Why the title Productivity Accounting: The Economics of Business Performance
We have borrowed the title from Hiram S. Davis, who was a staff member and Director of the Industrial Research Unit. In the seventies, after some organizational changes, this Unit became the Department of Management in the Wharton School, University of Pennsylvania (US).
Davis published Productivity Accounting in the year 1955. In it he studied productivity in a business, and devoted much of his attention to the relationship between productivity growth and financial performance, a relationship he called “productivity accounting”. He also explained the need to convert the accountant’s current price accounts to constant price accounts in order to obtain a productivity measure independent of prices. Davis also continued his interest in the distribution of the benefits of productivity growth to consumers, resource suppliers, labor, management and investors and, with this approach, he is an unrecognized early precursor of the stakeholder theory.
The title of the book is a tribute to Hiram S. Davis and, by means of him, all the researchers who made significant contributions to the field, but have had limited recognition.
The cover of the book
It took some time to decide the photo of the cover of the book. We considered some proposals from the editorial, but we decided to suggest a small set of photos from the buildings of the Catalan architect Antoni Gaudí (1852-1926). The designer chose the benches of the Parc Guell (http://www.parkguell.cat), which ended up appearing on the cover of the book. The editorial sent us two proposals for the cover, and we agreed with one of them. The anecdote is that, although we love the current cover of the book, the first time that we saw it, it was already in print. It seems that the department of marketing took the final decision. The former cover of the book is reproduced.
Previous versions
In the process of writing the book, Knox was piling up the different versions of the chapter's manuscripts on the floor of his office. It was sometimes useful, particularly when it was necessary to recheck a former hand note or when we were unable to find an older version in our computers. The pile kept staking up till the cleaning service started complaining. Some pictures were taken.
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Which references the book uses
The book examines productivity dispersion and the determinants of productivity change by relating productivity change to change in financial performance, and by exploring the distribution of the benefits of productivity. The study is set within an analytical framework, augmented with empirical applications. A wide range of literature, in business and economics, created around the world over a long period of time, in academy, in consultancies and in government agencies has been reviewed.
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We have learned much about productivity dispersion and its persistence from studies that appeared nearly a century ago in Monthly Labor Review, a journal published by the U.S. Bureau of Labor Statistics. We have gained valuable insights into the relationship between productivity and business financial performance from reading Productivity Measurement Review, a journal published quarterly from 1955 through 1965 by the European Productivity Agency. We have gained additional insights into the distribution of the benefits of productivity change, and to alternative definitions of these benefits, from reading several monographs published under the auspices of the Centre d’Étude des Revenus et des Coûts (CERC) in Paris during the late 1960s and early 1970s. All this literature is incorporated together with current references in business and economics into an understandable theoretical framework, using a standard mathematical notation. The book includes contributions originally written in English, French and, also, Spanish.
What we expect
This book intends to help researchers and practitioners in the evaluation of firm behavior from a quantitative perspective. Additionally, we also expect it to lead to the rediscovery of interesting old topics, draw the attention to new subjects and, as a consequence, open new lines of research.
The book can sometimes be quite audacious. For instance, in Chapter 6, after presenting the Malmquist productivity index in an indicator form inside of a profit approach, there is a proposal for a flexible definition of productivity "depending on the circumstances" (p. 271).
Above all, we expect the readers to find it interesting and useful and not to adopt an indifferent stance towards its contributions.
Long abstract
Managers make business decisions; they do so at the company level and, in different guises, at the industry or sector level and the national economy level. Koopmans (1951) referred to these decision-makers as “helmsmen,” for the way they steer their businesses. Management decisions determine the economic performance of the business, and have financial implications for its owners, its lenders, its customers and its resource suppliers.
Accountants construct accounts from the outcomes of management decisions; they do so at the same three levels. These accounts describe financial performance, and they can be compared through time and across production units at each level. Although accounts record the financial consequences of management decisions, they also inform management decision-making. Accounts thus guide management decisions and record their consequences. They contain an enormous amount of useful financial information, but they generally contain no entry labelled “productivity.”
