Make Inefficiency Visible

The problem with much inefficiency is that we can’t see it. It lurks in all work – “baked in” to the way work is carried out, so to speak. Being able to see inefficiency is the first step to reducing it and becoming more productive.

To see inefficiency, we should make it visible. This means looking at work, asking what value is to be produced, and then analyzing the work activities to see which contribute directly to creating the value required and which do not. The “non-value adding” work steps are sources of inefficiency and should be reduced or eliminated from the work. This may be accomplished by either re-designing the work process or improving the way the work is carried out.

Every work process will have always have some slack or inefficiency. If the source of the inefficiency cannot be eliminated, it is sometimes a good idea to aggregate up the inefficiency and load it on to a worker (or group of workers) to make it visible and provide further impetus to reducing it or eliminating it. In this way, the value-adding work attains a higher efficiency and value-adding percentage because some of the inefficiency has been removed, aggregated and relocated elsewhere. The focus should then be on working to reduce or eliminate the aggregated non-value adding activity.

Keep in mind that efficiency is not just about doing more with less – producing more output with the same, or less, resources. Efficiency and productivity can also be measured by the value of output, not just by its quantity, per unit of input. A firm should always think of producing more valuable output with the resources it has, and not just only about producing more.

Inefficiency drives costs because it consumes resources. Inefficient activities have to be paid for. Firms should always pay attention to their value chains and seek to continuously identify and remove the sources of inefficiency. That’s what continuous improvement is all about.

Contribution and Productivity

Human resource (or labour) is a key input for most firms. Labour can be viewed as a resource to be consumed in the production process, and one whose cost should be minimized while its yield is maximized. Or it can be viewed as a value-adding resource which can help a firm achieve its full growth potential.

A firm’s human resource is unique among its inputs in that it can think, reason, and learn. The learning that a firm’s human resource can acquire and contribute can be a key determinant of productivity and profitability.

Accumulated experience represents valuable learning. A firm that can acquire this learning, and leverage it, can build a competitive advantage over rivals.

In many firms, accumulated experience is not leveraged. The learning is not codified, shared, or leveraged to drive improvements in work methods or processes. Leveraging learning means encouraging workers to develop new insights about their work and contribute their ideas for improvement. These improvements drive productivity.

If organizations are to succeed, members need to contribute towards the fulfillment of organizational purpose and goals. It is the job of management to build cultures and structures that encourage employees to bring ideas for improvement forward. Similarly, all employees in a firm have two primary responsibilities: an executive responsibility to carry out their job functions and processes; and a contributive responsibility to bring forward their ideas for improvement.

In many firms, the executive responsibility of workers is emphasized, and far too little attention is paid to the contributive responsibility. Japanese firms excel at eliciting contribution from their workers and their productivity is higher as a result. And not just productivity as measured by efficiency, but productivity in terms of the greater value of output being produced per unit of input.

Productivity can be improved dramtically through innovation and improvements to the way work is done. This is akin to changing the technology base of the firm. Firms that neglect to consider how they will gain contribution for improvement from all employees are likely to find that their productivity levels will stagnate.

Supply Side Strategies and Value

Most business improvement programs and methods are focused on a firm’s supply side. They are aimed at helping a firm to supply the same or more output at a lower cost. Initiatives like Lean, Six Sigma and so forth are valuable for helping a firm to obtain greater efficiency and productivity – producing the same, or more, output with less, or the same, resources.

However, efficiency – the amount of output produced per unit of input – is one way to look at productivity. Another, more meaningful way is to look at the value of the output produced. Using the same resources to produce a more valuable output which commands a higher price in the marketplace has several advantages over mere cost reduction.

When a firm produces more valuable output which commands a higher price, that implies differentiation from rivals. Customers will pay that higher price because the good or service offers more value for the money and is not readily obtainable elsewhere. Secondly, higher value also implies innovation. To cut costs, one does not have to be particularly innovative, but creating additional value requires it.

