Part 2: Measuring Current Economies of Scale


Components of Productivity

Capsule: Productivity has two separate components. The first, the Efficiency of the Input, is the ratio of Inputs/ICD. The second, the Effectiveness of the Intermediate Cost Driver, is the ratio of Intermediate Cost Driver/Outputs (ICD/O). Productivity is the product of the two components (I/O).

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Symptoms and Implications:

The Company’s Productivity is expressed as the ratio of Inputs/Outputs (I/O). Most Inputs do not create an Output directly, rather the Inputs produce intermediate products, the Intermediate Cost Drivers (ICDs). The ratio of a physical measure of an Input Building Block Cost, such as number of People, to an Intermediate Cost Driver is a measure of the Efficiency of the Input. This measure is expressed, using People as Inputs, as FTE/ICD. The ICDs, in turn, produce the Output. The ratio of the ICDs to Output, expressed as ICD/O, is a measure of Effectiveness of the ICD. The fewer ICDs the Company can use to produce the Output, the less cost involved. Productivity is then the result of multiplying Efficiency x Effectiveness, Productivity = Input/ICD x ICD/Output = Input/Output. For the remainder of this section of the diagnostic, we will use People as the Input for brevity of our explanation. The Company may employ similar approaches when using Purchases or Capital as the Input. We will discuss the Efficiency of the Input and the Effectiveness of the ICD in turn.

Efficiency of the Input

Each functional cost organization manages its People to produce the Intermediate Cost Drivers for which it has responsibility. For most functional cost units, this is their primary task. The supervisors and managers in the functional cost unit work to improve the Efficiency of the Input by managing their People. The measure of their success is the ratio of Input/ICD, in this case, FTE/ICD.

Examples of Efficiency >>

There are two typical actions that improve the Efficiency of an Input. The first is to reduce the rate of cost for the Input. This does not necessarily reduce the actual numbers of Inputs, for example FTEs. However, the lowering of the rate of costs paid for an Input is equivalent to using a fraction of the original Input. The second typical action that improves the Efficiency of the Input is to reduce the number of units of Input not producing Output. This approach does reduce directly the number of Inputs required to produce an Output.

Examples of Efficiency through the Reduction in Rates of Cost >>

Examples of Efficiency through the Reduction of Inputs Not Producing Output >>

Effectiveness of the ICD

In some cases, the individual organizational unit also controls the unique ICDs and their occurrence that contribute to the Output. At a minimum, most functional cost units can help in the evaluation of each ICD and its value to customers. So, a secondary task of each functional cost unit is to measure and manage the Effectiveness of the Intermediate Cost Driver. This Effectiveness is measured as ICD/O.

Examples of Effectiveness >>

There are two characteristic approaches to improving the Effectiveness of ICDs. The first is to redesign the products, or the processes that produce the products, in order to reduce the Intermediate Cost Drivers. This process usually reduces the unique ICDs in the product. The second approach is to use the ICDs with more Output. This approach reduces the quantity of a unique ICD needed to produce the Output.

Examples of Effectiveness Using Product and Process Redesign >>

Examples of Effectiveness by Using ICDs with More Output >>

Productivity as Product of Components

Productivity, Input/Output, is the product of multiplying the Efficiency of the Input, Input/ICD, times the Effectiveness of the ICD, ICD/Output. In equation form, Productivity = Input/Output = (Input ÷ ICD) x (ICD/Output). In our discussion so far, People would be the Input, so we modify the equation to reflect its application using FTEs: Productivity = FTE/Output = (FTE/ICD) x (ICD/Output). This is an accurate representation of the way things work since the employees produce ICDs and Company practices and policies determine the number of ICDs in the final Output. The Productivity of the FTEs in the organization is a product of their Efficiency (i.e., FTE/ICD) x the Effectiveness of the ICD (measured by ICD/O).

Examples of Productivity >>

Questions for Components of Productivity

  • What is the Productivity, Input/Output, of each functional cost organizational unit today? Use FTEs as the first measure of the Input in measuring Productivity.

  • What is the Efficiency of Input, Input/ICD, for the ICDs of each functional cost organization? Use FTEs/Output as the first measure of Efficiency of Input.

  • What is the Effectiveness of the ICD, ICD/Output, of each ICD in the functional cost organization?

The Company now has the capability to create countable measures of Productivity deep within the organization. It now turns its attention to measuring the Economies of Scale it is creating as the business grows.

Basic Strategy Guide Users Return to Step 27

Summary Points

Next: Measuring Economies of Scale in Each Cost Function