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Introduction
CHAPTER 1: INTRODUCTION
This chapter provides the foundation for the study of productivity and
profitability by analyzing what these two parameters are all about. It elaborates
the important relationship between productivity and profitability that how they
relate with each other.
The aim of a nation is to improve the living standards of the citizens, increase employment and
generate more pool of jobs. Profit is said to be the main reason of existence of any organization.
1.1: Profit
Profit is basically the amount a business makes after accounting for all the expenses, regardless
of the nature of business. Profit can also be defined as a difference between the purchase price
and the cost incurred to produce a product. Profit comes from combinations of different factors
taken by the management like good governance, sales, innovation and investments. It is the key
objective for all the organizations to earn and sustain profit. People wishes to invest in those
organizations which are more profitable. [1]
1.2: Productivity
Productivity is defined as the ratio of what is produced to what is required to be produced.
Productivity helps to define both the scope for raising living standards and the competitiveness
of an economy. Productivity has thus, an increasing position in formulating financial
performance. (Elliot, 2007) [2]
Productivity is said to be the relationship between total outputs with total inputs. Output such as
goods and services produced and Inputs include capital, material, labor and other resources. [2]
Productivity ratios vary in measurement units. They can be measured in percentages, dollars per
hour, pieces per day, hours per day etc. If productivity ratio is measured in revenue per cost, then
it directly relates to profitability. Productivity can only be measured for tangible inputs and
outputs.
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1.3: Profitability
Profitability is the foremost central aim of all business ventures. Without profitability, no
business can survive for the long run. So finding current and previous profitability and predicting
future measures of profitability is very important. Simply it can be said that profitability is
measured with income and expenses. Income is an amount that is produced from the activities of
the business and expenses are all the cost of resources incurred or consumed by the activities to
produce goods and services of the business. Profitability is ability of companies to make profits,
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as a positive difference between the proceeds from his own activities and cost of manufacturing,
marketing and other transaction costs. [6]
1.3.1: Profitability ratios
Profitability ratio is a set of financial metrics that are used to assess a business's capability to
generate return in regards with its expenses and other related costs incurred during a specific
period of time. [7]
A range of Profitability Ratios can be used to evaluate the financial status of a business. These
ratios, generated from the income statement, can be used over a period of time to identify the
upcoming problems [6].
Profitability ratios include:
Productivity has direct impacts on firm profitability, measured in terms of certain financial
matrices. Productivity and profitability both key parts of performance criteria in which
organization need to measure, analyze and evaluate its performance. [8]
Increasing productivity levels can significantly increase profitability and decline in productivity
results in decrement of profitability. When the prices of inputs increase, the cost of expenses
incurred in producing the product also increases. This disturbs the partial productivity and total
productivity, so in return the profitability of a company is affected negatively.
A lot of research material is available on individual profitability and productivity, treating them
individually, but a very little research has been done on the relations of these two parameters on
each other. Profitability is most of the time analyzed by taking ratios from income statement;
although the back end of profitability of any company is the production process from the
production department, but the productivity is negligibly discussed and noticed. So it can be
observed that the production process is the basic indicator of profitability and there is a direct
relation between productivity and profitability ratios.
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Independent variables of productivity taken for research are partial productivity, and total
productivity. Dependent variables of profitability are gross margins, net margins, operating
margin and return on capital employed (ROCE).
We have selected manufacturing sector for our research because its output is tangible and
quantitative, so it can be easily measurable. We will cross compare two sectors with each other.
The sectors are food industry, oil and gas industry.
1.5: Hypothesis
H1: Increase in partial productivity will increase profitability
H2: Increase in total productivity will increase profitability
1.6: Objectives
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In the environment of competition, the success of businesses is based on efficient and effective
use of their resources that represent the level of productivity. Michael Fleming uses the
productivity measurement as a management tool and relates them with profitability and the
factors which affect it. (Fleming, 1970)
Productivity is a combined measure for effectiveness and efficiency, i.e., a productive
organization is both effective and efficient. Measurement of productivity needs to consider
various inputs and outputs of the products or services produced to be adequate and appropriate.
