You are on page 1of 25

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

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.

Page 1

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

1.2.1: Role of productivity


Productivity plays a vital role to the economy of any country because it allows achieving more
with investing less. Capital and labor are both insufficient resources, so maximizing their impact
is always a center concern of modern business. Productivity enrichment come from technological
advancement, such as competitive strategies and increased skill levels within the workforce of
any organization. Productivity is measured by many economists as an indication for predicting
future levels of GDP growth. [3]
Increasing national productivity can increase living standards because more real financial
standards can improves people's capability to buy goods and services, enjoy freedom, and
improve education and living standards and put in to social and ecological programs. [4]
Increasing productivity is a major and central goal or purpose for many corporate people, as the
market is more creative in their workforce and in predicting the future demand, the more money
they can bring into their businesses. Or increased productivity means that carrying out services at
a quicker rate than it was before. Productivity enhancements have been determined as source of
economic growth, high living standards and increased wages. [5]
Kendrick Creamer (1965) proposed that companys productivity can be measured as three types
on indices:
Partial productivity: Ratios of output to the single input such as capital, labor, material,
land etc.
Multi factor productivity: Ratios of output to more than a single input such as land,
labor, material, capital etc.
Total factor productivity: Ratios of net or gross output to the sum of labor and capital
input.

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,
Page 2

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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:

Operating profit margin


Net profit margin
Return on assets
Return on equity
Return on capital employed
Return on investment
Earnings per share

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.

Page 3

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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.

1.4: Problem Statement


To investigate how measuring different levels of productivity (considering the direct effect) helps
to explain fluctuations in profitability.

1.5: Hypothesis
H1: Increase in partial productivity will increase profitability
H2: Increase in total productivity will increase profitability

1.6: Objectives

To perform a trend analysis of productivity and profitability of sectors under


consideration.

To investigate the direct link of productivity levels with profitability ratios.

Page 4

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

CHAPTER 2: LITERATURE REVIEW


This chapter provides the overview of previous research conducted on different aspects of
profitability ratios and productivity. It explores different articles and case studies that comprise
of main focus of the research and summarize relevant literature.
The application of the concept of productivity is differently in the banking sector because their
output is service. In banking sectors deposits liability lack of skilled employees, banks policy,
absence of accountability and responsibility affects the productivity. These aspects of
productivity affect the profitability of banks. There is a strong correlation between them. (Md.
Jahirul Hoque)
E.Griefell and C.A.K.Lovell, create a link between productivity (partial productivity and total
productivity) and profit through price effect and productivity change effect. Productivity enhance
by introducing technology in organization that effect the profitability. Favorable prices also
contribute in enhancing the profits. The total productivity not only contributes in profits but also
the other factors (i.e. more favorable prices). According to Gold (1970), partial productivity is
not enough to measure the profitability. Partial productivity measure the productivity of single
input. (Lovell E. G.-T.)
According to Eilon,Gold and Soesan (1975), and Issikawa and Sudit (1981) productivity is
directly related with profits. According to Kurosawa (1975) and Eldor and Sudit (1981), there are
three stages of decomposition of profit change. In first stage, the price and quantity affect the
profit. At second stage, the quantity affects the productivity. At third stage, technical change and
operating efficiency affects the productivity. (Lovell E. G.-T.)
According to Elion (1985) the efficiency of resources (inputs) effect the organization
performance but they are largely neglected. (Lovell E. G.-T.)
R.D.Banker, H.H.Chang and S.K.Majumdar studied the change in productivity, profitability and
price recovery of firms in U.S telecommunication industry. Profitability is measured by two
components productivity and price recovery. (R. D. Banker)

Page 5

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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)

Page 6

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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:

Structure conduct performance (SCP)


Market based view (MBV)
Strategy- structure performance (SSP)
Organization environment structure performance (OESP) (Schoemaker, 1993)

