Understanding Total Factor Productivity
Total factor productivity, or TFP, might sound like a new time-management strategy, but it’s actually a common economic measurement.
What Is Total Factor Productivity?
Total factor productivity is a measure of how efficiently labor and capital are used.1
Why Is Total Factor Productivity Important?
Total factor productivity can help to demonstrate how cost-effective a business is. TFP is also used to determine how efficiently labor and capital are used in industries and even countries.
The Bureau of Labor Statistics (BLS) tracks total factor productivity. In 2021, private business TFP in the United States increased 3.2%, the biggest growth since 1983.2
How Do You Calculate Total Factor Productivity?
To calculate TFP, divide total production, also referred to as output, by the average costs, or inputs.
For instance, if you have a small business selling salsa, your inputs include the vegetables and spices that go into making the salsa, along with the jars and labels for your salsa, and any kitchen equipment you use to make salsa, such as a food processor. You store the salsa in a refrigerator. Perhaps you also have a worker who helps you make salsa. And you pay for accounting software to keep track of sales. All of those costs—for vegetables and spices, jars and labels, a food processor, electricity to run the refrigerator, a worker, and accounting software, are your inputs. The number of jars of salsa you make in a day is your production. Let’s say you can make 50 jars of salsa a day. That’s a lot of salsa!
You know that a taco festival is coming up and you’re going to need to make more salsa to sell at the festival. You get a bigger food processor and another part-time worker to assist you in making salsa. Plus you have to buy more vegetables, spices, jars, and labels. Your inputs have now increased. And you’re making a lot more salsa.
But maybe your new helper isn’t a very good salsa maker. Perhaps the company you bought jars from closed their business, and your new source for jars is more expensive. Maybe there’s a worldwide tomato shortage and so your salsa ingredients are now more expensive. Considering all of those factors, if your number of jars of salsa (your output) doubled but your costs (inputs) also doubled, your TFP is the same as it was before you made changes to prepare for the taco festival.
Or maybe your new helper is a salsa whiz, your high-tech food processor is helping you make salsa faster than before, you can spend less on jars by buying them in bulk, and the cost of tomatoes has dropped. Perhaps you’ve tripled your output to 150 jars of salsa a day. If your output tripled and your inputs only doubled, your total factor productivity has improved! Your salsa-making business is more efficient. Congratulations!
Understanding your business’s TFP can help you uncover ways to operate more efficiently. Understanding your industry’s TFP can reveal trends that may impact your business.
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