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The Productivity Imperative: Companies Sharpen Their Focus on Continuous Improvement

Oct. 16, 2023
Across industries, digitization and other investments are spurring gains. Up next: An AI-driven boom.

A productivity boom? In this economy?

Three years after word began spreading about an illness called COVID-19, the U.S. economy has largely digested supply chain, labor and inflation shocks. But neither businesses nor their workers have declared the all-clear: The latest Chief Executive survey of leaders reveals a far more negative outlook for 2024 versus early summer while a new study from the Employee Benefit Research Institute shows a majority of workers remain anxious about work-life balance and other quality-of-life issues.

Despite the progress made since the depths of the pandemic, some sand remains in the gears of the economy that would normally delay notable productivity gains—even if 2024 brings more growth and no recession.

And yet…

The strong Oct. 6 job market report for September, which showed payrolls, hours worked and wage gains all still growing but more slowly than in recent months, set several observers to talking in some depth about a productivity boom.

“Job gains are strong and broader-based but wage growth is moderating alongside inflation,” economist and University of Texas professor Julia Coronado said on X, the social media platform formerly known as Twitter. “Labor supply is robust and the unemployment rate is unchanged since [February] 2022. Could this be our 1994/5 moment?”

Productivity boomed in the second half of the 1990s, averaging 2.5% annually versus 1.5% in the five prior years. Researchers have since observed that the step up was the result of multiple factors—a tightening labor market that led companies to invest more in employee training and development as well as increased competition and innovation that was helped by IT investments, including in the early internet—that one could argue are present in today's economy.

Skanda Amarnath, executive director of the Employ America think tank, said peeling back some of the headline layers of the recent jobs report showed that investment-sensitive sectors have been consistently adding higher-paying, higher-quality jobs, which delivers a “double kicker, adding both to capital goods and final production over time.”

“Q3 productivity could be 2% to 3.5%,” Amarnath wrote. “We usually only see those gains in productivity estimates when we’re *losing* jobs.”

It might be different this time

Productivity, efficiency and growing profit margins are of course a staple of corporate life: Numbers crunched by Yardeni Research Inc. show that the trailing four-quarter average operating profit margin of companies in the Standard & Poor’s 500 Index has steadily climbed to more than 12% from around 5.5% in 1994.

This business cycle, however, a few factors that haven’t been present often over the past 30 years are adding urgency to productivity pushes: 1) Inflation, while it has retreated from 2022’s painful peaks and continues to irritate in various ways; 2) Executive teams are investing billions to overhaul their supply chains and manufacturing footprints, which is broadly pushing up costs; and 3) Job cuts are no longer the go-to lever for margin improvements because many CEOs and CFOs don’t want to turn loose workers they may not be able to rehire in a structurally tight labor market.

That last dynamic is likely to endure: The Bureau of Labor Statistics last month predicted that U.S. labor force growth will average just 0.4% annually through 2032, which is just a third of the growth rate from 1992 to 2002. Firms will have to make do with fewer workers and be more mindful of the labor dynamics of other sectors. Craig Arnold, chairman and CEO of Eaton Corp., last month told attendees of the Morgan Stanley Laguna Conference that the supply of skilled laborers such as electricians and welders is a concern for the maker of electronic components, industrial controls and much more.

“What we worry about beyond what is happening inside our own four walls is, ‘Is industry ready?’” Arnold said. “The gating item [for working through Eaton’s backlogs] ultimately will be, ‘Can you get the labor you need to deal with the real demand that’s in the marketplace?’”

Other executive teams are asking similar questions about their operations and regularly coming up with tech- and systems-driven encouraging answers that are contributing to Amarnath’s outsized productivity estimates. Here are three recent examples:

  • Also speaking at the Morgan Stanley gathering, General Electric Co. CFO Rahul Ghai spoke of some of the blocking-and-tackling happening at GE Vernova, the conglomerate’s energy holdings unit that will be spun out around the turn of the year. Leaning on Lean principles, Ghai said the team at the company’s gas turbine-focused plant in Greenville, South Carolina, has digitized its outage management process and trimmed its response time by a quarter.
    Technicians, Ghai added, now know—thanks in part to iPads—“exactly what to do to talk about standard work and then can provide feedback to the people back home on what needs to get better. So talk about continuous improvement […] Think about what that does for the business: double-digit cost reduction, incremental capacity.”
  • Investments in digitalization also are proving fruitful at Northrop Grumman Corp., Chairman, President and CEO Kathy Warden told investors this summer. The defense contractor has built an integrated ecosystem that allows its employees, customers and partners to speed up the design, integration, testing and production of Northrop’s high-dollar products.
    “We’re also investing in and advancing the technologies in digital systems in our factories,” Warden said. “On the B-21 (strategic bomber], we’ve successfully demonstrated the use of this [system] to realize over 15% labor efficiencies in one area of the build. And in June, we launched the expansion of this approach across the whole build process.”
    In addition to bringing more production programs into the digital sphere, Warden said Northrop’s teams are pushing this approach into their business operations, including to streamline their supply chain.
    “We have over 20,000 suppliers and we’ve begun securely connecting them,” she said. “Over the next several years, we expect to have the majority of our supply base fully integrated. This is expected to lower supplier costs and significantly improve productivity.”
  • At Occidental Petroleum Corp., President and CEO Vicki Hollub has put the productivity playbook under wraps.
    Speaking to analysts and investors in early August, Hollub lauded her shale drilling teams’ engineering work, which she said have dismantled her expectations of a few years ago that Occidental’s Permian Basin operations and, hence production, would soon plateau. Instead, Hollub said, the output from Occidental’s West Texas wells has been “pretty phenomenal” and the methods and processes used there will be applied across the company.
    “The teams continue to surprise me, continue to go beyond what I thought we would ever be able to do,” Hollub said of Occidental’s shale work. “I’ve now asked the teams to stop talking about it. […] It’s just too important to our company and to our shareholders.”

Winning companies have long set themselves apart by scoring such smart and incremental productivity gains. Today, they’re starting to supplement those wins with tales of artificial intelligence tools driving more improvements. It’s very much early innings but the potential is enormous: Depending on the rate at which AI is widely adopted and integrated with other technologies, McKinsey & Co. analysts think automation taken broadly could juice productivity growth by more than 3 percentage points annually through 2040.

That growth will come with a price tag, however. Analysts at Morgan Stanley this summer wrote that chief information officers plan to more than double their IT spending versus pre-COVID levels for at least the next several years.

“Non-tech sectors, such as retail and manufacturing, appear to be particularly primed to invest in new technological capacity, and therefore may see more productivity gains,” the analysts wrote. “As a result, even markets with less direct tech exposure may benefit more this time than during the digital proliferation that happened in the 1990s and 2000s.”

With labor markets tight and several other cost pressures like to persist, using technology to continually grow productivity feels more than ever like table stakes. As public companies begin to report their quarterly results and lift the curtain on 2024 plans, we’ll be paying close attention to which leadership teams are coming to the table with clear strategies and lots of chips in their pockets.

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