Select Committee on Trade and Industry Third Report


13.   The main objective of the Government's industrial policy is to increase the country's prosperity. An important means of achieving this objective is to improve the UK's rate of productivity growth and, specifically, to reduce the productivity gap with other leading industrialised countries. It is important to recognise, however, that levels of prosperity or living standards are not the same as levels of productivity. GDP per head (the usual measure of living standards) is the product of output per hour (labour productivity), average working hours and the employment rate. This explains why France and Germany have higher levels of labour productivity than the UK, but levels of GDP per head are much closer: productivity differences are largely offset by lower employment rates in France and Germany. Similarly, if we consider productivity growth, Germany performed better than the UK in the 1990s, but GDP grew more quickly in the UK because its employment performance was far better than that in Germany. Productivity is of course very important. But we should not forget that in determining living standards so, too, is the level of employment.

14.   The debate about the 'productivity gap' has mainly focussed on the performance of manufacturing. On the basis of output per hour worked, manufacturing productivity in the UK is 55% lower than in the USA and 30% lower than in France and Germany.[16] Total factor productivity in manufacturing, taking into account stocks of physical capital and skills, is also significantly lower than in France (by 10%), Germany (20%) and the USA (43%).[17] And whereas manufacturing productivity in the USA increased by 41% between 1990 and 1999, the gain achieved in the UK was about half of that.[18]

15.   No matter how manufacturing productivity is expressed, the gap between the UK and our international competitors is significant and shows few signs of narrowing. The Government has the objective "to have a faster rise in productivity than its main competitors over the next decade so that it closes the productivity gap".[19] The Government's target is an ambitious one, given that policies aimed at producing sustainable improvements in productivity will need time to take effect. Our international competitors, who already enjoy a productivity advantage over the UK, will also be seeking productivity growth, making UK manufacturing's task all the more difficult. Nevertheless, it is essential that Government, working with industry, provides the necessary stimulus to encourage productivity growth.


16.   Analysis of the manufacturing productivity gap by the National Institute for Economic and Social Research (NIESR) indicates that the key determinants of manufacturing productivity are physical capital intensity, skill levels within the workforce and the effectiveness with which capital, labour and skills are combined, as measured by total factor productivity. During the course of our inquiry, we found a great deal of agreement that, in addition, factors such as innovation and investment in research and development (R&D), the effect of exchange rates on competitiveness and the regulatory burden on industry, particularly on small and medium-sized enterprises (SMEs), will affect UK manufacturing productivity. The Government identified two additional factors, which we will not address in detail in this Report. While we welcome the long-term macro-economic stability to which the Government is committed, we note that the stability achieved over the period 1997-2002 has not been accompanied by an increase in productivity in the manufacturing sector. In fact, the reverse has applied. The Government also told us that increased competitive pressure is associated with improved efficiency and productivity growth. The manufacturing sector has certainly seen increased competitive pressure in recent years, but has not responded with productivity gains.

Capital intensity

17.    A major factor contributing to the productivity gap is the relatively low physical capital stock to augment the productivity of labour. The CBI and others identified this as a particular problem in the UK for decades.[20] NIESR calculated that in 1999, compared with the UK, capital investment per hour worked was 80% higher in France, 34% higher in Germany and 33% higher in the USA.[21] Even though, in the view of academics, the high capital investment in France and Germany is partially attributable to comparatively high labour costs in those countries, the UK has obviously lagged far behind its major competitors in investment in manufacturing. There has been a general downward trend in UK manufacturing investment intensity over the past 25 years, falling from 13% over the period 1975-1980 to 11.5% in the period 1991-97.[22] More recently, investment during the third quarter of 2001 was just less than £4 billion, a fall of 13% compared with the same period in 2000.[23]

18.   The causes of this long-term trend have changed over time. The CBI and others believe that historically the volatility of the macro-economy has played a major part in discouraging long-term investment in the sector.[24] More recently, the macro-economic policies of successive governments have produced a sustained period of relatively low inflation and a more stable economy, but liberalisation of markets and world recession have forced companies to reduce prices in order to remain competitive, leading to smaller profit margins, thus restricting the ability of firms to make funds available for investment. This may have reduced the effectiveness of Government incentives such as 40% capital allowances for investment in plant and machinery by small firms, and reforms in capital gains tax.

