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India has a productivity problem. Just look at Revenue Per Employee data

Revenue per employee or RPE benchmarking provides the impetus for management teams to debate changes in strategies and tactics.

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Productivity, economists of all stripes agree, is the single biggest determinant of a nation’s standard of living in the long run. That the world has been in a productivity funk for over a decade does not augur well. In the US, annual productivity growth since 2005 has averaged 1.3 per cent less than half the annual productivity growth of 2.8 per cent from 1995 to 2004. With the exception of Spain, 29 other developed countries have also experienced sharp declines in productivity growth rates.

The productivity funk is at odds with what we read, hear, and see. The smartphone, for instance, has transformed many aspects of everyday life for a few billion people across the world. Bill Gates has  pronounced that “innovation is moving at a scarily fast pace” and Vinod Khosla, the venture capitalist,  predicted “the beginnings of a very rapid acceleration in the next 10, 15, 20 years.” Academics Erik Brynjolffson, Daniel Rock and Chad Syverson assert that there is no contradiction between the pessimistic facts described by productivity statistics and the optimistic promises of novel technologies. Both views are legitimate when an economy is in the throes of radical structural change.

Numerous studies have shown that India’s productivity problem is reflected by the substantial disparity in productivity across India’s firms. For instance, analysing India’s manufacturing firms, economics professors Chang Tai Hsieh and Peter Klenow find that the 90th percentile firm is five times as productive as the 10th percentile firm—a greater disparity than is the case in the US and China. Other studies have shown that poor infrastructure, (over) regulation, severe capital constraints, and an inadequate supply of highly trained workers have contributed to low productivity within India’s firms.

In this column, I ask and answer two questions about Indian productivity. First, how has productivity changed over the last three years? And second, what can firms, as opposed to the government, do to jump-start productivity?

Also read: Where’s the middle? India needs more midsize companies for economy to grow

Measuring productivity

I use revenue per employee, or  RPE, as a proxy for productivity and performance. The RPE, as a measure,   has salient virtues. It is easy to compute because many firms report their revenues and employee headcounts: RPE equals the firm’s revenue divided by (the number of) the firm’s full-time employees. Comparisons of RPE with the cost per employee (CPE) allow the firm to estimate its return on talent. Comparing a firm’s RPE with the RPE for related competitors enables the firm to benchmark its productivity and performance. For instance, a company may not be able to match its competitors on scale but may have the edge in getting more from its smaller resource base. And importantly, RPE benchmarking provides the impetus for management teams to debate changes in strategies and tactics.

Two caveats to the use of RPE must be noted. First, as Goodhart’s law (“when a measure becomes a target, it ceases to be a good measure”) warns, RPE is vulnerable to manipulation. Firms may boost their RPE by relying on contract workers and/or part-timer workers who don’t get counted as employees. Second, a firm’s RPE is influenced by industry characteristics, such as the required fixed assets (machines, software, land, buildings, etc.). Oil companies, for instance, have much higher RPE than consulting companies because the oil industry requires a lot of fixed assets while the consulting industry does not. Software has enabled firms to scale their operations in remarkable ways. In 2015, before its sale to Facebook (now Meta), WhatsApp was managing a user base of 900 million people with a mere 50 engineers!

I use the Prowess database (assembled and managed by the Centre for Monitoring the Indian Economy) to estimate the RPE for a sample that includes 3,107 firms and 8.44 million employees for the three years, 2019-2021. This sample includes many listed firms, many privately-owned firms and some State-owned firms.

Also read: When will India become an upper-middle-income country like China? Unlikely for 25 yrs

RPE by firm size

Figure 1 reports the average RPE by firm size. Firms with annual revenues above $1 billion are classified as large; firms whose annual revenues exceed $500 million but fall short of $1 billion are classified as upper midsize; lower midsize firms are those with annual revenues between $50 million and $500 million, and small firms are those whose annual revenues are below $50 million.

Illustration by Prajna Ghosh | ThePrint
Illustration by Prajna Ghosh | ThePrint

Notice that the RPE has been falling for classes of all sizes. That the RPE declined in 2020 will not surprise readers because the Covid-19 pandemic more or less shut down the Indian (and world) economy for several months. What is surprising is that the RPE fell in 2021 even though real GDP grew by 8 per cent.

Upper and lower midsize firms experienced declines in RPE of 22 per cent and 21 per cent respectively. Even in large firms, the class size that benefited most from the economic rebound in 2021 experienced a 7 per cent decline in RPE.

