How Important Is the “Service Sector Effect” on Productivity?

In the cost-driven U.S. service economy, are worker benefits being sacrificed in the name of lower-cost services to customers? Are these social costs more than offset by the benefits of job creation, the consumption stimulus that spurs job creation, and lower unemployment?
by James Heskett

Summing Up

Do increases in social sector productivity, which seem to prevail at least in the U.S., benefit consumers at the expense of workers? Or is the scale weighted in favor of the latter who may benefit two ways, in terms of both an income stream from increased employment and lower costs? Respondents to this month's column appeared to be about equally divided on these issues.

John Inman commented, "I sometimes feel that we are racing to the bottom to provide products and services at ever lower pricing without considering the true costs. . . . We need to start to question our motives, our paradigms, and what we are willing to accept and ignore to get what we think that we need." C. J. Cullinane was concerned that "This trend (service sector relative growth) will indeed catch up with the United States in the form of fewer medical and retirement benefits as well as lower paying jobs . . . one look at the American auto industry gives us a glimpse into the future economy." As Daniel Hayes put it: "I see a shakeout coming among low-cost service providers unless they find ways to provide value to both customers and employees. There's no reason that both sides can't win, with better service and more satisfied employees."

On the other hand, E. Hassen cautioned, that "Before criticizing, we should examine carefully the social sector effects of wage deflation and higher productivity. In all ecologies things are not simple." Kamal Gupta commented, "There is no way to grow other than [to] keep on increasing productivity."

Hoshang Jhaveri sought to explain why the growth in service sector productivity has been so remarkable: "Workers in the service sector are better exposed to their customers than the ones in classic manufacturing. . . . To that extent service sector workers are persuaded, by their own concern for self-respect and appreciation, to perform optimally."

Several trends are clear. As economies develop, they generate proportionately more jobs in services than in manufacturing, farming, or other extractive industries. In the U.S., for example, fewer than 20 percent of all jobs are in non-services. Other developed economies are approaching this. This raises several questions. For example, just what is the optimal amount of service sector activity in an economy that meets consumer needs while contributing optimally to overall economic health? Has the U.S. gone too far? What obligations does this create for increasing service sector productivity? Do manufacturing-based economies have some kind of inherent advantage over service-based economies? If so, just what is it? Or does an increasing emphasis on services naturally accompany the growth of a knowledge society, representing an insurance policy for the continuance of innovation and progress necessary to maintain world economic leadership? What do you think?

Original Article

One can make the argument that a small group of organizations like the Vanguard Group, Southwest Airlines, and Wal-Mart (in the U.S.) have had a profound impact on the way we live and work. They share several things in common: (1) a penchant for driving down costs in their respective industries, (2) a focus on serving customers, and (3) policies and competencies that have literally changed the rules of the game for their respective industries worldwide.

In spite of recent adverse publicity regarding Wal-Mart's personnel practices, all of these organizations have made their places of work so attractive that their employees may work harder over longer hours than they otherwise might. Whether this leads to a higher standard of living than that of their European counterparts is debatable. But there is growing evidence that providing pleasant work environments, aided to some degree by new technology, has spearheaded the continued high rate of improvement in productivity in the U.S. in recent years. In fact, a recent report by the McKinsey Global Institute has found that five of the top seven industries that have led productivity growth in the period of 2000 to 2003 are service industries like retailing and financial services.

Increasing productivity in the service sector has been accompanied by increasing employment, a phenomenon somewhat at odds with experience in the glory days of manufacturing. Thanks in part to new technology, service sector workers work smarter. But they are working just as many hours as before. Perhaps lower-paying jobs force people to work more hours to sustain a certain lifestyle. But it may also be that more customers (including workers who need more services if they are to maintain their "work style") want and are able to afford the services these workers deliver. Whatever it is, Americans continue to work long hours at a time when people in some other countries increasingly stand by watching them do it.

James Surowiecki, in a piece last year in The New Yorker, argued that the more that Americans work, the more they spend. And the more they spend, the more jobs they create. This perhaps explains the painful difference in unemployment rates in Europe and the U.S., providing at least one explanation for the recent riots in France.

According to Daniel Gross, one of the important factors contributing to the development of cost-driven, productive service firms in the U.S. is thought to be a system of laws and regulations that provide more latitude to large organizations in their dealings with employees, customers, suppliers, and competitors. In recent years, questions have been raised about whether those laws and regulations should be tightened to prevent certain practices, particularly concerning the accounting and payment for work and failure to provide healthcare. All of this raises a number of questions.