(Kumar, 2011) (Meyer, 1980).
By measuring the productivity is an important means to achieve this goal. And how can it
achieve its goals, and is as follows, the function of the organization is provided valuable
information as you want. (Drucker, 1991) They are only useful for the measurement of
productivity when it is used to achieve the goals and objectives of the fabric to achieve the effect
and reflect to improve productivity. This requires the commitment of all management involved,
and teamwork. (Lovell) (Eilon, 1985)
Measurement plays an important role in managing performance. This allows you to determine if
your business operates well. It also provides information and effectively your organization
manages its resources. In essence, measuring the performance identification and evaluation of
the relevant input and output data. (Rao, 1989) (Wolf, 1990) Organizations should monitor and
analyze their performance in terms of performance levels of productivity, measurement of
different performance. (Drucker, 1991) Profitability levels reflect how effective and efficient use
of resources of the organization so. Comparing the levels of performance must be made between
similar organizations, such as the two companies in the same sector. (Fitzroy, 1987) (Florkowski,
1987)
Organizations often consider the benefits that an important measure of success. Using the results
as a measure seems to imply that the organization will benefit more if costs such as salaries and
depreciation of capital reinvestment decreases. But the reduction of wages to increase profits
tends to lead to conflict in the relationship between employees and management. Minimizing
investment capital often has a negative impact on efficiency in operations, and ultimately affects
the outcome. Therefore, the increased profit by reducing these costs is only a short term measure.
(Florkowski, 1987) (Stevenson, 6 Edition)
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Productivity measures allow administrators to separate the changes in earnings due to the factors
of productivity and sales activities that are related due to changes in output prices on input costs.
(Rajiv Banker) Productivity is for the long-term competitiveness and profitability of
organizations. It can be treated effectively if managed in a comprehensive and systematic
manner. Measurement of productivity is a requirement for improving productivity. (Rao, 1989)
(Drucker, 1991)
The performance was considered serious, usually as an important condition for the long-term
competence of the company and the success of the company that serves the financial objectives.
(Yazdanfar, 2013) Another factor to explain the importance of profitability, is its impact on
economic growth, employment, innovation and technological change. There are many theoretical
approaches on firms profitability:
Wen-Ruey Lee investigated about quality and productivity as the two important indexes for any
firms performance. He said that quality and productivity are positively related to each other, and
increment in one of it can results in increase in profit. He researched on the relationship models
between quality and profit. The four models relating the quality-cost relationship that were used
are: Juran's Optimum Quality Cost Model, Dawes' Quality-Cost Model, Harrington's PoorQuality-Cost Model, and Taguchi's Quality Loss Function Model. The six productivity profit
relationship models which he used are: Adam Hershauer-Ruch's model, Papadimitriou's Profit
Decomposition Model, Sumanth's model, the APC model, Miller's model, and Miller's ROIbased model. (WEN-RUEY LEE, 1997)
In development countries macro-economic factors like inflation increase the cost of production
decline the company productivity as a result profitability automatically decrease. Company cant
perform well in inflationary situation. Land labor and capital cost effect revenue of a company.