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
Page 7

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

component of performance improvement. A.E.Oluleye and K.A.Olajire examined the


performance of two media companies in comparison, they evaluated that privately owned
companies in developing countries, achieved productivity through continuous improvement
while the government owned faced decline in productivity in same period. The differences in
both organizations were of quality, capacity utilization, technology and pricing regimes. (Olajire,
2001)
According to Liang-Hsuan Chen, Shu-Yi Liaw and Yeong Shin Chen generally a business with
higher productivity is considered more profitable in Taiwan. They performed the F test to relate
the financial ratios (return on total Asset, total asset turn over, inventory turnover earning per
share) with productivity. The results showed that the labor costs are increasing where as there is
shortage of resources in the environment of global competition. So the companies have to reduce
their production cost and increase their efficiency. (Liang-Hsuan Chen, 2001)
Kendrick and Creamer (1965) presented total productivity index, capital labor productivity index
and partial productivity and a model of total factor productivity was presented by Taylor and
Davis in 1977. (Liang-Hsuan Chen, 2001)
For a firm, productivity is the major attribute to achieve cost and quality advantage on its
competitor. According to Misterek et al (1992), improvement in productivity can be described
into five relationships, increase in output for the same level of input, increase in output and
decrease in input, decrease in input for the same level of output, increase in output at the faster
rate than the input and decrease in input at the faster rate than the output. According to Miller
(1984) productivity is long term measure to monitor production excellence whereas profitability
is short term measure and it is more suitable rather than profitability. According to Tangen
(2002), it is not necessary that increase in productivity lead to increase in profitability in short
term but increase in productivity leads toward long term profitability. (Tangen, January 2005)
According to Miller (1984), the profitability could be differing from productivity through price
recovery. According to Miller (1984), Wolf (1990) and Edgren (1996), it can be defined as
Profitability = Productivity+ price recovery. (Tangen, January 2005)
Ownership effects on the productivity and profitability in the SOEs as well as capital structure
and welfare burdens have a significant effect on the financial performance. Firms ability can
measured with accounting ratios such as ROA and they are used for calculations of treatment of
inventories, long term investments, depreciations and tax treatments. Soft loan has significant
Page 8

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

effect on profitability and productivity. According to Chinese economists, technical efficiency


improvement is measured by total factor productivity. (Anming ZHANG, 2002)
Naveeda Salam investigated the total factor productivity and profitability of manufacturing
sector in Pakistan. Three sources of gains in total factor productivity that have been identified
are: increases in total factor productivity occur due to technological improvements,
improvements in X-efficiency due to changes in production methods and adjustment of resources
from the less productive to the more productive producers. (Salam, 2004)
According to (Sink and Tuttle 1989), there are seven performance criteria such as productivity,
profitability, quality of work life, innovation, quality, effectiveness and efficiency which an
organizations need to measure, analyze and evaluate. MCP/MT is a performance measurement
technique used at the functional and organizational level. This technique is based on mutiattributes decisions. (Singhtaun, 2005)
In Bangkok Thailand, Kongkiti Phusavat and Watcharapon Photaranon (2006) integrate the
productivity with financial performance in term of profitability at operational level. According to
Sink and Tuttle (1989) productivity is one of the criteria of performance. According to Harper
(1984), it is important for an organization to focus on continuous productivity to maintain its
growth rate. (Photaranon, September 2006)
According to Sumanth (1985) and Hoehn (2003), companies become more productive to follow
cost competitiveness and long term profitability. According to Sink (1985) productivity is a
relationship between outputs including goods and services and inputs that are used to produce
these outputs. Inputs include capital, labor, energy, material and data. According to Sink (1985)
the multi factor productivity was developed by American productivity center in 1977 to measure
productivity and price recovery and to relate their results with profitability. (Photaranon,
September 2006)
By using APC model (use of Excel), Mohan P.Raocreatea link between productivity, price
recovery and profitability of the organization. According to APC model the productivity and
profitability can be tracked through multi factor productivity. He examine that price recovery is a
result of inflationary effect on the inputs and outputs. Negative price recovery shows that there is
a greater effect of inflation on resources and price/cost of goods sold are not recovered. (Rao M.
P., 2006)

Page 9

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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