In the cost-driven U.S. service economy, are benefits to workers being sacrificed in the name of lower-cost services to customers? Is there a significant cost in terms of quality of life or social costs that have to be shared by everyone? Or are the social costs more than offset by the beneficial creation of jobs, the stimulation of consumption that leads to more job creation, and lower unemployment? Should we believe, praise, or criticize the social sector effect? How important is it? What do you think?

    • Kurt Cooper
    • Accounting Officer, Pima County (Arizona) Natural Resources, Parks and Recreation

    A cost-driven economy does sacrifice workers' benefits in the name of lower services to consumers. There is a significant cost in terms of quality of life which should be borne by everyone. Here's how and why.

    If one researches the publications of the Federal Reserve of Boston, Chicago, etc. their research clearly shows that cities with a higher quality of life bring in the businesses which stimulate the economy. The question is: when your city or county has a lower quality of life and few prospects for bringing in large businesses, what can one do?

    The answer is to upgrade the quality of the service sector. From higher wages to better parks, to increased quality of education and roads, ergo, apply classic Keynesian economics to the problem.

    The problem is that many businesses do like the low wages and do not really care about how things look as long as they are making money. If one looks carefully, though, one finds that those businesses are not home grown, but are either non-local businesses which have purchased local businesses or businesses which have moved on to take advantage of an unskilled workforce.

    The only thing one can do in this case is to elect officials willing to raise taxes to pay for an increased quality of life. And officials who are willing to be tossed out of office if they do.

    Other than that, one must "vote with one's feet" and leave the poor economy as it is and go to a place with better jobs—assuming that is an option.

    • Sandeep Sreedharan
    • Principal, Nihilent

    Traditionally the service sector is known to be more bureaucratic and less innovative. Innovation in service products and processes would lead to higher efficiency and performance. Management of the service sector has to develop a strategy to communicate the role of innovation within the company and decide how to use technology, processes, and people, and drive performance through the use of performance indicators.

    To drive low cost services, management most often loses its focus on aligning innovations, which in turn leads to longer working hours, attrition, and lack of employee motivation. Incentives and rewards programs should be in sync with the innovation management strategy, capturing employees' "efforts" to achieve them rather than concentrating solely on the numbers.

    • José María Gil V.
    • Energy Management & Manufacturing México

    I consider productivity of the service sector a key factor for workers' well-being all through the value chain.

    The problem is in how we define or measure productivity. The paradox you mentioned in your introductory text, about how improving productivity in manufacturing implies sacrificing job positions meanwhile for service sector represents more job opportunities, may explain the following facts (from my point of view).

    1) Growth in productivity, exclusively in manufacturing or plant capacity delivered to the market, would represent an inventory accumulation and capital cost problem if it is not accompanied by a compensatory effort in the commercial and service sectors in order to communicate a signal to the market of a new reality in the value offered by the firm: shorter lead times, reliability, flexibility in the mix offered, capacity to test and develop new concepts, and so on.

    This lack of equilibrium or synchronization finally forces us to adjust backwards, reducing job positions in the production departments and hurting those who made their best effort or at least did their part towards productivity. What a dilemma and a wrong message to the organization.

    2) The problem then is: What do we understand as productivity? And how and where do we measure such productivity?

    For the manufacturing departments, measuring productivity is very simple because the indicators are very tangible and generated inside the company. Thus the indicators to measure productivity are easily related to cost, so productivity is a cost-driven function. For commercial and service departments, on the other hand, productivity depends mainly on external information, and here is the problem. Generally speaking, people try to measure productivity in the traditional cost-driven way even though it is really an external value-driven function or index even harder to quantify.
    It is the perceived added value (not always measured but indirect or implicitly perceived by the customer or end user) that allows new business opportunities, meaning job positions.

    So the companies whose strategist can (a) gather reliable and opportune external information, (b) measure or infer effectively intangible variables, and (c) introduce such variables in a model to harmonically bind two different equations (cost/value-driven functions), are the ones that will be sustainable over time and have the chance to grow steadily.

    These mismatched equations are the root causes for most of the lay-offs, closure of manufacturing facilities (mainly in developed countries), and change resistance throughout the organization. The wrong message is sent to the labor force through reengineering: "Productivity hurts."

    We need to understand that value is not equal to cost.

    • Andrew Dugdale
    • CEO, ICDL

    In an ever more information-aware society, consumer expectations are set by the response time and service levels of the Internet. Hence, service businesses are always competing to deliver against these new benchmarks. Additionally, many service businesses have a very poor understanding of their customers' needs compared to many Internet sites, primarily due to the greater complexity involved in obtaining the data.

