Part 2: Measuring Current Economies of Scale
CREATING COUNTABLE MEASURES OF PRODUCTIVITY
Capsule: Productivity is a measure of the number of Inputs required to produce the Outputs for customers. The Company may analyze the physical Inputs by evaluating the chain leading from the basic costs of the business through the cost drivers in each organizational unit to the final Output. The best measure of physical Output for customers is usually a customer order.
For helpful context on this step:
Symptoms and Implications:
As we will see in a later section, Economies of Scale occur because some costs remain fixed as the business grows. This is a critical concept for strategy and cost management. But before we get to Economies of Scale, we have to measure Productivity. Productivity is an important physical measure of Economies of Scale.
We need physical measures for both Inputs and Outputs. Productivity measures the amount of Inputs required to produce an amount of Output. If we can count both Inputs and Outputs, then physical Productivity is the ratio of physical Inputs/physical Outputs. This measure of a physical Productivity ratio improves as the number of Inputs required to produce one Output declines.
Inputs are costs. There are many concepts that companies use to measure and manage costs. In measuring and managing physical units of cost, we prefer to use links among physical measures. We use units of People (e.g., Full Time Equivalents), Purchases (e.g., tons of steel) or Capital (e.g., machine hours) as the first link. These are the Company’s Basic Building Block costs. In turn, these Basic Building Block costs work in the Company’s functional cost organizations to produce parts of the final Output. These parts are the products of the functional cost organizations. We call these products Intermediate Cost Drivers. These Intermediate Cost Drivers yield the Outputs for the customer in the final link of the physical chain. We will discuss each of these cost-related links in succeeding pages of this section of StrategyStreet.
What, then, do we use for the physical measure of the Output for the customer? We use customer orders or transactions. There are other measures, but most of them are more useful as Intermediate Cost Drivers than they are as countable measures of the final Output. One set of measures might be numbers of customer shipments or customer accounts. But, there may be several shipments per customer order so the customer order measure is more useful as an end-point because the Company would prefer to use the number of shipments per order rather than the other way around. There are also many customer accounts that are dormant. Again, the Company would prefer to reduce the number of accounts per order as a Productivity objective. The other measures are cost drivers rather than cost end-points.
Contrasting problems occur with numbers of separate products and units of individual products. The Company would like to have higher numbers of products and units of product per customer order, so these measures may appear to be better than a customer order. However, many customers buy more than one product or unit of any particular product per order. The Company seeks the order as its end point rather than the sale of an individual product. What the Company recognizes with these measures is that more separate products and more units of product are also revenue drivers, not cost drivers. The Productivity objective with revenue drivers is to increase the physical counts per order. But the order itself remains a better expression of the final Output because it subsumes the other two measures.
Using customer orders as the key physical measure of Output for the customer is practical for most companies. Most firms have accurate figures for customer orders for several previous years. This helps measure both current Productivity and its changes over time, an indicator of the Company’s creation of Economies of Scale.
Productivity and Customer Benefits Questions
The counts of the Output apply to all of the measures of Productivity. Next, we count the physical measures of the first link in the Productivity chain, the Input Building Block Costs of People, Purchases and Capital.
Next: Building Block Costs