19.   The CBI, the TUC, the Industrial Society and EAMA identified the attitude of financial markets in the UK as a major factor in the low investment performance of companies of whatever size in the sector. The Industrial Society pointed out that even for multi-national companies, financial institutions in the UK expect higher rates of return from investment over shorter periods than their counterparts in the USA or elsewhere in the EU. As for support for SMEs, the Society was of the view that "the institutional structure simply does not exist ... it has not existed for 100 years."[25] The CBI and EAMA also drew attention to the difference in the support from capital markets for SMEs in Germany compared with the UK.[26] Even when financial support is forthcoming, it is often at a high cost to the business. EAMA told us that, in addition to interest rates being marginally higher in the UK, British banks often impose extra interest charges, up to 5 per cent in some cases, to compensate for what they see as the increased risk associated with smaller firms.[27] This is not a problem confined to the manufacturing sector, as the Competition Commission's recent review of banking services to SMEs has concluded.[28] But as a result, UK companies find investment more expensive to service than their European or American competitors.

20.   Another difference between patterns of investment in the UK and other countries is the degree to which venture capital is used for manufacturing investment. Less than one per cent of SME finance is derived from venture capital, which again is rather different from the situation in countries like Germany and the USA. But it seems that this disparity may derive as much from the reluctance of small firms to yield equity in their business in return for capital investment as from the preference among venture capitalists for higher-yielding investments with shorter pay-back times than manufacturing can deliver.[29] The Government is trying to encourage the use of such resources through the Regional Venture Capital Funds, which are being established in England as public/private partnerships and administered through the Small Business Service (SBS). The Government expects in this way to make up to £235 million available for small scale venture funding.[30] The success of this initiative will depend not only on whether the SBS can deliver the private sector finance to match public funds available, but also the extent to which SMEs can be persuaded to accept this type of funding.

21.   We will be returning to the problems businesses experience in accessing venture capital during our inquiry into the UK biotechnology industry this Summer.

22.   The long-standing shortfall in capital investment in the manufacturing sector is the main obstacle to improving productivity in the sector. Changes in attitude are required from all parties if this obstacle is to be overcome. Financial institutions need to recognise that manufacturing investment may require a longer term view than other types of investment. Banks in particular should review their lending policies with respect to small firms. And SMEs should be more flexible in their approach to securing investment, and more open to investment using venture capital. The Government has a central role in encouraging such a profound change in culture. In the shorter term, it should consider the extension of its policy to provide more encouragement to investment. We heard a number of calls for tax credits to boost manufacturing investment. We recognise the difficulty of ensuring that such support is properly directed, really encourages productive investment and provides value for money for taxpayers. Nevertheless, we think that the Government should consider introducing some form of tax credit for volume-based investment. It will be necessary, however, to ensure that such an incentive does not subsidise investment that would have been undertaken in any event.

Skill shortages

23.   It is a matter of record that there is a significant gap between UK industry and its major EU competitors in terms of the skills base within the workforce.[31] Nearly all of the witnesses to this inquiry identified the skills shortage within industry as another major obstacle to improving productivity. We found general agreement that the UK workforce falls behind France and Germany in terms of basic literacy and numeracy, and data provided by the DTI showed that the UK has a lower proportion of workers with intermediate skills.[32]

24.   The CBI/TUC Productivity Report to the Treasury found that one in five adults of working age have low levels of literacy and numeracy and that 32% of the UK workforce do not have Level 2 (GCSE) qualifications. Low skilled employees were found to receive less training from their employers than their more highly skilled colleagues. Shortages of skilled employees have hampered growth in manufacturing industry, both locally and nationally, during economic upturns, as well as limiting the potential for switching to high tech industries.