Economists have analytical skills and interests that are complementary to those of managers and accountants. Although accounts contain no direct productivity information, economists are able to extract productivity information from them. This information enables them to quantify the contribution of productivity change to change in financial health. They also are able to quantify the financial contributions of the main drivers of productivity change, generally but not exclusively identified with improvements in operating efficiency and the adoption of new technologies, and this information can be used to inform business and public policy. Finally they are able to identify the beneficiaries of the financial fruits of productivity change, and to quantify their gains or losses. The ability to extract so much relevant economic information from the accounts has been emphasized over time by a wide range of scholars. We exploit this ability throughout the book.
With this complementary financial and productivity information at hand it becomes possible to associate alternative management practices with higher or lower productivity, and hence with better or worse financial performance. It is also possible to associate various features of the operating environment with productivity and hence financial performance. This information does not appear in company accounts, but it plays an important role in the relationship between productivity and financial performance. Accounting for variation in the operating environment, either through time or across businesses, levels the playing field when conducting a comparative performance evaluation. The relationship between productivity and financial performance is also influenced by movements in prices paid for resources and received for goods and services. The role of productivity and prices in influencing financial performance is an old theme that permeates the book.
Much of what we know about the relationship between productivity and business financial performance comes from accounts. It is difficult to overstate the significance of the synergies between accountants and economists, or the significance of the resulting information. Most importantly, it is difficult to overstate the significance of productivity itself. At the company level, improvements in productivity go straight to the bottom line, to the benefit of various beneficiaries. Profitable companies expand, and their hiring and investment activities contribute to growth in the economy. At the economy level, these productivity gains raise income per capita and contribute to a higher standard of living. Productivity patterns go a long way to explaining the Schumpeterian creative destruction responsible for the survival and disappearance of companies, and at the aggregate level to answering Landes’ (1990) rhetorical question “Why are we so rich and they so poor?”.
The interest in the relationship between productivity and profit provides us with an opportunity to forge a linkage between the business and economics literatures, in an effort to encourage interaction. We call this relationship productivity accounting. It allows us to provide answers to relevant questions that regularly appear in the academy and, also, in the business press. Special mentions include
i) What is the nature of the relationship between productivity and business financial performance?
Formal models characterizing the relationship have been developed in the literature. We examine these models and extensions to them in Chapters 2 – 6. The ratio models in Chapters 2 and 3 are based on index numbers, and the difference models in Chapters 4 – 6 are based on indicators. The models in Chapters 7 and 8 exploit both index numbers and indicators.
ii) What factors drive productivity change?
We provide an analytical framework within which economic analysis can identify, and quantify the contributions of, the primary drivers of productivity change. The analysis is based on primal (production) or dual (cost, revenue or profit) best practice frontiers. We introduce these frontiers in Chapter 1, and we use them within a productivity accounting framework, throughout the book. Therefore, the primary drivers of productivity change can be empirically implemented using linear programming techniques based on Data Envelopment Analysis (DEA) or following an econometric approach based on Stochastic Frontier Analysis (SFA).
iii) How are the financial benefits of productivity growth distributed?
Davis’ procedure for productivity accounting not only quantifies productivity change, it also quantifies the sharing of the fruits of productivity change. Both productivity accounting and accounting for the distribution of the fruits of productivity change have been implemented by Kendrick & Creamer and, extensively, by writers associated with the French public institution CERC (Centre d’Étude des Revenues et des Coûts) (1969a and elsewhere). To us, it was an interesting old topic, which we have carefully treated throughout the book. Moreover, we think that it has not drawn enough attention by the stakeholder theory yet.
After an introductory chapter, the book is divided in three parts and seven chapters. Part II contains three chapters and Parts I and III two chapters each. With regard to the contents, the book establishes the nature of the relationship between productivity and financial performance in Chapters 2 and 3 (Part I), in which financial performance is measured by profitability; in Chapters 4 – 6 (Part II), in which financial performance is measured by profit; and in Chapter 7, in which financial performance is measured by cost. Chapter 8 explores the relationship when financial performance is measured by return on assets (ROA), the ratio of profit to assets. In total, the book features 386 pages. As a curiosity, Chapter 5 is the shortest and Chapters 8 the longest. The book is organized as follows.
