What truly drives sustainable growth for a business? While increasing sales or profits is often celebrated, these metrics alone fail to provide a complete picture of a company’s long-term potential. Traditional financial accounting primarily focuses on the size of inputs or outputs but overlooks a fundamental question: how well does a company transform its resources into results?
What is missing is a measure of efficiency that explains how much of a company’s growth arises from smarter, more effective use of its resources—not just from increasing the size of inputs.
The Importance of Firm-Level TFP
At the national level, Gross Domestic Product (GDP) avoids double counting of production by only considering the value of final goods and services produced within an economy. As outputs of some industries are inputs of other industries, the intermediate goods cancel each other out. While gross output might be reported at the firm level, value added—which removes the intermediate goods—is what ultimately matters in aggregate economic measures. Gross Value Added (GVA) measures the value a company or sector adds to its inputs; it is aggregated in national accounts, often using surveys, industry reports, and statistical methods.
Due to this method of aggregate-level production accounting, GVA per employee or GVA per unit of output remains a commonly used proxy for productivity at the firm level. However, while useful, this metric can be misleading for several reasons:
- Short-term gains, long-term risks: A company might boost its GVA by cutting back on purchasing intermediate goods. However, this approach can be short-sighted, compromising scalability, innovation, or quality, which are crucial for sustained growth.
- Efficient but low-value operations: A firm could operate with remarkable efficiency—producing significant output from minimal inputs—but without adding substantial value to the goods it processes.
This is where Total Factor Productivity (TFP) comes in. Just as macro-level TFP aggregates the efficiencies of firms and sectors to assess how well an entire economy or industry is using its resources, firm-level TFP measures how well a company transforms all its inputs—labor, capital, and materials—into output, independent of the value added or the quantity produced. It captures the true drivers of sustainable growth: efficiency and innovation.
Measuring TFP at the firm level helps the company identify inefficiencies, target improvements, and achieve sustainable growth. By highlighting how effectively labor and capital inputs are utilized, TFP provides critical insights that standard financial metrics cannot offer.
Growth Accounting: A Diagnostic Tool for Businesses
Growth accounting is a framework that allows businesses to break down output growth into contributions from key factors such as labor, capital, and efficiency as measured by Total Factor Productivity (TFP). This tool is vital for understanding whether a company’s growth is driven by the expansion of resources—such as hiring more staff or investing in new equipment—or by real improvements in operational efficiency that maximize output with the resources at hand.
Traditional Growth Accounting Models: Cobb-Douglas and KLEMS
Traditionally, growth accounting often uses the Cobb-Douglas production function as a model. This function assumes that output is a function of labor and capital, typically in the form of: Y = A⋅Lα⋅Kβ
Where:
- Y is output,
- L is labor input,
- K is capital input,
- A is Total Factor Productivity (TFP), and
- α and β are the output elasticities of labor and capital, respectively.
This model is simple and effective but does not capture the full spectrum of inputs in a contemporary company. The KLEMS framework expands the traditional model by including additional factors such as Energy (E), Materials (M), and Services (S), allowing for a more nuanced view of how output is generated. These additions acknowledge that in modern manufacturing and service industries, factors like energy consumption, materials usage, and external services are critical inputs that drive productivity.
Introducing the KLMSC Framework for Firm-Level Growth Accounting
While the KLEMS framework is useful at the macroeconomic or industry level, at the firm level, data can often be more directly connected to financial performance metrics in the company’s Profit and Loss (P+L) Statement. To align growth accounting with real-world financial reporting, we propose a streamlined framework, the KLMSC framework, where:
- K = Capital (mapped to Depreciation According to Plan),
- L = Labor (mapped to Personnel Expenses),
- M = Materials, Supplies, and Goods (which includes energy as a component),
- S = External Services (capturing outsourcing, consultancy, etc.),
- C = Other Operating Expenses (including miscellaneous costs that do not readily fit in the other categories).
This model allows companies to use the data directly available in their P+L Statements to measure the contributions of each input factor to overall growth, making it easier to track and optimize efficiency across the entire organization.
By focusing on Total Factor Productivity (TFP), this framework provides deeper insight into how effectively a business uses its resources—capital, labor, and other inputs—to generate output. TFP represents the portion of growth that cannot be explained by increases in labor or capital alone. It captures improvements in efficiency driven by better processes, innovation, or organizational changes, making it an essential tool for identifying areas where operational improvements can have a significant impact.
The Value of Growth Accounting for Businesses
Understanding growth through the KLMSC framework is crucial for businesses aiming for sustainable growth. By breaking down output growth into its key components, it can be assessed whether business growth is driven by:
- Input Expansion: Is growth simply the result of adding more labor, capital, or other inputs?
- Efficiency Gains: Is the company improving its processes, technology, or organizational practices to do more with the same or fewer resources?
This insight is invaluable because growth that comes solely from input expansion is often less sustainable in the long term. Businesses that focus on improving their TFP—by enhancing the efficiency of their operations—are better positioned for sustained growth. If a company is investing heavily in labor or capital but is not seeing corresponding improvements in TFP, it may indicate inefficiencies or missed opportunities for process improvement. On the other hand, if TFP is increasing, it suggests the company is finding smarter ways to use its resources, leading to more sustainable growth over time.
How TFP Drives Long-Term Success
By tracking TFP and understanding how each input contributes to output, businesses can make informed decisions about where to focus their efforts. Whether investing in new technology, improving employee training, optimizing material usage, or refining operational processes, the KLMSC framework provides a structured approach to identifying key drivers of growth.
In conclusion, growth accounting using the KLMSC framework offers businesses a powerful diagnostic tool to understand the sources of their growth. By aligning growth accounting with standard financial data from the P+L Statement, companies can identify areas for improvement and track their progress in achieving long-term, sustainable growth driven by efficiency gains rather than just input expansion.
What is Your TFP?
Do you know your TFP? Are you curious about your company’s true efficiency? Find out how Total Factor Productivity (TFP) and the KLMSC framework can provide insights into the efficiency, productivity, and growth potential of your company. Sign up for a free consultation and take the first step toward smarter, sustainable success.