25.   The Government has recognised the need to address the lack of basic skills among school leavers and has announced plans to encourage training for technical and vocational careers, through reform of the school curriculum. The new Local Learning and Skills Councils are intended to work with the Small Business Service, local authorities and other educational service providers to produce post-16 training programmes at a local level. However, a witness from the British Chambers of Commerce expressed doubts as to the degree of flexibility that these Councils would have in practice to respond to the needs of their local industries, given that a very large percentage of their funding was reserved to certain centrally-determined types of training.[33] It is essential that Local Learning and Skills Councils respond effectively to the views of manufacturing businesses to address the skills need of the sector in their area. The Government should review the proportion of funds available to meet specific local needs.

26.   Given that OECD and other studies have shown a positive link between investment in employee training and productivity, we were surprised that many UK firms do not make employee training a higher priority. We were advised that, although the best and most productive companies recognised the benefits of providing training and personal development programmes to their employees, too many regarded it as excessively expensive or too difficult to improve the skills base of their workforce.[34] This was a particular problem for SMEs, which often could not afford to lose key workers for significant periods of time from the workplace.

27.   It is obvious that an efficient and productive organisation matches the skills and qualifications of its staff to their roles within the organisation. In a survey of global productivity, however, Proudfoot Consulting found that among the countries surveyed, UK companies had a particular problem with inappropriately qualified employees in their structure.[35]

28.   Several witnesses argued for some form of Government incentive to help employers provide training for basic and intermediate level skills. The Government has responded by announcing in its Budget Statement financial incentives for employers to make provision for staff training, coupled with an entitlement for lower-skilled workers to training in basic skills.

29.   Improving skills is essential for the future development of manufacturing; yet many employers, particularly SMEs, either do not recognise the need or find it difficult to invest in training for their staff. We welcome the Government's action to give an incentive to employers to provide training for their workforce. We will monitor the effectiveness of the implementation of the Government's policy as it affects the manufacturing sector. At the same time, while recognising the particular difficulties faced by SMEs, we urge employers to play a more active role in encouraging skills development among their workforce. Having a more highly skilled and flexible workforce will be beneficial for all companies in the long term.

30.   The Government's Modern Apprenticeship (MA) Scheme is another welcome initiative which should help address the technical skills deficit in the manufacturing sector. According to the DTI, as at 23 December 2001, 16,800 people were engaged on Engineering Manufacturing Advanced and 4,900 on Foundation MAs.[36] We were perturbed, however, to learn that the industry felt that there was a shortfall of perhaps 10,000 engineering-based modern apprenticeships.[37] Given the importance to the sector of providing an adequate supply of suitably trained new entrants, the Government must take all the steps necessary to ensure that the supply of engineering modern apprenticeships meets demand in the future.

Management Issues

31.   In addition to their reluctance or inability to provide employee training British companies are often loath to adopt new technologies and management strategies which can improve productivity and competitiveness. For example, lean manufacturing systems use a range of management tools to improve productivity by streamlining design and production processes and functions, reducing waste and maximising the efficiency of production and delivery systems. The EEF Productivity Survey has shown that firms which employ lean manufacturing techniques in their business get a significant return in terms of improved company performance. Yet adoption of these techniques by UK companies is very patchy. Only one third of firms in the UK have adopted lean manufacturing across their whole organisation while 40% have not undertaken any lean manufacturing at all.[38]

32.   Compared with their US counterparts, UK manufacturers have also been relatively slow to embrace new workplace initiatives such as output monitoring, performance appraisal, and a range of other techniques to improve communications with employees. Research has shown that the introduction of such initiatives had a significant effect on productivity growth in US manufacturing in the 1990s, and UK companies employing similar techniques have, in the main, found them to be successful in increasing profitability and productivity.[39] Yet, again, a large number of UK companies have been reluctant to embrace them. According to the EEF and others, the most common barrier to adoption of these improvements seems to be opposition to change from management as well as employees. There appears to be a general lack of understanding of the benefits of adopting these practices which reinforces a conservative attitude to change among some managers.