Creating higher value output is a demand side issue. To offer higher value, a firm must understand customers’ needs and design and create superior value which satisfies that need. To accomplish this, a firm needs to understand consumer and utility theory, neither of which are supply side solutions.

I find it interesting that Lean adherents profess to be oriented around value, but yet jump immediately into improving the efficiency of value chains, and don’t necessarily improve the value being offered. Lean adherents will claim that reducing waste and inefficiency is commensurate with improving value, yet this assumptions has two flaws. First, if it doesn’t command a higher price, it is not higher value. Even higher quality is not higher value unless the customer perceives it to be so and is willing to pay the higher price to offset the higher costs that providing such quality entails. Secondly, superior value has to be designed from a deep understanding of the demand side of the business. Fixing the supply side doesn’t address that.

Innovation, Uncertainty and Strategy

Should a firm innovate and, if so, how quickly? Answering this question involves determining whether the firm should invest resources to grow rather than adopting a more conservative strategy. As with any other strategic question, determining the pace of innovation is an issue that is clouded with uncertainty.

The answer to how rapidly a firm should innovate will have implications with respect to R&D expenditures, technology development and adoption, organizational structure, and strategic partnerships and alliances. These, in turn, will affect the firm’s cost structure, revenue streams, and profitability.

With respect to innovation, three types of uncertainty can be identified. First, there is the technical uncertainty associated with determining what can be done in what time, and at what cost. Secondly, there is market uncertainty where the rate of market acceptance and adoption for new innovations cannot be known with precision. Finally, there is competitive uncertainty, where the response of competitors to an innovation cannot always be predicted.

Firms can model and help resolve these uncertainties through the use of decision trees. A decision tree allows a firm to logically work through the innovation process and examine the decision alternatives available at every stage. The tree can be used to evaluate and select the optimal innovation responses at each level of analysis. Applied thoughtfully, decision trees can help manage the uncertainty surrounding innovation and help a firm determine it preferred rate of innovation.

Why Productivity is Important

Productivity is the value of output produced by a unit of labour or capital. Using the same amount of labour or capital to produce higher value output, or producing the same value of output with less labour or capital, is what is meant by productivity improvement.

Productivity is at the heart of competitiveness. If a firm is unproductive and does not use its natural, physical, human, and capital resources wisely, it is not likely to be competitive within its industry.

Productivity can be improved by making innovations which reduce resource consumption and its associated costs. Producing the same value of output with fewer resources (less labour, less capital, etc.) reduces a firm’s costs and improves its productivity. Firms may reduce resource consumption by developing or using new production methods or technologies, developing new linkages with other firms, or choosing to perform different activities in their value chains.

On the other hand, productivity can also be improved by making innovations which increase the value of the output which is being produced. Using the same resources to produce a higher value output that commands a higher price is another form of productivity improvement. Firms can increase the value of their products and services through addressing under-served or unmet needs, improving their quality and reliability, and developing new technologies and capabilities in their products and services.

Firms have a choice in how they choose to improve productivity. Whichever pathway they choose, they must have the capability and capacity to innovate. Innovation is what underpins and drives productivity. If there is no innovation, there can be no improvement in productivity.

Green and Competitiveness

Caring for the environment is not just about meeting any regulations that may be in force. Innovations that a firm makes in response to environmental regulations, or out of a sense of environmental responsibility and stewardship, can lower the total cost of a product or improve its value. Costs can be lowered through innovations which allow a firm to use its inputs more productively, and value can be improved by reducing the environmental impact of the product for users.

Pollution equals inefficiency. Pollution is a form of economic waste. When a firm creates environmental impacts by releasing pollutants, harmful substances, or wasted energy, this signifies that resources have been used incompletely, inefficiently, or ineffectively. These wastes represent externalities that a firm imposes on other members of society, who must bear the resulting consequences and costs.To remedy the consequences of externalities, firms must incur additional costs, such as handling toxic wastes, their treatment, and their disposal.

