# Understanding Production Efficiency: Definitions and Measurements

## What Is Production Efficiency?

Production efficiency is an economic term describing a level at which an economy or entity can no longer produce additional amounts of a good without lowering the production level of another product. This happens when production is reportedly occurring along a [production possibility frontier (PPF)](https://www.investopedia.com/terms/p/productionpossibilityfrontier.asp).

In practice, production efficiency can be estimated by comparing the output rate to standard output. Analysts and production managers use this concept to identify inefficiencies and bottlenecks in existing processes.

### Key Takeaways

*   Production efficiency is achieved when an economy or organization reaches a point where it cannot produce additional amounts of a good without decreasing the production of another good, indicative of operating on a production possibility frontier (PPF).  
    
*   Analysts often measure production efficiency using a formula: (Output Rate ÷ Standard Output Rate) x 100, which calculates the efficiency percentage of outputs produced concerning expected standards.  
    
*   Economies of scale can enhance production efficiency by reducing per-unit costs as production increases, although this relationship can be undermined by diseconomies of scale as operations become too large and complex.  
    
*   Market competition is a key driver of production efficiency by incentivizing firms to innovate and streamline their resource allocation to maintain competitiveness and reduce production costs.  
    

## Key Concepts of Production Efficiency

In economics, the concept of production efficiency centers around the [charting of a production](https://www.investopedia.com/terms/v/value-engineering.asp) possibility frontier. Economists and operational analysts will typically also consider some other financial factors, such as capacity utilization and cost-return efficiency, when studying economic operational efficiency.

Economic production efficiency means using all resources fully to make the most cost-efficient product possible. At maximum efficiency, a business can't produce more units without changing its production process. The company will seek to gain added capacity capabilities by lowering the production of another product.

The Federal Reserve provides a monthly report on industrial production and capacity utilization, which can help understand production efficiency for the manufacturing, mining, electric, and gas utilities sectors. Analysis of production efficiency also involves a close look at costs. Generally, economic production efficiency simultaneously suggests that products within scope are being created at their lowest average total cost. Economies of scale and cost-return measures are also evaluated.

Overall, maximum production efficiency can be difficult to attain. As such, economies and many individual entities aim to find a good balance between the use of resources, the rate of production, and the quality of the goods being produced without necessarily maxing out production at full capacity. Operational managers must keep in mind that when maximum production efficiency has been reached, it is not possible to produce more goods without drastically altering portfolio production.

## Exploring the Production Possibility Frontier

The production possibility frontier is central to the economic concept of production efficiency. Variables are charted on the x- and y-axis to show maximum production levels. Maximum economic production efficiency, therefore, includes all of the points along the production possibility frontier curve. Excel and other similar software make charting the curve easier.

The PPF curve shows the maximum production level for each good.  If producing more of one good means making less of another, maximum production is reached.

> **Fast Fact**
>
> PFF curves aren't always two-dimensional; as we'll discuss in the next section, consider how companies can have dozens if not hundreds of products to manufacture.

## Illustrative Example of the Production Possibility Frontier

Imagine a company faced with the decision to produce either guns or butter. The PPF represents the maximum output combinations of two goods that can be produced given fixed resources and technology. In this scenario, the company can produce 100 guns, 100 units of butter, or any combination along the PPF where resources are allocated efficiently. See the graph below for the graphical example.

Initially, if the company produces 100 guns, it utilizes all available resources for gun production, maximizing output in this sector. Conversely, if it produces 100 units of butter, resources are allocated solely to butter production. These points on the PPF illustrate the efficient use of resources dedicated entirely to either guns or butter.

However, the company can also produce points such as 80 guns and 60 units of butter. This allocation shows a trade-off between guns and butter production. To achieve this combination, resources are shifted from gun production to butter production, demonstrating the opportunity cost of producing fewer guns to produce more butter. As long a the company manufactures along the PFF line, any combination of goods is considered efficient.

This fictitious (and somewhat silly) example is helpful to understand how more complex, intricate companies must decide between trade-offs. Consider international firms like Apple which must allocate resources between iPhones, Macbooks, software development, virtual reality, or accessories like AirPods.

## Methods for Measuring Production Efficiency

In addition to operating based on a PPF, analysis of production efficiency can also take other forms. Analysts can measure efficiency by dividing output over a standard output rate and multiplying by 100 to get a percentage. This calculation can be used to analyze the efficiency of a single employee, groups of employees, or sections of an economy at large.

The formula looks like this: 

﻿ $\text{Efficiency}=\text{Output Rate}\div\text{Standard Output Rate}\times100$﻿

The standard output rate is a rate of maximum performance or the maximum volume of work produced per unit of time using a standard method. When maximum production efficiency is achieved for any sample under analysis then production efficiency will be at 100%. If an economy is producing efficiently, then it will have a production efficiency of 100%.

## Comparing Productivity and Production Efficiency

Productivity is a measure of output relative to input. It's typically expressed as a ratio of what is produced (goods or services) to the resources used in production (labor hours, materials, or capital). For example, if a factory produces 100 units per hour of labor, its productivity would be 100 units/hour.