Page 10

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

production efficiency in Sugar Firms of Pakistan. Pakistan economic growth cannot be


sustainable without improvement in the total factor productivity. (ABDUL RAHEMAN, 2009)
According to Masayuki Morikawa, the existence of labor unions has statistically and
economically positive effect on the organizations productivity. Strong coordination between
management and labors can enhance the productivity and profitability. In 2007, business
government-academia forum was established for labors in which Japanese provide education and
training to their employees to upgrade their human capital. According to Brown and Medoff
(1978), labor unions have positive impact on productivity of the organization and argue that,
unions can increase the productivity by improving coordination between labor and management.
On the other hand, unions may decline productivity by destroying market through their
monopoly powers. (Morikawa, 2010)
Maria Teresa Bosch-Badia links the productivity (total factor productivity and Labor
productivity/partial productivity) with profitability by using the data of financial statements of
companies. There is a functional relationship between return on operating Asset, labor
productivity and total factor productivity. The return of operating asset is used as a variable that
depend on productivity ratios. (Bosch-Badia, 2010)
Productivity measures try to motivate improvement of material resources and assess attempts to
produce more with less input while maintaining quality. In the short term may increase
production profits when prices rise faster than input costs rise. (Meyer, 1980) The market forces
in the long run, however, the competition prevent a firm step increased the specific expenses of
the company, or country-specific customer. Arises only sustainable competitive advantage
through higher than the competition or offering products and services that their competitors
cannot match professional productivity. (Rajiv Banker) (Kumar, 2011)
Company should have to improve its quality and follow standards at timely basis (JIT) to
increase productivity. JIT helps Company to manage its inventory and utilize labor potential
properly. Provide material and resources to the labor according to need of the targets and receive
maximum inputs from them increase the productivity. Through inventory management company
can minimize its product wastages; as a result it increases productivity. Regular base innovation
improves company financial performance. Company can takes adequate results through
operational innovation. (Beate Klingenberg a, 2012)
Page 11

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

Training of human resources is affected on organizations activities and accelerates with


efficiency continuously. Training must be scientific and practical. Education is most important
part in productivity and profitability in the organization. In the past, organizations give training
to their employees according to their job and teach how do work productively but there is no
place for scientific research and education. Productivity can enhance through practical training
and scientific, when productivity increase then profitability automatically can be achieved.
(Morteza khan, 2012)
Return on equity is statistical significant variable in Sri Lanka. The efficiency and productivity is
measured by operating expenses ratios, personal productivity ratios and cost per borrower.
Financial structure is measured through debt/equity ratio whereas profitability is evaluated by
return on equity ratios under this research. (Dissanayake, 2012)
A research has been conducted in Pakistan to measure the performance of manufacturing
companies by using the financial ratios (total assets, sales, Expenses, Profit before tax and return
on Asset). The results show that total assets, sales, profit before taxes are correlated and they give
the indication of economies of scale. Financial ratios are tools to gauge the performance of
companies by using their financial statements but its drawback is that they are not enough to
analyze the companies performance. Performance of a firm is directly correlated with its
efficiency; achieving higher/desired output by using minimum input is considered to be as higher
performance. (Tahir, 2012)
A research is conducted to identify the prevalent situation of productivity in Pakistan of
automotive industry. He enlightens the importance of productivity in todays era, its impacts on
our lives and discussed the flaws of productivity in automotive industry by pointing out some
issues and factors that are neglected and in the end by neglecting those resources, there is a
negative impact. Total Productivity was measured by Sumanth (1994), all partial productivities
and Total Factor Productivity (TFP) using Cobb-Douglas production function. Data contained
the number of employees, wages of these employees, total man-hours consumed, fixed capital
input, working capital input, cost of materials used, cost of energy utilized, cost of all other
expenses including taxes, traveling expenses, and all other overheads. The outputs both in
quantity and in value terms were also taken. Then productivity analyses of the firms were carried
out. (Sheikh Zahoor Sarwar, 2012)

Page 12

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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

Page 13

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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.

