CHAPTER ELEVEN

Managing Capital Productivity

A HUNDRED YEARS AGO, around 1880, Karl Marx based his prediction of the inevitable and imminent collapse of what we now call “capitalism” or the “free enterprise system” (both terms were not in use until after Marx’s death) on the “law” of the diminishing return on capital.

What happened instead is that for a century the productivity of capital in the developed countries—or rather in developed countries with a market economy—was going up except during the most severe depression years. This is one of the major achievements of modern business and the one on which the other achievements perhaps ultimately rest. In part, this achievement was entrepreneurial: the steady shifting of capital from old and rapidly less productive areas of investment into new and more highly productive areas, e.g., into technical or social innovations, which, as Joseph Schumpeter, the great Austro-American economist, convincingly demonstrated seventy years ago, is the true “free capital” of a modern economy.

But the steady increase in the productivity of capital is equally the result of managerial action, of continuing effort to improve the amount of productive work a given unit of capital performs in the business. One example is commercial banking, where one unit of capital today finances many times the volume of transactions it did in Marx’s time.

Yet Marx’s basic logic was impeccable. If indeed the productivity of capital were to decline inexorably, a system based on market allocation of capital—that is, the free enterprise system—could not survive more than a few short and crisis-ridden decades.

The most disturbing fact in today’s world economy may, therefore, be the reversal since the early sixties of the long secular trend toward higher productivity of capital in the developed countries. The downward trend is by no means confined to the free enterprise countries of the West and Japan. It is even more pronounced in the Communist world and especially in Soviet Russia, where, according to all information, the already very low productivity of capital in industry and agriculture has been suffering precipitous and near-catastrophic decline in the last ten to fifteen years. But this is cold comfort for us in the market economies. In a system such as the Soviet economy, where capital is allocated by political fiat rather than by the market, low and declining productivity of capital harms at first only efficiency, living standards, and costs. It need not endanger the system itself for a long time.

The evidence of the last hundred years is, however, quite clear: There is nothing inevitable, nothing inexorable, about the downward trend of capital productivity. Productivity of capital can be maintained and even increased, provided only that businessmen work at it constantly and purposefully.

In fact, working on the productivity of capital is the easiest and usually the quickest way to improve the profitability of a business and the one with the greatest impact. Profit, as the first chapter of any business economics textbook explains, is profit margin multiplied by turnover of capital, that is by productivity of capital. If the profit margin is 6 percent, for instance, and the capital turns over once a year, then there is a 6 percent return on the total capital. If capital turnover can be raised to 1.2 times a year, total return on capital will go up to 7.2 percent.

To raise profit margins by 20 percent is usually extremely difficult and may be impossible in a competitive market. But to raise capital turnover from once a year to 1.2 times a year often requires only consistent but routine hard work. Indeed, on the basis of quite a few years experience in this field, I am willing to predict that an improvement of this magnitude—that is, an improvement of 20 percent in the productivity of capital over perhaps four or five years—should be available to anyone who seriously tackles the job.

Yet, despite its importance and payoff, not many business managers pay much attention to the productivity of capital, let alone work systematically at raising it. Nor have managers of public-service enterprises such as hospitals paid enough attention to the productivity of capital even though it has fallen a good deal more sharply these last few years in the public-service institution than it has fallen in private business.

One reason, perhaps the single most important one, is that managers, as a rule, get little information on the productivity of capital in their businesses. Most businesses know, of course, how many times a year they turn over their entire capital. But the annual turnover of the company’s entire capital in a business, say a paper mill or a department store, is an aggregate. And one cannot manage an aggregate. One always has to manage—and therefore to measure first—major components separately. Yet few managements know what the meaningful components of capital are in their business, let alone what the productivity of capital for each of them is, could be, or should be.

The first step toward managing the productivity of capital is therefore to determine the main areas in one’s own company in which capital is actually invested. There rarely are more than a handful. In a typical manufacturing business, for instance, machinery and equipment; inventories of materials, supplies, and finished goods; and receivables usually together account for three quarters of total money invested. In a typical department store there are shelf space (or selling space), receivables, and inventories (inventories in retailing usually have to be subdivided, e.g., into wearing apparel, home furnishings and furniture, appliances, etc., to be meaningful and manageable). How much productive work does the capital employed in each of these areas do? How often does it turn over? How much does it return or contribute? Then one can ask: How much could it and how much should it produce, and what do we have to do to bring this about?

Managements also need to learn a few elementary rules about managing the productivity of capital.

One can increase the productivity of capital in two ways. One can make capital work harder. And one can make it work smarter. This is one of the main reasons, by the way, why the productivity of capital is more easily managed than that of the other two main resources—physical resources and human resources. The productivity of human resources can usually be raised only by making them work smarter; that of physical resources, only by making them work harder.

