What it means
Imagine an economy produces more this year than last year. Was it because more people worked, because factories and equipment expanded, or because everyone became more efficient?
Growth accounting answers that question by assigning a share of the growth to each source. The method starts from a production function, which is a formula linking inputs to output.
Economists measure the growth rate of output, labour and capital, weight the input growth by each input's share of income, and treat whatever is left over as total factor productivity. That leftover captures better technology, management and organisation.
The idea is useful for business because the same split applies to a company. A firm whose sales grew 10% by hiring 10% more staff has not become more efficient, while a firm that achieved the same growth with no extra staff has improved productivity.
Investors often prefer the second kind, because growth driven by productivity is cheaper and more durable. In practice, the labour and capital shares are often around two thirds and one third in many economies, although the right figures depend on the data.
Analysts take growth rates from national statistics or from company reports, then compute the residual. The result is only as good as the measures of capital and labour used.
A key nuance is that the residual is a catch-all, so it also absorbs measurement error and anything not captured in the inputs. It should be read as an indicator of efficiency gains, not as a precise measurement of technology.
The approach also helps with forecasting. If a country expects its workforce to shrink, the only way to keep output growing is through more capital or better productivity.
Planners and investors use that logic to judge whether long-term growth targets are realistic.
In practice
Real-world examples.
Example
A government economist explains that national output grew 3% last year. Hiring and investment explain only part of that, and the remaining share comes from improved productivity. The finance ministry uses the split to judge whether growth is sustainable, and it publishes the result alongside its budget forecasts.
Example
A private equity analyst examines a manufacturing company whose revenue rose 12% in two years. Most of the increase came from a larger workforce and new machinery, while productivity barely changed. She lowers her valuation because growth is costly to maintain, and she asks management what plans exist to raise efficiency.
Example
A retailer introduces a new inventory system and sees sales per employee jump while headcount stays flat. The operations director uses a simple growth accounting split to show the board that most of the growth was productivity. The board approves further investment in technology and asks for the split to be reported each quarter.
Formula
Calculation
Output growth = (labour share x labour growth) + (capital share x capital growth) + productivity growth
So productivity growth = output growth - (labour share x labour growth) - (capital share x capital growth)
Suppose a company's real revenue grew 8%. Its labour hours grew 3% and its capital base grew 6%. Labour accounts for 60% of its cost base and capital for 40%.
Contribution from labour = 0.60 x 3% = 1.8%. Contribution from capital = 0.40 x 6% = 2.4%.
Productivity growth = 8% - 1.8% - 2.4% = 3.8%.
So almost half of the growth, 3.8 out of 8 percentage points, came from efficiency rather than from extra inputs.Case study
Seen in the real world.
Northgate Printing is an illustrative, fictional company whose revenue grew 9% a year for three years. The chief executive celebrated, yet the new finance director was uneasy because margins were flat.
She ran a growth accounting analysis and found that labour and equipment explained nearly all of the growth, leaving little for productivity. The business was growing by adding capacity rather than becoming more efficient.
The company introduced automation on its slowest production line and tracked the residual each quarter. In this fictional story, margins began to improve once productivity became a larger part of the growth, and the chief executive began quoting the productivity figure in investor updates.
Watch out
Common mistakes.
- Treating the residual as a pure measure of technology, when it also contains measurement error and anything else not captured by the inputs.
- Using inconsistent time periods or units for output, labour and capital, which distorts the split.
- Assuming that higher growth is always better, without asking how much of it came from simply adding inputs.
Questions
People also ask.
What is the Solow residual?
It is the part of output growth that cannot be explained by growth in labour and capital, and it is commonly used as a measure of productivity change.
Can a business use growth accounting?
Yes, by treating revenue as output and using staff hours and invested capital as the inputs.
Why do the labour and capital weights matter?
Because they decide how much of the growth in each input is credited to output, so inaccurate weights shift the size of the residual.
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