    Finally, whilst consumer expectations go up, the amount they are willing to pay is being driven down, again by expectations set by the Internet. So how can service businesses survive? Segmentation is the only answer, and it is time that organizations recognized that one size does not fit all. As in any customer base, some people want quality, some are just price sensitive, and some sit in between. So, the message to the service industry has to be: Get smarter! Understand the market, identify where you sit, and position yourself accordingly. Mass production models are dead!

    • Margie Parikh
    • Lecturer, BK School of Business Management

    I think the issue is not the working hours and productivity of labor, but the basic value that is added to or destroyed from the final product/service by each component of the entire business model for a given industry.

    One of my clients was describing an IT tie-up between a small firm and a giant. The giant has a contract with another firm for supply of skilled IT professionals for different projects. This human capital provider, in turn, has many other small suppliers.

    Obviously, this chain is proving as costly as $220 per programmer hour to the customer that the tie-up firm charges. The charges are the end result of marking up at each stage, where the programmer actually charges $35 per hour. The client also often bears costs of highly specialized skills via contacting consultants from places like Colorado to New York, $2,000 for weekly flights and hotel bills, and so on.

    How long can the costs be sustained under the current business model even though the professionals are productive?

    I think we need to take industries and, as Jack Welch did, seriously study which are the "value drivers" and how much value they add, and which are the "value Busters" and how much value they destroy. I am sure productivity and social responsibilities are not the only issues.

    • John Inman, EdM., PHR
    • OD and Training Manager

    I sometimes feel that we are racing to the bottom to provide products and services at lower prices without considering the true cost of production and acquisition of products and services. Are we ignoring social, cultural, and ecological costs in doing so? Why are we training managers to focus on profit at all costs? It is no wonder that we have so many managers who focus on cutting costs as a means to profitability.

    And on the topic of unemployment, is low unemployment in and of itself the goal? Are the jobs being created non-family wage jobs? And if so, I ask, "So what?" At what rate are we producing family wage jobs? Look at wealth accumulation and the growing divide between the wealthy and the rest of the workers in the United States. I personally do not feel that it is an attractive picture to have one household needing two, three, or four jobs to keep afloat. And more to the point, I feel that those who have wealth have little if any empathy toward those who do not. The common refrain might be heard through the halls of the senior and "C" levels of corporate America: "If these people would apply themselves, they too could do what we have done." Are we so sure?

    We need to take a strong look at what we are doing and what we are generating as fallout, and start to question our motives, our paradigms, and what we are willing to accept and ignore to get what we think we need. There is more than one path [to wealth] and there may be other paths that create less collateral damage. It all starts with the questioning. I do not have all the answers but I wish I did.

    • E. Hassen
    • NHS

    What are worker benefits? We all strive for health, wealth, and fulfilling leisure.

    Technological developments drive higher quality living: Life in 2006 is in magnitude better than life in 1906, for both the wealthiest and the poorest.

    Paid work supports health, allows for the accumulation of wealth, and is generally a prerequisite for fulfilling leisure. It also promotes social gender equality, reduces the number of children women have, and improves women's health and longevity.

    Higher employment drives consumption, which drives technological development, which improves quality of life.

    Regarding social sector effects, it is to be remembered that for most of us, in our striving for health, wealth, and fulfilling leisure, we do not do the small things that need to be done consistently. It is the complex, cumulative effect of individual actions and omissions that produces individual health, wealth, and fulfilling leisure—not the actions of large corporations.

    Before criticizing, we should examine carefully the social sector effects of wage deflation and higher productivity. In all ecologies things are not simple.

    • Hoshang Jhaveri
    • Consultant, TietoEnator Software Technologies Pvt. Ltd.

    The service sector effect on productivity is substantial and will grow over time.

    Workers in the service sector are better exposed to their customers than the ones in classic manufacturing or "smoke stack" industries. The "products" they deliver are more personal. The individuals who produce and deliver them are also more visible. To that extent service sector workers are persuaded by their own concern for self-respect and appreciation to perform optimally.

    Besides, as more people work in a restricted area and have greater interaction with each other, they develop a healthy respect for each other. This automatically generates a need for playing in teams. To sustain team playing, investments in a happy and comfortable workplace become necessary. Perhaps this is the driving force for service companies to increase social costs of the kind where shared facilities are required.

    Though there's a lot more to say, I will stop here because I am sure someone else has put it more elegantly.

