Production is a process of combining various material inputs and immaterial inputs (plans, know-how) in order to make something for consumption (the output). It is the act of creating output, a good or service which has value and contributes to the utility of individuals. Economic well-being is created in a production process, meaning all economic activities that aim directly or indirectly to satisfy human needs. The degree to which the needs are satisfied is often accepted as a measure of economic well-being. The satisfaction of needs originates from the use of the commodities which are produced. The need satisfaction increases when the quality-price-ratio of the commodities improves and more satisfaction is achieved at less cost. Improving the quality-price-ratio of commodities is to a producer an essential way to enhance the production performance but this kind of gains distributed to customers cannot be measured with production data.
Economic well-being also increases due to the growth of incomes that are gained from the growing and more efficient production. The most important forms of production are
- market production,
- public production and
- production in households
In order to understand the origin of the economic well-being we must understand these three production processes. All of them have production functions of their own which interact with each other. Market production is the prime source of economic well-being and therefore the “primus motor” of the modern economy. Note that when we later discuss production we refer to market production. When discussing a single unit in the production process, the term “company” is used.
In principle there are two main activities in an economy, production and consumption. Similarly there are two kinds of actors, producers and consumers. Well-being is made possible by efficient production and by the interaction between producers and consumers. In the interaction, consumers can be identified in two roles both of which generate well-being. Consumers can be both customers of the producers and suppliers to the producers. The customers’ well-being arises from the commodities they are buying and the suppliers’ well-being is related to the income they receive as compensation for the production inputs they have delivered to the producers.
Stakeholders of production
Stakeholders of production are persons, groups or organizations with an interest in a producing company. Economic well-being originates in efficient production and it is distributed through the interaction between the company’s stakeholders. The stakeholders of companies are economic actors which have an economic interest in a company. Based on the similarities of their interests, stakeholders can be classified into three groups in order to differentiate their interests and mutual relations. The three groups are as follows:
The interests of these stakeholders and their relations to companies are described briefly below. Our purpose is to establish a framework for further analysis.
The customers of a company are typically consumers, other market producers or producers in the public sector. Each of them has their individual production functions. Due to competition, the price-quality-ratios of commodities tend to improve and this brings the benefits of better productivity to customers. Customers get more for less. In households and the public sector this means that more need satisfaction is achieved at less cost. For this reason the productivity of customers can increase over time even though their incomes remain unchanged.
The suppliers of companies are typically producers of materials, energy, capital, and services. They all have their individual production functions. The changes in prices or qualities of supplied commodities have an effect on both actors’ (company and suppliers) production functions. We come to the conclusion that the production functions of the company and its suppliers are in a state of continuous change.
The incomes are generated for those participating in production, i.e., the labor force, society and owners. These stakeholders are referred to here as producer communities or, in shorter form, as producers. The producer communities have a common interest in maximizing their incomes. These parties that contribute to production receive increased incomes from the growing and developing production.
The well-being gained through commodities stems from the price-quality relations of the commodities. Due to competition and development in the market, the price-quality relations of commodities tend to improve over time. Typically the quality of a commodity goes up and the price goes down over time. This development favorably affects the production functions of customers. Customers get more for less. Consumer customers get more satisfaction at less cost. This type of well-being generation can only partially be calculated from the production data. The situation is presented in this study. The producer community (labor force, society, and owners) earns income as compensation for the inputs they have delivered to the production. When the production grows and becomes more efficient, the income tends to increase. In production this brings about an increased ability to pay salaries, taxes and profits. The growth of production and improved productivity generate additional income for the producing community. Similarly the high income level achieved in the community is a result of the high volume of production and its good performance. This type of well-being generation – as mentioned earlier – can be reliably calculated from the production data.
Main processes of a producing company
A producing company can be divided into sub-processes in different ways; yet, the following five are identified as main processes, each with a logic, objectives, theory and key figures of its own. It is important to examine each of them individually, yet, as a part of the whole, in order to be able to measure and understand them. The main processes of a company are as follows:
- real process
- income distribution process
- production process
- monetary process
- market value process
Production output is created in the real process, gains of production are distributed in the income distribution process and these two processes constitute the production process. The production process and its sub-processes, the real process and income distribution process occur simultaneously, and only the production process is identifiable and measurable by the traditional accounting practices. The real process and income distribution process can be identified and measured by extra calculation, and this is why they need to be analyzed separately in order to understand the logic of production and its performance.
Real process generates the production output from input, and it can be described by means of the production function. It refers to a series of events in production in which production inputs of different quality and quantity are combined into products of different quality and quantity. Products can be physical goods, immaterial services and most often combinations of both. The characteristics created into the product by the producer imply surplus value to the consumer, and on the basis of the market price this value is shared by the consumer and the producer in the marketplace. This is the mechanism through which surplus value originates to the consumer and the producer likewise. It is worth noting that surplus values to customers cannot be measured from any production data. Instead the surplus value to a producer can be measured. It can be expressed both in terms of nominal and real values. The real surplus value to the producer is an outcome of the real process, real income, and measured proportionally it means productivity.
Income distribution process of the production refers to a series of events in which the unit prices of constant-quality products and inputs alter causing a change in income distribution among those participating in the exchange. The magnitude of the change in income distribution is directly proportionate to the change in prices of the output and inputs and to their quantities. Productivity gains are distributed, for example, to customers as lower product sales prices or to staff as higher income pay.