33.   We were told by a number of witnesses that a few hours spent by key personnel in thinking about how processes can be improved can result in very substantial increases in productivity. We urge more companies to invest the comparatively small amount of time, both from management and workforce, to at least examine the potential of well-known techniques. The identification and dissemination of best practice can help to overcome the reluctance of firms to embrace new techniques and thereby make major contributions to the improvement of productivity. We endorse the activities of the sector-specific Forum programmes, such as "Accelerate" and PICME, and the CBI's Fit for the Future Campaign, both of which are Government/Industry joint initiatives and which provide valuable sources of advice, particularly, but not exclusively, to SMEs. Support for such activities should be demand-led. The Government has already committed £20 million but should be prepared to provide extra resources should it be necessary.

34.   The quality of management in UK manufacturing has also been identified as a barrier to improving productivity. A Proudfoot Consulting survey found that inadequate management and insufficient supervision was a major contributor to loss of productivity, indicating that managers were not fulfilling their roles or being allocated enough time to supervise their staff effectively.[40] The National Skills Task Force found that UK managers compared poorly with their international counterparts in terms of their adaptability and entrepreneurial and technical skills.[41] The CBI pointed out that, while the proportion of graduate level employees in UK and German manufacturing industries was roughly the same, the CBI/TUC Productivity Report identified concerns that qualified engineers and scientists may lack managerial skills.[42]

35.   Low quality management may derive at least partially from a poor image of manufacturing as a career. The EEF Productivity Survey showed that nearly 25% of manufacturing companies have difficulties in recruitment and retention of suitable staff, and that these difficulties were undermining company performance. Salary levels and skills shortages were the factors most commonly identified by firms struggling to attract or retain staff, but nearly 20% of firms so affected also identified as a factor poor perception of the manufacturing sector as an employer. This was supported by anecdotal evidence from other witnesses, such as EAMA.[43]

36.   Poor perception of manufacturing is not something that can be changed overnight. Part of the answer lies in Government leadership, and a clear commitment to manufacturing as an important, valuable and — not least in terms of R&D potential — exciting and innovative sector would help. In this context, we welcome the apparent change of heart on the part of Government to recognise the importance of manufacturing industry to the UK. Parallel changes in the way that, for example, the financial institutions regarded investment in manufacturing would help improve the sector's prestige.[44] However, although changes in perception would help manufacturing industry to recruit and retain higher quality managers, on their own they will not provide the managerial skills which the industry needs now in order to avoid falling further behind in the productivity league. Companies need to invest in developing the skills of the key managers involved in production to take advantage of best practice in areas such as lean manufacturing.

Effect of exchange rates on competitiveness

37.   60% of UK manufacturing exports are sold on European markets. The relative strength of sterling compared with European currencies since 1997 has had a significant impact on the cost competitiveness of UK manufacturers, who have found it difficult to compete effectively in EU markets. UK-based manufacturers selling to domestic markets have also faced increased competition from relatively cheap imports, and the comparative weakness of the Euro may have affected the competitive position of UK firms exporting to markets such as the USA.

38.   Such exchange rate instability has been experienced before, notably in the 1980s. In that period, industry's response included an increase in manufacturing productivity which has not been replicated this time. This must be a major cause for concern. One major difference lies in the nature of industry's reaction over the two periods. In the 1980s, many major manufacturers increased competitiveness by reducing their workforces and bearing down on external cost. We have been told that this time around, many companies have been more reluctant to lose their skilled workforce and have chosen to retain market share by accepting minimal or even loss-making margins, as an attempt to ensure that they are properly-skilled and in a position to respond positively to any upturn in demand. However, firms can sustain a strategy of accepting minimal profit margins for only a limited period without seriously affecting their cash flow and compromising their ability to invest for their future development.

