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Why Manufacturers Need a Digital Vision

Manufacturing is the quintessential physical industry. No matter how much data is involved, manufacturing is defined as “the mechanical, physical, or chemical transformation of materials, substances, or components into new products.” If it ain’t physical, it ain’t manufacturing.

For many years, manufacturing was viewed as a productivity leader. But in recent years, that is no longer true. The growth rate of manufacturing productivity in the United States has slowed to a crawl, rising by only 0.3% in the year ending with the first quarter of 2018 with no signs of an immediate turnaround.

To be fair, part of the apparent productivity slowdown may be due to our inability to measure increased sophistication of products correctly. For example, new airplanes and machine tools may have far better electronics built into them that cannot be correctly tracked by economic statisticians. Even something as simple as a valve might be evolving in materials and even functionality.

Manufacturing Productivity Growth Is Plunging
10-year growth rate (four quarter average)


But the productivity slowdown in manufacturing extends far beyond advanced goods. Nondurable industries such as food processing have seen productivity slowdowns as well. For example, labor productivity in the very important food manufacturing industry has not risen in 15 years, according to data from the Bureau of Labor Statistics (BLS). Meanwhile, the entire industry employs less than 1000 software developers.

For a while, the weakness in U.S. manufacturing was obscured by the success of the largest American manufacturing multinationals. According to a study by McKinsey Global Institute, large U.S.-based manufacturers enjoyed returns on capital exceeding 20% in the 1997-2013 period, much higher than their European and Asian peers.

In recent years, the profits malaise has hit the bigger industrial firms as well. Since 2007, there has been almost no growth in manufacturing profits as measured by the Bureau of Economic Analysis (BEA), after adjusting for inflation.

Annual Growth of Manufacturing Profits
Adjusted for inflation


How far back does the manufacturing productivity problem go? It matters which indicator you view. If we look at labor productivity—output per unit of labor—productivity growth was strong through the middle of the 2000s. Manufacturers followed a strategy of replacing people with machines or shifting labor-intensive low-value operations to other countries with cheaper labor. Non-core workers like cafeteria workers or cleaning staff were outsourced to other non-manufacturing companies. Fewer workers and the same output led to higher labor productivity.

But that is not the whole story. If we look at “multifactor productivity,” manufacturing’s problems go back much further. Multifactor productivity takes into account the usage of purchased services, energy, capital, and intermediate inputs. For example, if a manufacturing company buys a machine to replace some of its workers, labor productivity will rise. But multifactor productivity may or may not go up, depending on how expensive the machine is relative to workers.

Similarly, if a manufacturer outsources part of its production process to another company, that will show up as a drop in labor but an increase in purchased parts. Labor productivity will go up, but multifactor productivity might rise or fall depending on the efficiency of the second company.

Multifactor productivity corresponds much more closely to competitiveness and profitability than pure labor productivity does. Unfortunately, when we look at multifactor productivity growth in manufacturing by industry over the past 20 years, the situation is rather discouraging.  

Weak Multifactor Productivity Growth in Most Manufacturing Industries
Average annual growth of multifactor productivity, 1996-2016


One industry—computer and electronics products—shows very strong multifactor productivity growth over the past twenty years. But many manufacturing industries have weak or even negative multifactor productivity growth over the past 20 years. In other words, they have become less competitive.

Take the machinery industry, which includes everything from agriculture, construction and mining machinery, to industrial machinery, to heating and air-conditioning equipment, to turbines and power transmission equipment. Labor productivity has risen because machinery manufacturers have become more automated, reduced workforce, and sourced more parts from overseas. That is good news.  

However, multifactor productivity in the machinery industry has been flat for the past 20 years. That means the underlying productivity of the machinery industry has not risen for the past 20 years, taking into account the spending on capital equipment, purchased services, and materials. No economist or industry leader would have predicted that outcome in 1996, as the internet revolution started. That is why there have been two lost decades for manufacturing. 

Focus on the Machinery Industry Productivity