Productivity Down, Costs Up

Labor productivity was weak last quarter, and labor costs were strong.  The productivity data, though, are a bit misleading.

Productivity--output per hour of labor employed--declined by just a hair last quarter.  The four-quarter growth rate, shown in the chart above, increased by the smallest percentage since 1997.  But the news isn't quite that bad.  Productivity is very "pro-cyclical," meaning that it's high in booms, low in recessions.  In business terms, when times are good, increasing your output does not require a proportionate increase in workers.  In bad times, it's very difficult to cut workers in proportion to the reduction in sales or production.

What we see in last quarter's data is the weak GDP growth more than an underlying trend of weak productivity.  In fact, long-term trends are the only way to really see what's happening in productivity.  Unfortunately, it's hard to catch the first signs of a change in trend productivity.  However, the actual data are consistent with the same old underlying trend productivity growth, plus a weak quarter of GDP.  That's a judgment call, not hard science, but I feel very comfortable with this call.

In related news, unit labor costs rose a good deal last quarter.  This measures the cost of labor, taking into account its productivity.  When productivity is growing faster than compensation, then unit labor costs are falling.  That is not the case right now.  Costs are rising.

The higher labor costs get resolved in one of three ways:  first, the economy may expand, increasing productivity and thus reducing unit labor costs.  Second, companies may raise prices to cover their higher costs.  Third, companies may have to accept lower profits.  In actuality, all three can happen.  The economy will expand at a faster growth rate in the future.  In the meantime, there will be a lot of profit squeeze and a little pricing hiking.

Business strategy implications:  Ignore the national productivity data, but continue working to improve productivity in your company.  On the cost side, here are three tips for whether you can pass on cost increases to your customers: 1) if you and your direct competitors have little excess capacity, pass on your cost increases; 2) if your customers are in a strong financial condition, pass on your cost increases; 3) if your customers view you as just another supplier, rather than a valued supply-chain partner, pass on your cost increases.