| Chapter 1: Introduction |
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Part I |
Productivity and Profitability |
| Chapter 2: Profitability Change: Its Generation and Distribution | |
| Chapter 3: Decomposing the Productivity Change and Price Recovery
Change Components of Profitability Change |
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Part II |
Productivity and Profit |
| Chapter 4: Profit Change: Its Generation and Distribution | |
| Chapter 5: Decomposing the Quantity Change and Price Change Components of Profit Change | |
| Chapter 6: Decomposing the Productivity Change Component of Profit
Change |
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Part III |
Productivity, Cost and Return on Assets |
| Chapter 7: Productivity and Cost | |
| Chapter 8: Productivity, Capacity Utilization and Return on Assets |
A short abstract of each one of the Parts of the book can be found below
Part I Productivity and Profitability
We define profitability as the ratio of revenue to cost. Our primary objective in Chapters 2 and 3 is to identify the factors that generate change in profitability. One set of factors, which we refer to as sources, consists of changes in quantities and prices of outputs and inputs. Individual quantity changes aggregate to the overall impact of quantity change on profitability change, which we call productivity change. Individual price changes aggregate to the overall impact of price change on profitability change, which we call price recovery change. In this framework profitability change consists exclusively of productivity change and price recovery change. A second set of factors, which we refer to as drivers, consists of phenomena such as technical change, change in the efficiency of resource allocation, and size change. The ability of management to harness these factors drives productivity change, which is one component of profitability change. Our second objective is to identify the recipients of the financial impacts of productivity change. Among the potential claimants to these impacts are consumers, resource suppliers including labor, and lenders to and owners of the enterprise. Thus the sources of productivity change are changes in quantities of outputs and inputs, and the recipients of the fruits of productivity change are those agents paying or receiving changes in prices of individual outputs and inputs.
Part II Productivity and Profit
This Part II deals with the generation and distribution of profit: the difference between revenue and cost, and its change. In Chapters 2 and 3, profitability change and its components are expressed as ratios, as pure numbers, while in Chapters 4 - 6 profit change and its components are expressed as differences, in monetary units. In Chapter 4 we provide an introduction, largely historical, to the subject. In Chapter 5 we take a somewhat more analytical approach based on empirical indicators, the difference analogues to empirical indexes that are expressed in ratio form. We attribute profit change to change in quantities and change in prices, and we explore the distribution of the financial impacts of quantity change. However the introduction of empirical indicators enables us to identify and characterize two components of the quantity effect and two components of the price effect. In Chapter 6 we consider various approaches to the search for the economic drivers of productivity change. We introduce best practice technology and varying degrees of optimization in order to identify the economic drivers of productivity change and to quantify their contributions to profit change. Because best practice technology is unknown, it must be estimated, and this, together with a sufficiently large sample to make estimation feasible, is the price to be paid for gaining insight into the economic drivers of productivity change. In all three Chapters profit change is expressed in monetary units. Consequently, the impacts of productivity change and its economic drivers are also expressed in monetary units.
Part III Productivity, Cost and Return on Assets
Chapter 7 explores the relationship between financial performance and productivity performance in an environment that ignores the revenue half of the picture. In such an environment financial performance depends on cost, and productivity performance depends on output and input quantities, and also on input prices. Focusing analysis on the cost half of the picture is easily motivated and widely practiced. It is worth mentioning: i) in some sectors output prices are missing, particularly in services e.g. health care; ii) in some sectors firms have limited control over output quantities, and therefore over revenue; iii) in other sectors firms lack control over output quantities and output prices. This occurs under incentive regulation, in which firms must satisfy demand and the regulator sets prices so as to provide firms with an incentive to increase productivity in order to contain or reduce cost. In these sectors the analysis of financial and productivity performance necessarily takes on a cost perspective. Chapter 8 explores the relationship between productivity and financial performance when financial performance is measured by return on asset (ROA), the ratio of profit to assets. ROA is a widely known measure of financial performance. It can be used to compare the financial performance of firms of varying size within an industry or sector, since it normalizes profit by assets, which is likely to vary with firm size. This chapter shows how change in the rate of capacity utilization, productivity change, price recovery change and size change influence ROA change. Chapter 8 builds the decomposition around a theoretical Malmquist productivity index, and a similar decomposition around empirical Laspeyres and Paasche quantity and price indexes.