Productivity myths, reality, failure and opportunity

Most people think of productivity in the context of the private sector. But Alan Castleman says productivity across all sectors is important and growth is something Australia seems to be failing at.

Productivity, or rather the lack of it, seems to have been receiving more news coverage this year. This is good but it mainly seems to demonstrate the continuing shallowness of understanding of the concept and in particular, how to do anything about improving productivity on a national basis.

There has been much debate in business and policy circles about the dire performance of Australia’s productivity (especially as it compares to other countries).  At least it is good to see this increasing public recognition of our poor performance, as recognition of a problem is usually a prerequisite to improvement. 

Within the private sector, productivity improvement has been a key component of successful companies.  The private sector has always appreciated this, in part because lack of productivity growth usually leads to the company losing market share and going out of business or being taken over.

Within government however, the subject is little understood and whilst it is talked about, little is really done.  This flows through in a significant way to publicly owned enterprises where union resistance to change, supported by government, has frequently stifled improvement and indeed often lowered productivity.

It seems to have only recently dawned on economists and governments that productivity is important and that Australia has failed badly in achieving significant productivity growth.  It is clear from the commentary to date that one of the reasons we have failed is that we have little understanding of what productivity really means, let alone how to really improve it.  It is one thing to understand the concepts around productivity, but quite another to know how to effect change.  Productivity is not just about outputs per worker and the like, and it will not be fixed just by freeing up markets as some economists fondly hope.  Freeing up markets is good, but totally inadequate.

I have worked at senior levels for many years in industries where I was involved in initiatives that brought about substantial productivity improvement.  I have been part of teams which have achieved substantial beneficial change and I have been an observer of the futility of governmental activity in this area and of the failure of the economics profession to come to grips with the subject.  I started life as an engineer, then an economist before becoming a company manager, executive, and latterly company director.

When I studied economics, three factors of production, land, labour and capital were spoken of together with the then recently identified concept of “enterprise” which became a fourth factor.  I consider it useful to think in terms of there being other factors of production as well. Capital can be usefully subdivided into infrastructure, enterprise level fixed capital, and working capital. Labour has many ways of being categorised and classified. Critical shortages anywhere can adversely affect everything else. Research capability is another factor.  Perhaps national morale and capacity of governments to make effective and timely decisions is another.
Productivity basically is the ratio of the value of outputs or outcomes to the value of the various inputs consumed in producing those outcomes.  The biggest weakness in my view, however, in getting to grips with productivity is that we place little focus on the “value” produced (or destroyed) by our various activities. Too much of our thinking relates only to the inputs, with virtually no concern for valuing outcomes.

Most people think of productivity in the context of the private sector.  The private sector is generally characterised by two relevant considerations.  The first is that there is competition and markets and thus prices for the outputs.  It is therefore possible to have an objective value placed upon the outputs of a private sector activity, although even here there can be major problems if there are other outcomes, either positive or negative, which are ignored.  For example, if an industry produces products which have a market value, but also produces harm, (for instance pollution, gambling addictions, illness from poor quality foods) then the value of the output overstates the position.  It is equally the case though that there can be positive outputs which are provided without charge to society and which consequently receive no effective recognition.

My major point of discussion today however relates to the public sector. When I studied economics, I was taught that in our national accounts, public enterprises were treated differently to public authorities as they were really like government owned private enterprises.  They had similar productive inputs and sold their product.  In most cases however, they operated as monopolies and often with regulated prices so that the true value of the output was questionable.  It was certainly not set in a competitive marketplace.  For public authorities, however, the commonwealth statistician simply assumed that the value of output was equal to the cost of the inputs.  This assumption allowed the statistician to complete the national accounts each year, but that was about all it told us.  I am unaware of any useful attempt to assess the value of public authority outputs or of government public service outputs. There is in consequence very little that can be said about their productivity as it is simply not measured.

Let’s take as an example the health system. The value of the Australian health system has many features which are not measured.  Indeed the focus seems to be predominantly on cost with value receiving no quantification other than crude measures of physical outputs – number of procedures etc and crude attempts at measuring quality of outcomes, mainly through measurement of error.  But even in this regard, measurement of error seems to be more focused on appeasing political and community sensitivities than any real exploration of productivity costs and potential opportunities. It doesn’t take much common sense to realise there are wider costs to the individual (along with their family and workplace) for every botched operation that must be redone, or for every extra day an individual spends in hospital fighting off a hospital-acquired infection, for example. But our use of measurement of error rates is a long way from reaching even this basic level of analysis.