Over the life cycle of any product, their always exists resource inefficiency. In most firms, this inefficiency manifests itself as process waste, scrap, etc., but when considered over the entire life cycle of a product these inefficiencies extend to include packaging, pollution caused by the product in-use, and disposal of the used product. Inefficiency is introduced when customers have to incur costs to deal with these unwanted environmental impacts from using the product.

Innovating improvements that address environmental impacts fall into two main categories: processes and products. Innovations made to processes to address environmental impacts can provide the following benefits:

• material savings resulting from more efficient and effective processing, substitution, reuse or recycling of production inputs
• increases in process yields
• superior utilization of the by-products of production
• conversion of waste into more valuable forms
• lower energy consumption during production
• reduced material handling and storage costs
• savings from safer workplace conditions
• elimination or reduction of the cost of activities involved in handling waste, transportation and disposal
• product improvements resulting from process changes made to reduce environmental impacts

Innovations made to products to reduce environmental impacts can have the following benefits:

• higher quality and more consistent products
• lower product costs
• more efficient resource use by products
• lower packaging costs
• safer products
• lower disposal costs for customers
• higher product resale and product value

Too often, firms see “going green” as simply meeting environmental controls and regulations imposed by government. If, however, adverse environmental impacts are seen as the inefficient and ineffective use of resources, even when regulations are being met, firms will be better motivated to improve their environmental performance.

Firms that can innovate solutions which reduce environmental impacts and improve resource productivity will improve their competitiveness as a result. While it is possible to take a minimalist approach and do only what is necessary to meet any environmental regulations that may be in place, the days are numbered for this type of thinking. Increasingly, customers globally are becoming more discriminating about the environmental consequences of products and services they use, and are seeking innovative suppliers who have found ways to reduce the environmental impacts associated with their product or service.

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Economic Untruths

The popular story is that the current European economic crisis is a debt crisis. Euro zone countries have gotten themselves into their mess because of fiscal profligacy – spending wantonly and racking up huge levels of national debt. The story sounds convincing, but on close inspection it is not true.

The source of the current Euro problems stems from the fact of a single currency for the EU. While there are efficiency gains from sharing a single currency, the downside is a loss of flexibility when asymmetric shocks hit the system, affecting some countries but not others.

Paul Krugman, in his latest book, End This Depression Now, effectively debunks the debt story as being the cause of the EU problems. Krugman identifies a “Eurobubble”, arising from trade imbalances, primarily between Germany and its poorer southern European neighbours. These trade imbalances created capital inflows which if turn fed booms that led to increasing wages and prices in the southern countries and, in Spain, fed a massive housing bubble among other things.

If one looks at the debt to GDP ratios for some key EU countries, we can see that high levels of debt did play a part in the problems of Greece and, to a lesser extent, Italy (see table below). However, many other countries, such as Spain and Ireland, had not accumulated massive debt to GDP levels when the crisis hit.

People who tell the fiscal profligacy story are those who want to tell less than the truth. They are those who would have you believe that all debt is bad and that the answer to the current EU crisis is austerity. The debt story is used to give cover to an ideological agenda that promotes less government and more inequality in the distribution of wealth. The facts, however, show that the debt story is simply not true.

On Competition

Firms should always know their competition. Not only is competitive information important strategically, the concentration of competitors, and their conduct in the marketplace, are determinants of market structure.

The first step in analyzing competition is to identify your firm’s competitors. A simple rule of thumb to follow is that a competitor is any firm that offers a product which is a substitute for that offered by your firm. Any two sellers in an output market are competitors if their products are close substitutes – that is, customers could use either product in place of the other.

Price elasticities of demand are useful for determining whether a product has close substitutes. Where demand is more elastic, the availability of substitutes will be greater.

