the door and are willing to wait. Hotels that add workers to enable earlier check-in make customers happier and might be able to charge higher rates, but probably don’t increase rooms sold.
  • Mini/micro-model – falling equipment costs also enable decentralized manufacturing. In some cases, such as metal manufacturing, automation reduces worker hours (video). In other cases, such as micro-brewers, there are more workers than if one large factory was producing all the barrels of beer. Yet, the microbrewers are profitable, with a boost from the recent tax law change.

These flavors simply bring together some of the accounting line items. In daily life, benefits can multiply or cancel out. Some are more enduring than others.

These realities are missed in high-level labor productivity estimates and assumption that higher labor productivity is always good. Similarly, policy-makers need not fret about weak aggregate average labor productivity growth when returns are rising. Understanding how businesses make decisions also helps explain the mystery of weak investment, as we’ve written previously.

The point is that higher labor productivity growth isn’t a helpful monetary policy guide when businesses have good reasons for flat or lower productivity. Multifactor productivity estimates have their own limitations as we’ve discussed previously in our Productivity Section.

In other words, there are good reasons for different balls in different games. All can help win a game, but not necessarily improve labor productivity.

The opportunity for monetary economists is to bring central bankers and business people together to see the game through the eyes of decision-makers (and microeconomists).

For more, see Investors, labor productivity is not widely weak; business models matter more, part 3 of 3 in this series.

To learn more about how to apply these insights to your professional portfolio, business or policy initiative, contact “editor” at this URL.

 

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