Australia’s health system is both a regulatory system and an operating one. The regulatory system attempts to protect Australia from imported diseases, incompetent doctors, substandard hospitals etc. Probably the value to us of these activities exceeds their cost.  The operating system is a major part of the economy. It includes all the health advisory and medical related services, including treatment that might restore a person to a long, healthy and productive life, outcomes which undoubtedly have value far in excess of the cost.  However, prolonging the life of someone who is in the final stages of a terminal illness, or keeping alive a baby with major health problems so that it can have a few years of difficult and perhaps painful life is a more complicated question and of course other value factors than the individual alone should be considered, such as the value of the relationship to the person’s family.  People shy away from these judgements, but I would argue that we should confront them.  If we are to truly understand the value of our system, we need to make such judgements, whether we act upon them or not.

The situations above of the terminally ill and the baby are the extremes which are so confronting they can colour the debate itself. Most issues are not so challenging and there is great value in placing values on the health outcomes, including negative outcomes, in order to make better decisions about health and to operate our health system more productively. Of course valuing health has many subjective elements to it but people in the health professions are obliged to make these judgements from time to time, or to shy away from them, but it would be much better if we had a more open and transparent understanding of the issues.  Whilst I say this involves subjective judgements, it is a fertile field for economists to start to value health. While valuations can be actuarial or comparative exercises, in many ways valuation is more properly an economics matter, and a great opportunity for the economics profession to expand its field.  There are many approaches to this subject and economists love alternative ways of going about things.

I’m sure that if we better understood and attempted to quantify the value of good health and bad health, we would make far better decisions about productivity in the health system.

I argue that “value” is what something is worth to someone wanting to acquire that thing or alternatively what it is worth to someone wanting to retain it. The best method we have to establish this is through the pricing mechanism of an effective and efficient market, ie, a market which has a sufficient number of buyers and sellers for a definable product, reasonable transparency and freedom from coercion. In simple terms, it is what someone else wants to pay for it. We know that monopoly situations usually overstate value, relative to the most desirable situation. Governments outlaw these situations for the private sector but not for activities they control.
The problem obviously in the public sector is that there is rarely an effective market for its services. I need not labour the obvious, but must stress that in the public sector, the practice of valuing services at cost may under or overstate their value. While in recent years governments have corporatized or privatised many former government enterprises, and sometimes this has led to some measure of competition, and thus a better pricing regime, it operates only in part of the government or public sector. There are many areas where the thought of valuing mandatory government services would be heresy to those involved in their delivery, and no doubt many who have to receive the services would not be prepared to pay anything if they had a choice.

In the private sector, firms which cannot obtain the free vote of their customers who choose to pay a price for their products, which exceeds cost, ceases to operate. This brutal driver ensures that the private sector produces more value than it consumes in its productive process. Furthermore, this process ensures that the most productive prosper the most and squeeze out the less productive. This is what has delivered Australia the only productivity gains it has had and our prosperity to date. In the public sector there are few current processes to ensure that this sector is a net producer of value to society. Casual observation suggests it is not.

I want to stress a point. It is not sufficient for me or anyone to conclude that I or they are worth their price or their salary. I am worth my salary only if someone else is prepared freely to pay for me with their own money. We do not have that in the public service and we don’t have it in some areas of the professions for example where market forces are barely existent, or in many trade union dominated labour markets.

Years ago in BHP, one of the techniques we employed in looking at the ‘overhead’ areas, was to ask each person to describe their job and to identify who required them to do it.  If you like, who in the organisation was prepared to ‘pay them’ for their work.  That led to quite a bit of bemusement.  If they couldn’t identify who required it, the logical next question was, would it matter if you stopped doing this job.  If they did identify that Mr Smith required their work, Mr Smith would be asked if that really was so, and did he think it was worth paying the amount of money it took to employ these people.  Frequently Mr Smith didn’t know why they were doing what they did and saw no value in it.  This was a harsh but effective way of identifying value and led to a substantial reduction in that workforce.  Over the years all bureaucracies, be they public or private sector, seem to grow because somebody thinks it would be good for certain tasks to be performed and usually additional people are recruited for the task.  No one subsequently assesses whether the task has taken on a life of its own and whether it really is worth continuing.  The task of creating new jobs is always more convivial than that of shutting down work.  The worst feature however of our public service health activity  is not just how much they cost for what I suspect is very little value, but that they create work demands on those closer to the front line of health delivery.  Doctors complain of the amount of time spent filling in forms and hospital administrators complain of the demands on them from above.  This happens in the private sector as well, but in the private sector, the market pressures and the limitations the market places on revenue, provides a discipline I find is lacking in the public sector.

It seems there are very few people in government experienced in the areas I am referring to.  Occasionally governments will institute a ‘razor gang’ which seeks to make some high profile cuts.  They rarely however ask, let alone answer the question whether huge slabs of government activity are needed or worth the cost.

We shouldn’t of course reduce productivity analysis to one simply about workforce size. A company that halves its workforce doesn’t do as well as one that doubles its production with the same workforce. Further, the company that doubles the value of its offering to customers, without a commensurate increase in production costs, will be more successful again.