Market structures vary acccording to the number of competitors and how they operate. Markets with many sellers offering similar products are more likely to feature competitive pricing. In contrast, markets with few sellers and differentiated products are likely to feature divergences in pricing.

A market with a single seller is a monopoly. Monopolists have the bulk of the market share and they ignore the pricing and production decisions of fringe firms. A monopolist has great market power and may set prices well above marginal cost without losing much, if any, business.

Monopolistically competitive markets have many sellers, each with a loyal customer base. Pricing is determined by the willingness of customers to switch from one seller to another. If customer loyalty is not strong, sellers may lower prices in an effort to attract customers away from rivals and industry profitability may be lowered by new entrants.

Oligopolies have market share concentrated among a few leading firms. Because each firm’s pricing and production decisions affects the market price, market prices can be either well above marginal costs or driven down to that level. Much depends on the degree of product differentiation and the competitive interaction between the firms that make up the oligopoly.

Prices are strongly correlated to market structure. As competition increases, price-cost margins tend to decrease. Knowing your firm’s competition and market structure is critical to formulating a sound competitive strategy.

Deconstructing Value Chains

When firms set about continuous improvement, they usually apply their efforts to legacy value chains. These are the set of processes that the firm has “grown up with” – the process chain that has evolved to serve the firm’s current customers.

Yet, because value chains are the means through which the firm creates and delivers its products and services, they become tied to the product life cycle. This means that value chains, like products, have lifespans.

When improving value chains, firms should always test whether the current chain would benefit from deconstruction – altering the pattern of activities that deliver value to customers. In many cases, legacy value chains can be deconstructed and reconstituted to provide different value to customers – value that is differentiated, commands a price premium, and which allows the firm to meet needs which are currently being under-serviced or ignored by rivals.

Opportunities for deconstruction often abound when fresh insights into customer needs and behaviours are obtained. One firm we at Anderson Lyall worked with found that integrating the customer service and sales processes opened up new revenue opportunities – service personnel were the ones most close to, and intimate with, the customer’s issues and problems. Integrating these separated functions into a unified process allowed this firm to leverage new sales opportunities and identify new product development initiatives.

Deconstructing often means de-averaging. Where a firm has an “average” competitive advantage obtained through value delivered from a single value chain, this advantage can often be multiplied and compounded by deconstructing the chain into multiple discrete chains focused on specific customer needs.

Improving legacy value chains is great, but deconstructing legacy chains based on new customer insights can be tremendously valuable.

Depressed Innovation

Why does Canada consistently lag other developed nations in productivity? A commonly held cause of depressed productivity is a lower intensity of innovation. Why would a developed country have a lower intensity of innovation?

Harvard’s Michael Porter model of the four stages of competitive development may hold the answer. Porter believes that national economies exhibit four stages of development. The first stage is Factor-Driven, where a nation leverages its basic factors of production – physical capital, human capital, etc. The second stage is Investment-Driven, where the nation and its firms invests aggressively in establishing their productive capability and capacity. The third-stage is Innovation-Driven where a nation’s firms broaden and upgrade their capabilities. The final stage is Wealth-Driven, where the economy begins to lose competitiveness as it lives off the wealth that has been created in the first three stages. The Wealth-Driven stage is a state of decline.

In the Wealth-Driven state, the pace of innovation falls due to a number of factors, including risk aversion, lack of willingness, and the propensity of firms and investors to preserve capital rather than accumulate it. Mergers and acquisitions increase and firms begin to compete on price rather than building new sources of competitive advantage.Sluggish wage and job growth reduce the incentive for workers to be productive and innovate. As personal incomes stagnate, the sophistication of domestic demand deteriorates, further eroding the incentive for firms to innovate. Manufacturing begins to decline due to its lessened ability to compete globally with more productive nations, and services assume a larger role in the economy.

Moving an economy back from the Wealth-Driven state to the Innovation-Driven state is not easy. Major policy changes from government will be required, along with shifts in social values and discontinuities which may jar the economy back to a more productive state.