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ii. Production
This ratio represents what has been produced by the company during the fiscal year (both in terms of products and services). Here again we need to adjust for variations in inventories, and take into account the products which have been manufactured by the company for its own use, along with the services rendered by the company to itself: such products and services will be accounted for at their production costs.
How should you analyze production ? Well, it can be seen through various lenses:
- from a productivity perspective: what is the average productivity of a worker ? You can
have a good idea by looking at the ratio (production / average headcount) and how it evolved during the past few years. However, be careful when interpreting such a ratio because it depends on the wages received by the workers: the higher the wages, the more incentives your employees will have to perform better and be more productive. This is the reason why the following ratio may be more relevant.
- from a cost perspective : what is the cost of labor per unit produced ? It is measured
by the ratio (production / total wages paid to workforce). Ultimately, this measure may turn out to be more important than the previous one, because at the end of the day what you really care about is maximizing the production for a given level of wages.
Additionally, please note that you might want to include in the “total wages paid to workforce” all the variable costs associated with the workforce, such as retirement benefits paid by the company, etc … Such costs are not wages in themselves but are incurred whenever you hire a new recruit, and shall therefore be taken into consideration.
Finally, always keep in mind that personnel costs are very inert: when you fire employees on June 31rst of year N, half of their payroll will still be accounted for during the year N (assuming that financial statements run from Jan. 1rst to Dec. 31rst), and the weight of their wages will completely disappear from the income statement only starting with the next fiscal year N+1.
This however does not represent a problem as you consider the “average headcount” and “total wages paid to workers” when conducting your analysis, and production will always be roughly proportional to these numbers (assuming everything else remains stable).
In this way, if you wish to have an idea of what will be the cost of labor per unit produced for the year N+1, you can use the ratio (production for the last 6 months of year N / total wages paid to workforce for the last 6 months of year N) as an estimate for the situation in year N+1. Nonetheless, forgetting about the fact that some employees were fired in June and keeping the ratio (production in year N / total wages paid to workforce in year N) as an estimate for year N+1 will carry a strong bias, since you decided to cut your workforce precisely in a bid to improve the year N ratio.
- from a capacity perspective : is the company working at below capacity or overproducing
? You can tell by computing the capacity ratio (production / total sales), where total sales include both the sales of goods purchased and those of services and goods produced by the company. If the capacity ratio is way greater than 1, than you need to determine why you apparently could not sell nearly as much as you produced. Two reasons might arise:
- you are overproducing, and should slow down the operations, otherwise you will run the risk of incurring huge storage costs plus that of never being able to sell the products you are piling up in your inventories.
- you are overvaluing your inventories, in which case it is necessary that you revise your valuation method.