Locating one’s inventory in strategically placed regional warehouses, so that the same amount of inventory can support a larger volume of sales, is making capital work harder. Controlling the product mix to sell a larger proportion of high-contributing products, or a smaller proportion of low-contributing ones, is making capital work smarter. Often one can do both simultaneously. But it is difficult to predict in advance which approach is likely to be appropriate in a given situation, more productive and less risky. Both need to be thought through for each major area of investment in each individual business.

Fixed capital and working capital, while both capital, require different approaches in managing their productivity.

Most businessmen know that nothing is more wasteful in a fixed asset than time not worked. Yet few seem to realize that the standard-cost accounting model assumes—and has to assume—continuous production at a pre-set standard for a given fixed asset, whether a rolling mill in a steel plant, a unit of selling space in a store, or a clinical-care hospital bed. The standard-cost accounting model, in other words, neither measures nor controls the single largest cost of a fixed asset: the cost of capital nonproductivity.

Similarly, cost accounting has to assume a standard product mix, even though both costs and revenues vary tremendously with different mixes (perhaps most for the hospital bed among all major pieces of fixed-capital investment). Managing time-not-worked and product mix are the most effective ways to improve the productivity of capital for most fixed investments. For this, however, one has to know first how much time is not being worked and why. One has to know the economics of various product mixes. One has to have economic information in addition to the analytical data of the accounting model. Then one can improve greatly the utilization of time and, with it, the productivity of fixed capital.

But working capital needs to be measured differently and to be managed differently. Unlike fixed assets, it is not “producing” capital but “supporting” capital. The question, therefore, must be asked: What does it, and what should it, support?

Receivables—that is credit extended by a business to its customers—are the obvious example. Companies typically measure their credit management by the proportion of the outstanding loans they collect. “We do a first-rate credit job since our credit losses are less than one percent” is a frequently heard comment. But manufacturers are not in the banking business nor, considering their cost of capital, could they compete with the banks. They give credit to make profitable sales. What then should the objective of a credit policy be in respect to market creation, product introduction, sales, and profits—with low-loss experience as a restraint rather than a goal or measurement? Every business that has asked this question has found (a) that it puts the bulk of its credit where it gets the least back and (b) that it gives the least credit where it gets the most back. Over a three- to four-year period, a business that systematically works on the productivity of the capital employed in receivables can expect that with two thirds of the money now tied up in credit it can finance a larger and more profitable volume of sales.

Finally, few managements seem to know that there are important areas in a business which are not normally considered capital investment—and surely do not appear as such in the balance sheet—but which behave economically very much like fixed capital and have to be managed, above all, for productivity of capital. These are the areas in which time is the major cost element, while, over any given period, other costs are relatively fixed and inflexible. Most important among them is the sales force (or the nursing staff in a hospital). This is “fixed human capital.” And economically it has to be managed very much as if it were “fixed capital,” without any qualifications.

There are great differences in selling ability between salesmen which no amount of training seems to be able to overcome, or even significantly to narrow. But the ablest salesman—or the most dedicated nurse—has only one resource: time. There is a fairly constant relationship between the time a salesman has for sales calls and the number of sales he actually closes. Time not available for work is the major, though usually totally hidden, cost element in these “fixed human assets.” And this means that, as in the case of all fixed assets, management first needs to know the productivity of time, and especially how much of the time that should be available for work is actually time not worked and not available for work, and why (e.g., because the salesperson spends two thirds of his or her time on paper work rather than selling). Sometimes it then takes very little change to bring about substantial productivity increases. To put a floor clerk in to take over the paper work has, in some hospitals, for instance, doubled the time nurses have for what they are paid and trained for, and want to do—patient care.

I fully realize that I have oversimplified a complex subject. Productivity is, after all, the combined result of the productivities of all three factors of production: capital, natural resources, and human resources. And it is just as dangerous to increase productivity of capital at the expense of lowering the productivity of the other two factors as it is to increase, say, the productivity of the human resource at the expense of downgrading the productivity of capital (as was done only too often these last twenty-five years).

Finally, I well know that there is a fair number of managers and managements, in small business as well as in large ones, who will, having read this far, say, “What else is new? We have been doing all this and much more for God knows how many years.” But these managements constitute, in my experience, a tiny minority even among large, professionally managed companies. Most companies have not even the data for the productivity of capital—and without them one cannot manage.

It is high time that American business managers, in the great majority, learn and accept that managements are paid for managing productivity, especially the productivity of capital, on which, in the last analysis, all other productivities depend; that the productivity of capital can be managed, and that the productivity of capital must be managed.

(1975)