    • Daniel Hays
    • Principal, PRTM Management Consulting

    That there is a drive toward low-cost services in the U.S. is certainly true, but are consumers and businesses really assessing the total cost of the services that they receive? It has been my observation that too many service businesses are competing on low cost and/or fixed price, where they should be working harder to convey the value that they offer. One good example is a well-known wireless company, which has clearly differentiated itself along the dimension of "best coverage," a strong selling point in the wireless phone industry. Not many companies go this route, however, and even Wal-Mart and Southwest are often perceived as "cheap" rather than as "best."

    With this in mind, it strikes me that satisfied workers are not only driven by a good working environment, but also by delivering something that customers truly value. How many of us have had poor experiences with the "lowest cost" home improvement contractors, wishing that we had paid a bit more for fewer headaches and better service? I see a shakeout coming among low-cost service providers unless they find ways to provide value to both customers and employees. There's no reason that both sides can't win, with better service and more satisfied employees.

    • Anonymous

    I think while it's good for large American organizations to deliver lower cost and higher quality services to clients, at the individual level the principle of earn more and spend more may not be the answer to a greater overall standard of living (including non-monetary factors). I think innovation and entrepreneurship, as always, will be the solution to fulfilling job creation in the future. So what we may be seeing is a passing phenomenon since people wanting more from their lives will want more than a monotonous store-clerk job at Wal-Mart! While Wal-Mart may be solving a temporary unemployment problem, it will be interesting to see if it is able to sustainably continue to keep workers in monotonous jobs, as employees start wanting more from their lives!

    • Srinivasan Kannan
    • CEO, UTMOST Group

    A fact of globalization is the proliferation of technology across economies. Developing countries like China and India have been absorbing and converting such knowledge to producing competitively priced products. Such products and industries, in the U.S., consequently look for rationalizing employee-related costs, among others, to remain relevant. At a macro level, if such compromises result in lowering costs and improvement in consumption and job creation, it is a welcome development for the economy. In the short term therefore, rationalization of benefits in such sectors cannot be eliminated. The U.S. has historically grown through constantly raising the "technology barrier." The space program, nanotechnology, and biotechnology—all are areas where it maintains its lead and consequently commands a premium. As the influence of the above industries increases significantly on the economy in the coming years, so will the benefits by way of reduction in "social costs."

    • Kamal Gupta
    • Director, Delta Petro Additives Ltd

    The reason that the U.S. economy has grown, while Europe has been stagnant, is growth of productivity and immigration. There is no way to grow other than increasing productivity. There is no employer large enough to drive down wages.

    In India, some people criticize the infotech companies for "exploiting" their employees and ruining their social lives by making them work night shifts. Yet when these companies seek employees, there are a hundred or more applications for each vacancy.

    Public sector banks in India used to shun automation due to the fear that it would displace employees. All the banks (except for rural banks) are now substantially automated and have grown exponentially, improved productivity, and not created any job losses.

    If the U.S. is to continue as the lead economy, it has to continue increasing productivity. Otherwise, it will join the ranks of Germany, France, the U.K., and other European countries.

    • C. J. Cullinane

    The service sector continues to grow while the manufacturing sector continues to shrink. This trend will indeed catch up with the United States in the form of fewer medical and retirement benefits as well as lower-paying jobs. The ripple effect of lower disposable income and less money available for each person's medical expenses will impact most sectors of the economy.

    Not everybody can be in the service sector. Someone has to plant crops or build products for the economy to keep growing. Less disposable income equals less investing, smaller cars, and possibly more foreclosures on homes bought with larger incomes.

    Eventually there has to be a balancing of the social and financial aspects of lower-paying service jobs, such as government supplied healthcare. Just one look at the American auto industry gives us a glimpse into the future economy.

    • Matthew E. Meek (HBS AMP 68)
    • Manager & President, MEM/MHM, LLC

    In your thought-provoking article, you refer to our getting used to $40-a-barrel oil. What would you think about a sustained price of between $60 and $80 barrel for Brent crude?

    • Daniel Menezes
    • Training coordinator, Saudi Aramco

    The desired end never ends. It's nature. The tendency for humans is to develop goals toward the next milestone, but the factor of individual discipline is also important.

    • Ulysses U. Pardey, MBA
    • Managing Director, Am-Tech, S.A., Panama

    In our business, I think our human resources are a key success factor and employees deserve part of the reward they earn for the company. However, labor laws and regulations do become strong disincentives for company investment to improve productivity when rewards to employees are a legal obligation. I believe there is room for workable agreements between employers and employees about rewards and productivity based upon common sense, fairness, openness, and a willingness from both sides.