The economic case for process improvement



Adam Morris
02/12/2018

economics of process improvement

Image: Shutterstock/Sergey Nivens

A promising trend has been the increased visibility of process improvement initiatives. Though many companies understand that process improvement is important, there are still a few that do not comprehend its integral part to commercial success. In order to understand process improvement’s central place for a business we can turn to economics for an explanation.

 

Companies at their most basic level can be seen as large production processes. By this I mean all businesses, no matter if they are making cardboard boxes or complex financial products, employ inputs, namely labour and capital, and turn them into outputs, or the goods and services the company provides.

 

In economics the relationship between inputs and outputs can be shown through a company’s production function – Q=f(X1, X2, ..., Xn) – where Q is the quantity of output and X is an individual input. What the production function shows is that there is a relationship between the inputs used and the output produced.

 

Whilst looking at companies at the most basic level one can see that the shared motivations of almost all private enterprise is to maximise profit. Or in other words, making the greatest return on the money invested on inputs. It is, therefore, not a huge leap of logic to suggest that the more efficient a company is with their inputs, the more profitable they will be.

 

What is efficiency?

 

In economics there are two definitions of efficiency:

 

Technical efficiency – This can be defined as achieving the maximum output from a finite set of inputs. When looking at business cases for process improvement initiatives it is this definition of efficiency that is usually the goal. Technical efficiency focuses on trying to eliminate duplication and waste within an individual process.

 

Allocative efficiency – This definition concerns itself with a wider strategic choice of which processes provide the greatest “utility”, or satisfaction, to customers when compared against the cost of inputs. Allocative efficiency, therefore, looks at allocating inputs to processes that produce the most in-demand outputs for the lowest cost.

 

Achieving technical efficiency

 

The aim of technical efficiency is to maximise the number of outputs from a fixed number of inputs. So an example of this could be a company producing more cardboard boxes without having to hire any more employees. This can be achieved through utilising process improvement techniques to reduce waste and non-value add activities.

 

A good way of measuring technical efficiency from an economic stand-point is to assess the marginal product of a factor of production. This assesses the change to output associated with a change to one input from a company’s production function, whilst all other inputs remain constant. The most common assessment is the marginal product of labour – the increase to output from adding one additional person to the process. If we go back to the example of producing cardboard boxes, in an inefficient process adding one more employee will have little impact on output, as much of their effort will be wasted on non-value add activity. In an efficient process their impact on output will be much higher as their activity is closer related to the number of boxes produced. By reducing waste within a process the more impact an additional resource will have, the more output will be produced and, therefore, the higher the marginal product of labour.

 

So, by achieving technical efficiency a business can increase the return it receives on the investment on inputs for that process, thus maximising profits.

 

Achieving allocative efficiency

 

Allocative efficiency is a wider question for a business as it requires analysing a collection of processes to understand which are most beneficial to a company. An example of this would be if a company produces small, square cardboard boxes and large, rectangular boxes they will need to decide to which process to allocate resources based on the demand by customers. A company will see a greater return on the investment in inputs if they allocate inputs to more, in-demand outputs.

In order to understand how allocative efficiency is achieved we need to understand the relationship between revenue and costs. On the face of it profit is easy to reach – Profit = Total Revenue - Total Costs. There is, however, an interdependency between total revenue and total costs, as revenue increases through increased outputs as must the number of inputs to produce these outputs, so increased costs too.

 

So, in order to understand which processes are likely to maximise profits we need to analyse all processes to see which is most likely to offer a marginal benefit (the additional utility a customer receives from consuming an additional unit of a good) equal to the marginal cost (the increase in the cost of production if output is increased by one unit). In other words, as the amount of output rises the satisfaction that product provides customers also rises by the same rate. The demand for the good is near equal to its supply – in economics this is called market equilibrium and is when the market is at its most efficient. Though markets will, in the real world, never reach equilibrium, in order for a business to be successful they need to get as close as possible.

 

Process improvement teams can help profit maximisation by analysing which inputs offer the closest equilibrium between marginal cost and marginal benefit. This, in the short term, will offer the greatest return on profits, and in the long term, will help companies produce economies of scale – reducing total costs as a company grows.

 

Process improvement – a key to economic success

 

So, the main motivation of all businesses is to maximise profits. In order to do this a company needs to be as efficient as possible with the inputs it uses. Process improvement can increase the return companies receive from their investment in inputs by reducing waste and maximise profits by allocating inputs to processes that support the most in-demand outputs, thus showing why process improvement is key to business success.