Productivity is the only determinant of long-term profitability in business.
The relationship between the two is rarely well understood and, therefore, is the source of poor management decisions. Management controls only two variables: price and quantity.
For example, it decides what quantity of labor to use (people hired) and what price to pay (wages or salaries). Conversely, it decides what products or services it offers to the market at what price and in what quantities.
The strategic configuration of these four variables determines sustainable corporate profitability. In traditional accounting, value is the product of quantity x price. Profitability is determined by maximizing the difference between the value received from the market and the value surrendered to the providers of input (materials, labor, etc.).
In traditional cost accounting, profit is maximized by maximizing the value of output and minimizing the value of input. This view obscures the true driver of long-term profitability: productivity x price recovery. The above equations can be restated as equally valid ratios:
The relationship of the three ratios explain bottom-line profit in terms of managerial effectiveness rather than accounting outcomes. Profits can be enhanced by increasing sales prices while decreasing the cost of input resources. Profits can also be enhanced by increasing the quantity of output while decreasing the quantity of input.
The former option is unsustainable as it will attract competition very quickly or price your products out of the market. The latter option is the only sustainable long-term strategy as gains in productivity enables reduction in price recovery. This increases market penetration and sustains competitive pricing. Every management team worthy of the title should be executing a productivity improvement strategy.