All businesses strive for growth. Growth means you can expand your team, pay better wages, and share stronger profits with owners and shareholders. How can businesses achieve growth? One of the most important ways is through higher productivity.

This kind of growth is different from using more resources or capital to hire more people or make more products. It comes from efficiency. Total factor productivity is a way to measure it.

What is total factor productivity?

Total factor productivity (TFP) is an economic concept that describes the portion of a company’s increased output that cannot be explained by increased capital or labor inputs and thus is considered a measure of operational efficiency. TFP is also known as the Solow residual because it was created by Nobel Prize–winning economist Robert Solow. TFP can apply to entire economies or industries.

By way of illustration, let’s use a highly simplified example. Imagine that two fishers, Wanda and Beth, are each given one hour, one fishing rod, and 20 worms. After the hour is complete, Wanda returns with 20 fish and Beth returns with 15. Wanda was able to generate more output with the same amount of input. Compared to Beth, her fishing trip has a higher total factor productivity rate.

What drives increases in total factor productivity in practice? TFP can increase when input returns a disproportionately large increase in output. For example, an increase in TFP often occurs when technological advancements increase production speed or workers gain experience and institutional knowledge. TFP can also be moved by macroeconomic and cultural forces.

Countries such as the United States use total factor productivity to evaluate economic health, and economists use TFP to analyze efficiency across industries.

How to calculate total factor productivity

The most common method for calculating total factor productivity is the Cobb-Douglas production function. This function divides a business’s total output by the weighted geometric average of capital and labor. Usually, the weighted averages used are 0.7 for labor and 0.3 for capital.

You must convert all the variables to the same unit of measurement to use this function. If capital input and total output are measured in dollars, then labor too should be converted to dollars. You can do this by multiplying the total hours employees worked by their average pay rate. The standard version of the function is written like this:

Y = A x K^α x L^β

Here’s what each variable in the above function represents:

Y = total output. This is the total production, in dollars, goods, or another unit, generated by a country or business.

A = total factor productivity. This is the variable you’ll need to solve for.

K = capital input. This is the value of the physical capital used during production.

L = labor input. This is the amount of labor, measured in total working hours, used during production.

α and β account for the output elasticity of capital and labor, respectively. Output elasticity is the percentage by which output changes if the input changes. In other words, if capital investment increases, or if the amount of hours worked (labor) increases, the values set for α and β determine how much output increases in tandem. In a system with perfect competition, α + β = 1.

What factors affect total factor productivity?

It may seem counterintuitive that output can change while input remains the same, but sometimes external factors influence operating efficiency. The following elements can affect TFP:

• Macroeconomics. Global economic shifts can affect the costs of goods and services. If a supply shortage creates a spike in material prices, the economy’s TFP will decrease. It will require more capital input to purchase materials necessary for production.
• Culture. Social and cultural forces can have an impact on labor efficiency. This is especially important for economists comparing total factor productivity internationally. Cultural attitudes toward work and the size of the workforce vary between countries. For example, a showdown in which workers reduce their productivity can lower TFP, while a workforce motivated by the possibility of a technological breakthrough might increase TFP.
• Technology. Technological advancements can increase productivity and decrease required inputs. If a laundromat replaces fully depreciated washing machines with energy-efficient models with a larger capacity, it will reduce the electricity needed to power the machines and increase the amount of clothing that can be washed per hour. The laundromat’s capital expenditure likely remains around the same, but its efficiency increases, thus raising its TFP.

How can small business owners use total factor productivity?

Total factor productivity analysis is used mostly by economists studying the broad economy or large companies doing productivity evaluation. A small business owner wouldn’t need this kind of analysis. However, it’s useful for all business owners to understand how output could change when there’s no change in inputs, such as capital, equipment, and labor. This can help a business owner spot inefficiencies, find growth opportunities, and control costs.