3.1: Data collection


The secondary data from financial statements is collected to compute:

Total productivity
Partial productivity
Gross profit margin
Operating profit margin
Net profit margin
Return on capital employed (ROCE)
Return on assets (ROA)

The companies selected for sampling are:


1. Pakistan State Oil (PSO)
2. Pakistan Petroleum Limited
3. Murree Brewery Company Limited
4. Mitchells Foods Limited
5. Byco Petroleum Pakistan Limited
6. Mari Petroleum Company Limited
7. Attock Refinery Limited
8. National Refinery Limited
9. JDW Sugar Mills Limited
10. National Foods Limited

Page 14

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

3.2: Test for analysis


The methods or tests selected for analysis are:
Correlation
Regression
Trend analysis
50 observations are taken from the selected companies for trend analysis, five years data from
each company and 36 observations are taken for regression analysis and 60 observations for
correlation.
3.2.1: Correlation
Correlation is one of the most common, important and useful statistical tool for analyzing the
variables. It is basically a statistical measure to compute that how two or more variables move in
relation to each other. The range of correlation is from +1 to -1 and symbol of correlation is r.
A zero correlation shows that there is no relationship between the variables. A correlation of 1
shows a perfect negative correlation, meaning that increase in one variable causes a decrease in
the other one and there is an inverse relationship between the two selected variables. A
correlation of +1 shows a perfect positive correlation, meaning that both variables move in the
same direction of each other that if there is an increase in one variable then the other variable
also increases and there is a direct relationship between the two selected variables.

3.2.1.1: Types of correlation


Correlation is broadly classified into following types:
I.
II.
III.
IV.
V.

Positive correlation
Negative correlation
Zero correlation
Linear correlation
Non linear correlation

I: Positive correlation

Page 15

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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.

3.2.2.1 Types of regression


There are several types of regression but two basic types of regression are:
I: Linear regression
II: Multiple regression
I: Linear regression
Linear regression uses a single independent variable to predict the outcome of dependent
variable.
II: Multiple regression
Page 16

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

Multiple regressions use two or more than two independent variable to predict the outcome of
dependent variable.

3.2.3 Trend analysis


Trend analysis is a tool to explain the financial information that what has happened in the past
year to predict the situation for the next year.

3.3: Sectors for analysis


Two sectors that are taken for the work are as follows:

3.3.1: Oil and gas sector


Oil and gas, is identified as the engine of the economy, it is expected that the exceptional growth
of investment activity in the country, to continue to promote the sector. This sector is also
considered as a sensitive sector, In order to attract domestic and foreign investors government
have to provide favorable conditions for oil and gas. As a result of the financial restructuring of
them in this area has become one of the most attractive areas of the economy.
Pakistan economy is strongly linked with oil and gas which means that fluctuations in these
prices affects others also. When oil prices starts getting to increase in international market,
domestic market also get effected and as a result prices of different commodities also moves
lively. Oil and Gas Regulation Authority which is quietly known as OGRA, controls the
competition in oil sector and provides a channel for foreign and local investor in participate in
this sector. Natural Gas Regulation Authority (NAGS) monitored the demand and supply of
natural gas which works under OGRA which works for best interest of the consumers. If these
authorizes fails to perform their duties it can be a major setback or blow for general public.
Therefore in order to ensure a healthy
Competition and with a view to protect the interest of consumers, these regulatory authority must
perform persistently and efficiently the duties which are assigned to them.
In Pakistan, demand of oil and gas is higher than supply which meets 18% of just domestic
needs. Shortfall in oil and gas starts making ghastly effects in industry of Pakistan specially

Page 17

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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

Page 18

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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:

Accelerating demand of food worldwide.


It is among top 10 KSE sectors.
The fastest growing sector of Pakistan.
Facing challenges in todays life due to increase in population.

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:

Pakistan food industry in deficient in food quality.


Increasing demand due to increase in population and changing needs of consumers.
Poor literacy levels, financial support and technical choices.

3.3: Variables for analysis:


A variable can be any characteristic, amount, figure or quantity that increases or decreases over
time, or takes different values in different situations.

Two basic types are:


Independent variable: Any quantity that can take different values and can cause
corresponding or relating changes in other variables.
Dependent variable: Any quantity that can take different values only in response to an
independent variable.