The morality and ethics of productivity.
I include this topic because I regard this as being greatly misunderstood as a result of great political and industrial misrepresentation since the industrial revolution, albeit unhelped by some employers who have at times provided ammunition for charges of worker exploitation.  (The irony of course is that the trade union propaganda around this issue ignores that by far the worst examples of exploitation have been in countries which have enslaved their populations in socialist workers paradises.)

The economics are simple. Most people contribute positively to production, at least for some of their lives. Everyone consumes some of that production. Debates can be held about the distribution of the income and wealth that flows from the production, but clearly the more value produced, the greater the pool of production available for distribution.

In any economy but particularly in a complex modern economy, production occurs in hundreds of thousands of entities, each of which uses the production of others in the course of production of their products or services. If the resultant productive value exceeds the value of the inputs, there is a net gain or profit. This is good because the economy as a whole is better off.  If the resultant value is less than the inputs, the entity makes a loss and the economy is worse off than if the the activity didn’t take place.

This is all pretty basic, but it is amazing how many people have swallowed the line that profits are bad.

We live in a society where we all receive all or part of our education and health care from our fellow Australians, although you could be deluded from government advertising that it actually comes from a beneficent government or two, or three governments for that matter. In truth some also is funded by overseas parties that lend to us.

No one can therefore claim no duty to society. Those who through misfortune or disinclination, are net beneficiaries from society, can still make a contribution and I would argue should do so. Any view that a person is “entitled” to rely just on others is not pulling their weight. That is the immoral or unethical issue.  We should all be prepared to contribute to society and we should applaud those who do most for the economy and society. Those are the one who are most productive.

Productivity improvement should be for everyone
For Australia to become a highly productive nation again, it is important to benchmark all our activities against others.  Some people however regard benchmarking as a process to satisfy yourself that you are OK.  It should be an exercise to search constantly for improvement.  Where others are better, you can look to whether there is something to learn.  A highly productive nation is one which has all of its activities operating well.  Optimally using all the factors of production for valuable outcomes.  This means we must know what the value of outcomes are, or at least make objective, valid assessments.  In factories and other private sector areas of production, we have productive workforces, but even here they are constantly improving in order to stay competitive.  Anyone who notices a group of municipal employees however, digging a hole in the road will observe an opportunity for enormous productivity improvement.

I often look at teams of men standing around whilst one of them moves a witch’s hat and think that I could do the same job with a third of the people in half the time, a productivity improvement of 600 percent.  Our federal treasury used to assume that national productivity improvement would occur at about 1.5 percent per annum.  The sad thing is that it’s all that it did, but if the Chinese and others can bring about effective productivity gains of 10 percent per annum year after year, there is a message for us that we should be looking for huge leaps in productivity.  That doesn’t mean that we should hassle those at the productive end of the workforce or burden productive firms with increased regulation.  It means that we should get much cleverer with all of our macro settings, having optimal use of our human skills and our capital resources extracting maximum benefit from our research and basically speeding up the rate at which we get things done.  Bureaucratic approval processes which take ages are highly unproductive.  If we could reduce a one year approval process to a month, we have in that single act had a twelvefold increase in productivity.

In this short space I have been able to only canvass a small part of the scope for improved productivity performance.  I hope to have simply illustrated some of the issues and some of the options.
 

Alan Castleman is a professional company director who recently retired after 18 years as Chairman of Australian Unity Limited, a diversified financial services, healthcare and aged care company. Over the past 20 years he has been chairman of over 15 public or private companies include two ASX listed companies. Before 1993, his executive career was at BHP where he held a number of senior executive positions, including eight years as General Manager at BHP Steel.

0 Comments

1. 

   vivek.puthucode

   September 10, 2012 at 4:50 am

   Public Value

   Alan,

   Thank you, great to read such a clear and concise picture of productivity debate. You have pointed out the issue of productivity in public sector which never gets discussed and the issue is always seen as its someone else’s problem to fix. The response to date has been use of blunt instruments like razor gangs, efficiency dividend and one-off budget cuts. This approach certainly does save costs in the short run however does not make them any more productive. There is a need to acknowedge the issue of government processes, efficiencies that can be gained through better use of technology and importantly the need to measure and communicate outcomes and value delivered.

   Taking the process issue, inefficiencies have been deeply embedded over a period of time and antiquated legislations and at times arbitary interpretations to matters such as privacy, secrecy and information sharing have all contributed to further build-up of inefficiencies.

   In terms of measuring value, the concept of ‘Public Return on Investment’ is a term developed by Centre for Technology in Government, University of Albany few years back which brings together Political, Social and Operational return on Investment decisions in Public Sector. I find this a valuable tool and approach to measure and communicate Value. 

   Hope the debate continues and the focus comes to the areas you have highlighed in your article.