Revenue decrease due to increase in expenses (inputs). (Olajire, 2001)
According to Swaim, Sink and Sumanth (1985), there is a separate effect of productivity and
price recovery on the profitability by using the multi-factor model. According to Kahen (1997),
we focus on labor input apart from material and capital inputs, considering it as an important
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According to Gregory v. Frazier companies who outsourced their operational parts perform well
and more productive than non-outsourced companies. These outsourcing provides company
leverage (cash) to invest in other product capacities. Outsourcing improves company cost
efficiency, productivity and profitability. Through outsourcing, company maintains a balance
among its operations. A company can utilize minimum resources (input) and maximize gains
(output) through it. Company labor and capital expenses decrease in outsourcing. (Bin Jiang,
2006)
Andreas Stierwald investigates the determinants of firms profitability. He defined firm-level
variables, such as lagged profit, productivity level and firm size, have a positive and huge impact
on firm profitability. Models of firm profitability can be classified into two major groups,
structure-conduct performance (SCP) and firm effect models. In the SCP model the market
structure determines firm behavior and profitability. In firm effect models, market structure is the
result of the distribution of firms and firm profits. (Stierwald, Determinants of Firm Profitability
- The Effect of Productivity and its Persistence, 2009)
Separately the productivity of many sectors (Cement, Pharmaceutical, automobile, Banking
&Sugar) has been measured but they were not compared with profitability ratios. On the other
hand, a research has been conducted to measure the performance of many organizations by using
financial ratios but they are not linked with productivity so we can say that a little work has been
done on the interlinking of productivity and profitability ratios in Pakistan. (Tahir, 2012)
(ABDUL RAHEMAN, 2009)
Other approaches also suggest that firms profit is depend on its performance which is mainly
determined by internal and external variables. (HELFAT, 2001) (Porter, 2002) More productive
firms have a competitive advantage over their less productive rivals which is likely to be
reflected in profitability. Firms with higher levels of total factor productivity earn higher profits.
(Stierwald, June 2009)
According to Abdul Rehman, Abdul Qayyum and Talat Afza, improved productive efficiency of
Sugar Industry can be achieved by using new available production technologies and efficient
operations. According to Coelli, et al. (2005), there are three components of productivity growth:
technical change, scale effects and changes in the degree of technical efficiency. The basic
objective of their research was to provide policy implications and strategies for improvement in
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The productivity of organization positively affects the profitability. It is the most significant
determinant of profitability. Firms are facing difficulties to achieve their required profits due to
price pressure in Swedish. Firms access the range of resources to be successful. According to
Werner felt, (1984) all tangible and intangible assets (cash, loans, capabilities, qualification,
organizational process, firms attribute and information) are referred as resources. The results of
this study show that larger and newer firms have higher productivity and they are more
profitable. (Yazdanfar, 2013)
The information provided by productivity measurement, helps to move from present status to
future status. The improvement in productivity increases the quality of product and service as
well as decreases per unit cost which increases the profits and sales in result. Furthermore, the
sales growth help to increase the market share. A research conducted in Tehran stock exchange,
found important relationship between capital productivity, employee productivity, total factor
productivity (independent variable) and total asset turn over ratios (dependent variable). It
further indicated that an increase in employee and capital productivity leads to decrease in total
asset turn over. In other words, it reduces the companys ability to use their resources/assets
efficiently and effectively. (Mozhgan Hamidi Beinabaj, 2013)
The productivity of organizations can be calculated in term of financial ratios. It is fact that the
manufacturing firm set productivity as a benchmark for key performance. Profitability, low cost
and sustainable competitive advantage is related to manage and improve the productivity. There
is a limitation of partial productivity that it only calculates efficiency of single output.
Multifactor productivity is more comprehensive type of productivity and its more common type
is total factor productivity (also called value added productivity). It interprets the efficiency and
effectiveness of labor and capital. A correlation study is conducted to find out relationship
between total factor productivity and financial ratios (profit before depreciation interest and tax,
profit before depreciation and tax, profit before interest and tax, profit before tax, profit after
tax). The results indicate that these ratios are very effective to describe total factor productivity
because they are highly correlated with productivity. (Bhushi, 2014)
According to Ondrej Machek, agriculture sector is the most important sector of any economy.
The researcher calculated and compared the two measures of performance of the agricultural
sector of the Czech Republic, the total factor productivity measured by the Fisher index of
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productivity. The financial performance measured by three profitability ratios, return on equity,
return on assets and return on sales. (Machek, 2014)
C H A P T E R 3 : D A TA A N D S A M P L I N G
This chapter outlines the body of the research, an extensive range of data source on which the
research has conducted. Given below is a description of all minute details of data and sampling
taken from different companies to conduct specified tests on it.