39.   For example, Toyota (UK), despite having one of the most productive car manufacturing plants in the EU,[45] identified the strength of sterling against the Euro as the biggest contributory factor in their losses each year since 1998. Exchange rate instability also reduces certainty and hinders forward business planning. Uncertainty over the prospects for the UK's entry into the single European currency, too, has also discouraged forward planning and investment.[46] This is particularly true of the engineering sector, where companies need to plan investments several years ahead of production. However, we found that, although the majority of the organisations we consulted were in favour of UK adoption of the Euro under the right terms, this view was by no means unanimous.[47] The Government's policy on the process of securing entry is clear, but its effect is not to provide industry with the degree of certainty needed.

40.   There is no doubt that the strength of sterling has adversely affected the competitiveness of UK manufacturing in the short term. This will impact upon productivity in the longer term, because many UK firms have chosen to squeeze margins in order to remain competitive, rather than make efficiency savings. The current situation therefore differs from previous periods of exchange rate volatility, which saw industry react by improving productivity.

Innovation and Research and Development (R&D)

41.   We found general agreement that the future success of UK manufacturing lies in the production of high-value-added goods, rather than the production of bulk commodities for which production costs here will almost always be higher than in Asia, for example. Innovation and the application of new technology are central to profitable growth in the value-added end of manufacturing and a successful R&D programme is essential to new product development, more efficient production methods and hence improved productivity.

42.   In this area as well as others, the UK lags behind its international competitors. The DTI's R&D scoreboard shows that average UK R&D intensity, or spend as a proportion of sales, is half the international average (2.1%, compared with 4.2%).[48] It cannot be coincidental that the UK manufacturing sector lies in the bottom half of the EU league which compares the share of manufacturing turnover from new or improved products.[49] Not all sectors fare so badly. For example, R&D intensity in the pharmaceutical sector, one of the UK's most successful sectors on international markets, is substantially higher than the international average (14.8% compared with 12.8%).[50]

43.   The DTI provides direct support for R&D in the form of sector-based research and technology programmes. It offers a range of schemes to raise awareness among firms of technical developments and to encourage industry to develop and take up new technology. The latter, though welcome, were seen by some witnesses as being difficult to access by smaller firms, who told us that take-up of the assistance on offer tends to be restricted to larger companies which already have a well-developed R&D programme. Smaller firms do not appear to have the resources to tap into such support systems, and investment in research and technology remains low compared with their international competitors.

44.   Against this background, the introduction last year by the Government of an R&D tax credit for small firms, with the option for companies not in profit to take a cash payment of £24 for every £100 spent on R&D, was a welcome step; as was the provision of a volume-based tax credit for larger companies which was announced in the 2002 Budget. We hope that these measures will provide sufficient incentive to UK manufacturing to take steps to reduce the R&D investment gap between it and its competitors. In particular, we are concerned that the tax credits should not simply subsidise research by large companies that would have been done anyway. We agree with the recommendation of the Treasury Committee that the effectiveness of the incentives should be closely monitored and reported to Parliament.[51]

45.   We will explore further the link between R&D investment and the exploitation of new technology and high value-added manufacturing during the course of our inquiry into the UK biotechnology industry.[52] We will also look at the effect of Government incentives such as grants, tax and share options to encourage R&D take-up in that industry.

The regulatory burden on business

46.   Many witnesses identified the imposition of new regulations as a significant burden on business in the UK. The DTI's Small Business Service Omnibus Survey identified 'regulation' as one of the most important concerns among SMEs.[53] Concerns were expressed to us not only about the compliance costs associated with new regulation, but the impact of new legislation originating in Europe and the manner in which it is implemented and enforced in this country. These are familiar themes, to which successive governments have been sensitive. Over the years we have seen many initiatives designed to cut down on red tape and bureaucracy, but the perception remains that UK business remains over-regulated, particularly in comparison to some of its EU competitors.