The production process consists of the real process and the income distribution process. A result and a criterion of success of the owner is profitability. The profitability of production is the share of the real process result the owner has been able to keep to himself in the income distribution process. Factors describing the production process are the components of profitability, i.e., returns and costs. They differ from the factors of the real process in that the components of profitability are given at nominal prices whereas in the real process the factors are at periodically fixed prices. Monetary process refers to events related to financing the business. Market value process refers to a series of events in which investors determine the market value of the company in the investment markets.
Production growth and performance
Production growth is often defined as a production increase of an output of a production process. It is usually expressed as a growth percentage depicting growth of the real production output. The real output is the real value of products produced in a production process and when we subtract the real input from the real output we get the real income. The real output and the real income are generated by the real process of production from the real inputs.
The real process can be described by means of the production function. The production function is a graphical or mathematical expression showing the relationship between the inputs used in production and the output achieved. Both graphical and mathematical expressions are presented and demonstrated. The production function is a simple description of the mechanism of income generation in production process. It consists of two components. These components are a change in production input and a change in productivity.
Production is a process of combining various material inputs and immaterial inputs (plans, know-how) in order to make something for consumption (the output). The methods of combining the inputs of production in the process of making output are often called technology. The production function can be used as a rough measure of relative performance when comparing technologies.
In the case of a single production process (described above) the output is defined as an economic value of products and services produced in the process. When we want to examine an entity of many production processes we have to sum up the value-added created in the single processes. This is done in order to avoid the double accounting of intermediate inputs. Value-added is obtained by subtracting the intermediate inputs from the outputs. The most well-known and used measure of value-added is the GDP (Gross Domestic Product is widely used as a measure of the economic growth of nations and industries.
The growth of production output does not reveal anything about the performance of the production process. The performance of production measures production’s ability to generate income. Because the income from production is generated in the real process, we call it the real income. Similarly, as the production function is an expression of the real process, we could also call it “income generated by the production function”. The real income generation follows the logic of the production function. Two components can also be distinguished in the income change: the income growth caused by an increase in production input (production volume) and the income growth caused by an increase in productivity. The income growth caused by increased production volume is determined by moving along the production function graph. The income growth corresponding to a shift of the production function is generated by the increase in productivity. The change of real income so signifies a move from the point 1 to the point 2 on the production function (above). When we want to maximize the production performance we have to maximize the income generated by the production function.
The production performance can be measured as an average or an absolute income. Expressing performance both in average (avg.) and absolute (abs.) quantities is helpful for understanding the welfare effects of production. For measurement of the average production performance, we use the known productivity ratio
- Real output / Real input
The absolute income of performance is obtained by subtracting the real input from the real output as follows:
- Real income (abs.) = Real output – Real input
The growth of the real income is the increase of the economic value which can be distributed between the production stakeholders. With the aid of the production model we can perform the average and absolute accounting in one calculation. Maximizing production performance requires using the absolute measure, i.e. the real income and its derivatives as a criterion of production performance.
The differences between the absolute and average performance measures can be illustrated by the following graph showing marginal and average productivity. The figure is a traditional expression of average productivity and marginal productivity. The maximum for production performance is achieved at the volume where marginal productivity is zero. The maximum for production performance is the maximum of the real incomes. In this illustrative example the maximum real income is achieved, when the production volume is 7.5 units. The maximum average productivity is reached when the production volume is 3.0 units. It is worth noting that the maximum average productivity is not the same as the maximum of real income.
A practical example illustrates the case. When a jobless person obtains a job in market production we may assume it is a low productivity job. As a result average productivity decreases but the real income per capita increases. Furthermore the well-being of the society also grows. This example reveals the difficulty to interpret the total productivity change correctly. The combination of volume increase and total productivity decrease leads in this case to the improved performance because we are on the “diminishing returns” area of the production function. If we are on the part of “increasing returns” on the production function, the combination of production volume increase and total productivity increase leads to improved production performance. Unfortunately we do not know in practice on which part of the production function we are. Therefore a correct interpretation of a performance change is obtained only by measuring the real income change.
A production model is a numerical description of the production process and is based on the prices and the quantities of inputs and outputs. There are two main approaches to operationalize the concept of production function. We can use mathematical formulae, which are typically used in macroeconomics (in growth accounting) or arithmetical models, which are typically used in microeconomics and management accounting. We do not present the former approach here but refer to the survey “Growth accounting” by Hulten 2009.
We use here arithmetical models because they are like the models of management accounting, illustrative and easily understood and applied in practice. Furthermore they are integrated to management accounting, which is a practical advantage. A major advantage of the arithmetical model is its capability to depict production function as a part of production process. Consequently production function can be understood, measured, and examined as a part of production process.
There are different production models according to different interests. Here we use a production income model and a production analysis model in order to demonstrate production function as a phenomenon and a measurable quantity.
A model used here is a typical production analysis model by help of which it is possible to calculate the outcome of the real process, income distribution process and production process. The starting point is a profitability calculation using surplus value as a criterion of profitability. The surplus value calculation is the only valid measure for understanding the connection between profitability and productivity or understanding the connection between real process and production process. A valid measurement of total productivity necessitates considering all production inputs, and the surplus value calculation is the only calculation to conform to the requirement. If we omit an input in productivity or income accounting, this means that the omitted input can be used unlimitedly in production without any impact on accounting results.
Appleton Greene has a number of standard and bespoke corporate training programs available which focus upon production. These programs enable clients to implement practical business processes that are designed to ensure that production improvements are professionally researched and developed, effectively implemented and consistently managed over a sustainable period of time.
Appleton Greene also has a variety of Learning Providers and Consultants with specific expertise and experience relating to production process re-engineering, improvement and sustainability.