Total productivity
Partial productivity
Gross profit margin
Operating profit margin
Net profit margin
Return on capital employed (ROCE)
Return on assets (ROA)
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Positive correlation
Negative correlation
Zero correlation
Linear correlation
Non linear correlation
I: Positive correlation
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When two variables moves in the same direction that an increase in one variable causes an
increase in other variable or a decrease in one variable causes a decrease in other variable then
those two variables are said to be positively correlated. Simply it can be said that there is a direct
relationship between the two selected variables.
II: Negative correlation
When two variables moves in opposite direction that an increase in one variable causes a
decrease in other variable then those two variables are said to be negatively correlated. Simply it
can be said that there is an inverse relationship between the two selected variables.
III: Zero correlation
When there is no relation between two variables or the change in one variable has no effect on
other then it is said to be zero correlation between them.
IV: Linear correlation
When a change in one variable results in a constant change in another variable then it is called as
linear correlation
V: Non linear correlation
When a change in one variable does not result in a constant change in another variable then it is
called as non linear correlation.
3.2.2: Regression
Regression is a statistical tool to determine or examine the strength between one independent
variable and one dependent variable.
Introduction
Multiple regressions use two or more than two independent variable to predict the outcome of
dependent variable.
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manufacturing sector. CNG is also considered as reason behind this shortfall because around 2
million vehicles have switched to CNG which starts giving caustic effects to the economy.
Pakistan is the largest consumer of natural gas in South Asia. Its gas reserves are reducing fast
because of the extremely inefficient pipeline system subject to theft in Third World conditions.
Nearly 40% of gas being consumed in households and at gas pumps is subject to this loss, which
puts further pressure on gas prices for consumers. Depletion of local reserves of natural gas has
dropped which means that there is a huge pressure to fulfill the demand according to supply. This
gap in demand and supply also disturbs energy generation. Oil and Gas contributes 77% of
energy requirement for Pakistan. This shows that if some crisis situation arises in this sector it
will have negative effects in the economy.
Reason that we have selected oil and gas sector is that there is a situation of crisis in Pakistan in
energy sector and it rely on oil and gas. Through our findings we can find the impact of low
productivity on profitability of the companies in this sector.
3.2.2: Food industry sector
The food industry is a very competitive and mature industry with little domestic growth. Global
market forces are driving the continual evolution of the food industry. Consolidation, changing
consumer preferences and increasing government regulations are dramatically impacting
manufacturing and business strategy. In this fiercely competitive marketplace, a greater variety
of products should be offered to meet consumer demand. At the same time, by cost-effectively
produce high quality products.
Pakistan is considered as one of the top 10 food manufacturing countries in the world. In this
sector agriculture contributes 21% to the country GDP which shows that if this sector faces crises
it will affect the GDP rate of the country. The growth rate in the food industry is 10% per annum
the most rapidly growing items are dairy products, fish processed, soft beverages etc. there is a
significant scope for investment expansion in the food manufacturing sector. Domestic demand
is buoyant and exports prospects are bright-although they are yet to be adequately explored.
Many of the food manufacturing companies are listed in KSE in which around 86 food
manufacturing companies are listed on the Karachi stock exchange. The food industry is having
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its major part in exports of Pakistan which is providing benefit to the economy of Pakistan, the
major exports of Pakistan are rice, fruits, spices, meat, fish and many others.
The food industry is considered Pakistan largest industry and is believed to account for 27% of
its value added production & 16% of the total employment in manufacturing sector. As the
economy continues to slowly improve, a wave of significant change is moving through the food
industry redefining how companies grow, operate, and manage risk. Rapidly advancing
technology is driving much of the transformation, providing opportunities to explore new ways
of doing business, and to better understand and engage with consumers. However, technology
does not come without challenges, exposing companies to new areas of risk and vulnerability.
