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Preferences are learned as well as natural: Business managers are taught to favor investment in machines and monetary instruments over investment in workers. In fact, two ratios drive Management training in Business Schools: The Capital-Labor ratio (K/L); and the productivity, or Output-Labor measure (Q/L), the quantity produced divided by the number of labor hours it takes to produce that service or good. Both measures train managers that cutting Labor is at the heart of how business profit is made.
Increasing the Output-Labor ratio Q/L to increase measured productivity can be done by investing more in automated machinery to replace workers, since capital investment and its cost are not counted in this measurement. But, increasing Q/L can be more easily done, and more quickly, simply by firing workers and requiring the remaining workforce to pick up the slack.
I teach Managerial Economics to business students. They all intuitively understand and buy into the textbook directive to reduce the firm’s costs and thereby increase profit, by cutting Labor both to improve Output productivity Q/L and to increase the K/L ratio itself. There’s only one problem with this approach: because it omits ¾ of what’s going on in a firm, the formula does not work.
There are three reasons for this theory/reality disconnect:
First, Even at low interest rates, Capital costs money. Borrowing funds to purchase expensive equipment (to replace workers) which requires extensive maintenance and, like all machinery, breaks down periodically, costs the firm in the aggregate more than the equivalent investment in workers doing the job of the machine. When the equipment breaks down, some firms wait days, even weeks, for replacement parts: such a shut-down costs the firms their entire output for that period of time, a very expensive consequence indeed. Should the borrowed funds be used instead for “investment” rather than equipment, returns are at the risk of the stock market investments selected. Over the last several years, even the market overall has lost about ¼ of its value. This means managers borrowed money, and now have to pay the interest on that borrowed money, but the investments they made with that money have rendered the money pot smaller… so there is even less to draw upon to pay that money back. This necessitates borrowing more funds, creating a vicious cycle downward.
Second, Labor is more flexible than Capital. People can and should be cross-trained to do each other’s jobs within a firm, so that if one person is tardy or absent, that job immediately gets done by others. As demand for products or services changes over time, employees can be retrained to perform the new different tasks. Machines are typically locked in to performing the original task over and over and over again.
Third, consumer purchases make up more than 70% of the U.S. Gross Domestic Product (GDP). Therefore, the fewer workers who have jobs, and the lower the wages they are paid, the less goods and services they can buy. When families replace shopping trips for nice things with absolutely needed items purchased from the Dollar Stores, the US economy suffers, including firms who cut their workforce and now discover their products are no longer in demand. Falling demand also makes it more difficult to repay borrowed debt.
So what should be taught, how should productivity be measured, and what should firms do to increase profitability and cut costs?
First, all of the costs in production must be measured, just as we measure total Output: A firm’s total productivity (Q/K+L), or Quantity produced divided by the total cost of both Capital and Labor inputs, not just Labor productivity (Q/L), more accurately and fully show the firm’s Output productivity.
Second, this more honest measure shows that Capital and Labor are substitutes – you can use less of one and more of the other – but one input is not inherently superior to the next. Managers can choose which aspect to invest more in, Capital or Labor, depending on the specific needs and characteristics of their firm.
Finally, optimizing Q/K+L results in a cheaper product, since all costs are minimized. Cheaper products spur demand, and more of the product or service is sold. This creates a sustainable upward “virtuous cycle” in which firms purchase more inputs to meet demand, including hiring more Labor, causing Labor to purchase more goods, but more importantly creating Demand-Pull on suppliers of intermediary products used in that company’s business. Demand-Pull includes everything from boxes to ship product, paper and office supplies, and ingredients in the production or service composition itself. Suppliers of these intermediate products experience this higher demand, themselves use more materials and labor, and the virtuous cycle expands.
Minimizing the input of Labor was an invention of Frederick Taylor in 1911. Has the world changed since then? What we teach in Business Schools, unfortunately, has not.
Janet Spitz, PhD School of Business College of St. Rose
We are delighted that Dr. Spitz has made a second contribution: She holds BA and MBA degrees from Cornell University and a PhD degree from Stanford University’s Graduate School of Business.
ARC, JMH – 9/27/11
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