Efficiency focuses on how well resources are used in production. It aims to minimize waste and maximize output for given inputs. Efficiency takes into account not just the quantity of output, but also the quality and the optimal use of resources. For example, if a factory can utilize the same resources as above but produce 110 units per hour, it is capitalizing on efficiency.

A process can be productive but not efficient. The most successful operations strive to be both productive and efficient, especially as a company scales. For instance, when a [start-up](https://www.investopedia.com/terms/s/startup.asp) comes to market, its proof-of-concept is based entirely on its ability to produce its goods. As the company grows or encounters capital constraints, this is when the company's efficiency comes into play.

## How Economies of Scale Influence Production Efficiency

Economies of scale refer to the cost advantages that businesses obtain due to their scale of operation, with cost per unit of output generally decreasing as the scale increases. This concept links to production efficiency because it affects how well a company produces goods.

As a firm grows and production increases, it can benefit from economies of scale. It can try bulk purchasing [raw materials](https://www.investopedia.com/terms/r/rawmaterials.asp) at discounted rates, spreading fixed costs over a larger number of units produced, and the ability to use more specialized and efficient machinery. Larger operations can also benefit from learning effects where workers become more skilled and efficient over time.

The relationship between economies of scale and production efficiency is not always linear, though. Increasing scale often boosts efficiency, but at some point, [diseconomies of scale](https://www.investopedia.com/terms/d/diseconomiesofscale.asp) can occur. This means when the operation becomes so large that coordination problems, bureaucratic inefficiencies, or other factors begin to increase costs per unit.

## The Role of Market Competition in Enhancing Production Efficiency

Market competition drives production efficiency. [Competition](https://www.investopedia.com/terms/p/perfectcompetition.asp) creates constant pressure on firms to outperform their rivals. In a competitive market, companies that fail to maintain or improve their efficiency risk losing market share to more efficient competitors or, in extreme cases, being forced out of the market entirely as goods become too expensive or unprofitable to manufacture.

One of the primary ways competition drives efficiency improvements is through innovation. Competitive markets push companies to invest in R&D for new technologies and processes. Consider how Tesla re-designed its assembly line and, according to Assembly Magazine, was able to reduce EV production costs by 50%.

Competition pushes companies to optimize [resources](https://www.investopedia.com/terms/a/allocationalefficiency.asp). Firms are compelled to critically examine their production processes, identifying and eliminating wasteful practices, reducing unnecessary costs, and maximizing the utilization of their assets. For instance, think about Starbucks and its drive for waste reduction. By moving towards reusable personal cups, Starbucks is able to reduce its cost per drink as no disposable cup, lid, or straw would be needed.

## Why Is Production Efficiency Important?

By maximizing output while minimizing costs, companies can enhance their profitability margins. Efficient production also contributes to meeting customer demand faster, maintaining quality standards, and reducing environmental impact.

## How Is Production Efficiency Measured?

Production efficiency is typically measured using various key performance indicators (KPIs) such as overall equipment effectiveness (OEE), labor productivity, cycle time, defect rates, and capacity utilization. It can also be visualized by PFF graphs.

## How Does Lean Manufacturing Contribute to Production Efficiency?

Lean manufacturing principles focus on eliminating waste and optimizing processes to improve efficiency. Techniques such as just-in-time (JIT) production, continuous improvement (Kaizen), and value stream mapping help identify and eliminate non-value-added activities, reduce lead times, and improve overall productivity.

## How Can Supply Chain Management Affect Production Efficiency?

Effective supply chain management plays a role in production efficiency by ensuring the timely availability of raw materials and components, reducing lead times, and optimizing inventory levels. Companies can be more efficient when they have what they need on hand; supply chain management makes sure they have what they need when they need it.

## The Bottom Line

A business is at maximum production efficiency if it cannot increase production of one good without reducing production of another. This means that the current scale of production is at a production possibility frontier.

Businesses can improve their production efficiency by eliminating bottlenecks and building on economies of scale. In the long term, market forces tend to drive production efficiency over time as businesses compete to eliminate unnecessary costs.

> **Article Sources**
>
> 1.  Board of Governors of the Federal Reserve System. "[Industrial Production and Capacity Utilization - G.17](https://www.federalreserve.gov/releases/g17/current/)."
>     
> 2.  Valdosta State University. "[Production Possibilities Frontier](https://www.valdosta.edu/colleges/business/deans-office/documents/senior-exit-exam-modules/economics/production-possibilities-frontier.pdf)." Page 2.
>     
> 3.  Assembly Magazine. "[Tesla Rethinks the Assembly Line](https://www.assemblymag.com/articles/97788-tesla-rethinks-the-assembly-line)."
>     
> 4.  Starbucks. "[Starbucks Innovates, Tests and Learns from Store Partners to Achieve Waste Goals](https://stories.starbucks.com/stories/2022/starbucks-innovates-tests-and-learns-from-store-partners-to-achieve-waste-goals/)."