The Appealing facts of selecting food industry and the reasons of selecting this industry for our
project are that:
Although Pakistan food industry is one of the largest but there are also some problems that the
country in facing in this respective industry. The problems are:
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The dependent variable of our project is profitability ratios. Profitability ratios are the tools to
measure the profitability of a company. Analysts measures, analyzes and evaluates the
profitability of a company with respect to its sales, asset and equity because the investors cannot
be attracted without profits. For this study, we have selected/chosen gross profit margin,
operating profit margin, Net profit margin, Return on Capital Employed (ROCE) and Return on
Asset (ROA) from profitability ratios.
3.3.2.1: Gross Profit Margin
Gross profit Margin is a financial tool to access the financial healthiness of a company after
paying the cost of manufacturing. In other words it represents/interprets the profit on per rupee of
sales in term of percentage after a company had paid its cost of goods. Company pays the further
expenses from gross profit such as operating expenses, administrative expenses, distribution and
selling expenses etc. It is also called Gross Margin. (INVESTOPEDIA) (J.Gitman, 2008)
It is calculated through following formula
Gross Profit Margin = (Gross Profit/Net Sales)*100
Gross profit comes after subtracting the cost of goods sold from sales. So, it tells what is left
after paying the cost of sales from sales. Cost of sale/good is the price of raw material, labor and
all inputs/expenses that are used in production. There is an inverse relationship between CGS and
Gross profit and direct relation between sales and gross profit. As more will be the sales, it will
increase the gross profit and a firm will have more capacity to cover its expenses and then to gain
profits. So, it must be high enough. If gross profit is less, it means that either companys sales are
less or cost of good is more and increase in the price of the raw material, labor and other inputs
used in production, will increase cost of good.
If company is not managing its manufacturing cost efficiently though wasting the raw material or
hiring extra labor then, it is not productive. To be Productive, it has to become efficient in term
of using its inputs (cost of goods sold). So, as more a company will be efficient in its CGS, as
more it will enhance its gross margin. (Zions Bank)
3.3.2.2: Operating Profit Margin
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Operating profit margin is a tool to measure the power of company to run its current operation
and earn from them. (Zions Bank)
It represents the profit on per rupee of sales in term of percentage after a company had paid its all
costs and expenses other than finance cost (interest), taxes and preferred dividend. It is the pure
profit because it presents the only profit made through operation that does not include the effect
of interest, taxes and preferred dividend. A high operating margin is preferable. (J.Gitman, 2008)
Operating Profit Margin = (Operating Profit/Sales)*100
Operating profit comes after subtracting the operating, administrative, selling and distribution
expenses from gross profit and then adding the operating income in it. There is an inverse
relationship between operation profit and expenses. If the expenses are more then it will lessen
the operating profit which means that a company is not managing/running its operations
efficiently. To be Productive it has to become efficient in term of using its inputs (operating,
administrative, selling and distribution expenses etc). So, as more a company will be efficient in
its expenses, as more it will enhance its operating profit margin.
3.3.2.3: Net Profit Margin
It represents the profit on per rupee of sales in term of percentage after a company had paid its all
costs and expenses, finance cost (interest), taxes and preferred dividend. A higher Net margin
will be better and preferable. (J.Gitman, 2008)
Net Profit Margin= (Net Profit /Sales)*100
We subtract the finance cost form operating profit; its equal to profit before tax. Net profit
comes after subtracting the taxes form profit before tax. The taxes are calculated on the profit
before tax. So as more will be the profit before tax, more taxes will be charged. Here, a company
can take advantage of tax shield effect, that is when a company uses debts as a source of finance
then cost/interest lessens the profit before tax and less tax charged on it.
To be Productive company has to become efficient in term of using its inputs (cost of goods sold
as well as expenses). So, as more a company will be efficient in its CGS and expenses, as more it
will enhance its net profit margin.
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To calculate ROA, we have taken net profits from the profit and loss statement and total asset
from balance sheet after adding the current and non-current assets. If company is not using its
asset efficiently though their maximum utilization then, it is not productive. To be Productive it
has to become efficient in term of using its total assets. So, as more a company will be efficient
in its asset, as more it will enhance its ROA.
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