Page 19

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

3.3.1: Independent Variables


In our research, Independent Variable is productivity and we have taken its further types in
research like Total productivity, Capital productivity, Labor productivity and Energy
productivity.
3.3.1.1: Total productivity
We acquire all inputs (all expenses) and divide it by output and then total productivity is
achieved. Represents all quantifiable output and input factors through total productivity and top
management obtain tremendous benefits to control profit by using total productivity.
(Prokopenko)
Total productivity = Total output/ Total input (Prokopenko)
We include all expenses like Administrative expense, Cost of goods sold, operating expenses,
Finance cost, taxation, fixed expenditure and distribution cost in form of input and net sales in
form of output from financial reports.
3.3.1.2: Partial Productivity
In partial productivity, productivity is measured through individual input and divides it by
output. Data can easily be obtained and measured in wide industry by partial productivity.
(Prokopenko) So, we have chosen further following measures for partial productivity. It includes
Capital productivity, labor productivity and energy productivity.
Partial Productivity = Output / Signal input (Prokopenko)
3.3.1.3: Capital Productivity
Productivity is measured by using Capital. Capital is based upon share holders equity, which are
obtained from the balance sheet of financial statements. More the share holders wealth more
will be the investment that would help us in purchasing new machinery and also in
implementation of new technology. The use of new and innovative technology will enhance
efficiency of machinery and productivity. Unit cost and time consumption will also decline due
to updated technology. Sales of companys products will increase and more revenue will be
generated accelerating the profitability.
Page 20

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

Capital Productivity = Total output/Capital (Prokopenko)


3.3.1.4: Labor Productivity
Labor productivity is measured in both business and the economy of a country. Labor
productivity means how much an output is given by a labor in a particular span of time or in
specific time duration. In other words, we say that Labor productivity measures the amount of
goods and services produced by labor in one hour. Labors productivity is most important factor
for any industry because it enhances companys revenue and profit. Provide facilities and give
incentives to labor according to their rank then workers also shows their commitment to the
company, which can improve worker morale and lead to increase in overall productivity and
efficiency. (Lister) When productivity will enhance then profitability will automatically increase.
We have used salaries and wages of those labors which are involved in CGS (cost of goods sold).
Labor productivity = Total output/ Labor (Prokopenko)
3.3.1.5: Energy Productivity
Companys systems are optimization because of its will to shrink the amount of energy
consumed per unit of output in an industrial process or building operations. When energy
consumed decrease at per unit then direct cost of energy per unit will also decline. ( SYSTEMS
OPTIMISATION to Improve Energy Productivity , 2013) There is maximum utilization of
energy resources by any company during production process such as fuel and power, gas, water,
electricity and oil. When companies will use these resources efficiently then their productivity
and profitability will also enhance. In financial statement, we have taken the amounts of fuel and
power and oil from the notes of CGS.
Energy productivity = Total output/energy (Prokopenko)

3.3.2: Dependent variables

Page 21

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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

Page 22

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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.
Page 23

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

3.3.2.4: Return on Capital Employed (ROCE)


Return on Capital employed measures the profit on capital that is used to generate the operating
profits/EBIT. In other words, ROCE calculates how much profit is earned on the money that is
invested on the stock/inventory, plants, machinery and equipment etc. The more/higher the rate
of capital employed, the more/higher a company will have a capability to have an
increment/growth in its profits (financial condition) and the profits growth will attract the
investors. (Fundamental Focus, 2012)
Return on Capital Employed = (EBIT or Operating Profit/ Capital Employed)*100
Capital Employed = Total Asset - Current Liabilities
To calculate ROCE, the operating earnings are used rather than net profit. It ignores the interest
and tax because they can vary from company to company. In other words, it represents the
relationship between profits from operation and cost/ investment on assets to generate those
profits. It is beneficial for the evaluation of capital intensive companies. (Fundamental Focus,
2012)
Capital employed is calculated by subtracting the current liabilities from total asset. In other
word, ROCE focuses on equity as well as the asset that are financed by debt. A higher ROCE is
preferable because it shows that company is using its employed capital very efficiently and
generating higher operating profits from them. To be Productive it has to become efficient in
term of using its capital employed through its maximum utilization as well as to become efficient
in running operations. (Fundamental Focus, 2012)
3.3.2.5: Return on Asset
It indicated how efficiently and effectively a management of company uses its assets to generate
the profits. In other words, it defines a relationship between net profits a company generates and
total asset that are used to generate them. So, more return on asset will be beneficial and
preferable. (Zions Bank) (J.Gitman, 2008)
ROA = (Net Profit/Total Asset)*100

Page 24

Productivity and Profitability Establishing a Direct link An inter-Sector Analysis

Introduction

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.

Page 25