Notice also the difference in magnitudes in average RPE across firm sizes. An employee at an average large firm had an RPE that was approximately seven times greater than the RPE at an average small firm. Moreover, the average large firm employed almost 21 times more people than the average small firm. So not only are larger firms generating greater RPE, but they are also employing more workers.

The McKinsey Global Institute (MGI) reports that large Indian firms (as a group) tend to be associated with better management practices than smaller Indian firms (as a group). The direction of causation should be clear. It is better management practices that lead to higher growth and, as a consequence, larger firms. Not the other way around. What is needed are better-managed firms across size classes.

Also read: India’s economic growth has lost momentum but slim corporate profits keep engine running

RPE by sectors

To understand how sectors (and their characteristics) influence RPE, Figure 2 reports the average RPE for four sectors: manufacturing, retail, wholesale and construction. These four sectors account for approximately 70 per cent of firms as well as employment (in this sample).

Illustration by Prajna Ghosh | ThePrint
Illustration by Prajna Ghosh | ThePrint

Notice that the average RPE has fallen over these three years for all four sectors. Manufacturing, the sector with the largest representation (in this sample in terms of firms and employment)—suffered a  28 per cent decline in average RPE. Though the retail and construction sectors constitute a smaller proportion of firms and employment (in this sample), they have also experienced sharp declines of 24 per cent and 19 per cent respectively.

Notice also that the wholesale and manufacturing sectors have an RPE that is between two and five times greater than the RPE of the retail and construction sectors. This is to be expected because the retail and construction sectors are labour-intensive whereas the manufacturing and logistics sectors are capital-intensive.

To reverse the trend of declining productivity, Indian firms will have to assess two things: First, the quality of their management practices and second, the intensity of their use of relevant technologies.

Also read: Leading economies of the world are driving global instability. What can India do to retain its balance?

‘Good’ management practices

Nicholas Bloom and his co-authors write in their paper for the Quarterly Journal of Economics that a high proportion of India’s firms score poorly on basic management practices such as in the monitoring of performance, the setting of targets and people management. The firms that received the lowest management scores were often founder-managed and reluctant to embrace professional managers (and management). The firms that received the highest scores were generally led by open-minded founders who delegated some (or many) decisions to professional managers.

The types of management practices that each firm needs will depend on factors such as the firm’s size, its financial position, the competitive pressures it faces, the quality of its managers, and more. Achieving ‘good’ management practice requires firms to adopt (and refine) their organisational structures (teams, roles and responsibilities), work practices (routines and systems), people management practices (recruiting and training), and marketing practices (analysis of customer needs and market conditions).

Raising the quality of management from ‘poor’ to ‘good’ starts with an awareness of best practices. Acquiring proficiency in the practice of management is not akin to a light switch that can be turned ‘off’ or ‘on’. It requires experimentation, doggedness, and a degree of comfort with failure.

Also read: Despite moderate performance over 40 yrs, India’s economic growth set to be substantial in 2023

Intensive use of technology

Diego Comin and Marti Mestieri reveal in their 2018 article for the American Economic Journal: Macroeconomics, that low-income countries have lower productivity and income compared to high-income countries not because they have not adopted important technologies but because they do not use these technologies with enough intensity. In India’s case, the lag in the intensity with which technologies such as cell phones, broadband, personal computers, fertilizers, electricity, steel, cars, trucks, tractors and more are used has increased relative to high-income countries.

One reason why firms are slow to use many technologies is the absence of complementary technologies or assets. Paul David noted in Technology and Productivity: The Challenge for Economic Policy, that more than half of US manufacturing firms had not embraced electrification in 1919- 30—years after the introduction of alternating current. The tipping point came in the 1920s, when machines were equipped with electrical motors. A modern example that illustrates the indispensable nature of some complementary technologies is the smartphone, without which products like WhatsApp, Instagram, etc. could not exist.

Management guru David Teece has argued that a firm’s competitive position in the modern economy is determined by the strength and inimitability of its complementary assets. Apple, for instance, is one of the world’s most valuable companies.

Its RPE was a staggering $2.45 million in 2021—because it has built an ecosystem that includes hundreds of independent firms whose activities, assets and products are perfectly aligned with Apple’s activities, assets and products.

Ram Shivakumar is a Professor of Economics & Strategy at the Booth School of Business at the University of Chicago. Views are personal.

(Edited by Zoya Bhatti)

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