47.   Much of the evidence received on this point was anecdotal, however. The BCC does try to quantify the costs of new regulations to business as a whole, using data from the Government's own regulatory impact assessments, and has estimated that over the period 1997-2002 this may have amounted to £15 billion, with recurrent costs running at an average of about £2.7 billion per annum.[54] Unfortunately in this case, the BCC has been unable to narrow the focus of its survey to cover the manufacturing sector alone.

48.   The general perception of an over-regulated industry does not seem supported by hard evidence. The DTI has pointed out that the UK has the lowest product market regulation of any OECD country,[55] and the UK labour market is less heavily regulated than many other EU countries.[56] Neither is there compelling evidence that the UK transposes and implements EU legislation more vigorously than other EU Member States. Indeed, the European Commission's Internal Market Scoreboard, which summarises the efforts of EU Member States to transpose EU legislation, puts the UK at no more than mid-table.[57]

49.   Government, business and the unions, however, recognise that, while the objectives and implementation of individual regulations may be acknowledged and accepted, the cumulative regulatory burden on business is considerable. The financial and management resources required to ensure compliance can be onerous, and impact disproportionately on SMEs. The Government has sought to address this, in some cases reducing the regulatory requirement for small businesses, and occasionally exempting them altogether.[58] We endorse this approach and recommend that consideration of the scope for further relaxation of the administrative burden imposed by regulatory demands on smaller businesses, or their exemption, be adopted as a routine element of the process of regulatory assessment.

16   Ev 182, Table 1 Back

17   Ev 183, Table 3 Back

18   EEF Catching up with Uncle Sam, ISBN 1-903461-20-0 Back

19   HM Treasury Productivity Report, November 2000 Back

20   For example, Ev 34 (EEF), Ev 85-7 (CBI), Ev 106 and 107-8 (TUC)  Back

21   Ev 106, paragraph 17 Back

22   TUC memorandum: original source The UK Productivity Challenge: CBI/TUC Submission to the Productivity Initiative, TUC and CBI, (2001). Back

23   Ev 181, paragraph 11  Back

24   Q 177 (CBI) Back

25   Q 163 (Industrial Society) Back

26   Q 177 (CBI), Q 256 (EAMA) Back

27   Q 261 Back

28   Competition Commission Report: The supply of banking services by clearing banks to small and medium sized enterprises, Cm 5319 (2002) Back

29   Q 262 (EAMA) Back

30   Ev 187, paragraph 39


31   O'Mahoney, M., and de Boer, W.: NIESR Review No. 179, January 2002  Back

32   DTI Competitiveness Indicators, February 2001 Back

33   Q 146 (Mr J Peel) Back

34   Ev 146  Back

35   Not printed Back

36   Ev 206 Back

37   Q 89 (EEF) Back

38   Ev 35, paragraph 16 Back

39   EEF - Catching up with Uncle Sam, ISBN 1-903461-20-1 Back

40   Not printed Back

41   Ev 183-4, paragraph 20: original source Johnson, S. and Winterton, J., Skills Task force Research Paper 3 (1999); and Bosworth, D., Skills Task Force Research Paper 18 (1999). Back

42   Ev 88, paragraph 5.10: original source "The UK Productivity Challenge: CBI/TUC Submission to the Productivity Initiative" TUC and CBI (2001). Back

43   Ev 146, paragraph 6.1.1 Back

44   See paragraphs 19 to 22. Back

45   Ev 216 Back

46   Qq 70 and 71 (EEF) Back

47   Qq 78 (EEF), 186-7 (CBI)  Back

48   DTI R&D scoreboard, 2001 Back

49   Eurostat Back

50   DTI R&D Scoreboard Back

51   Second report of the Treasury Committee, Session 2001-02, 2002 Budget (HC 780), paragraph 21 Back

52   See the terms of reference set out in our Press Notice No.18 (2002) Back

53   Ev 207 Back

54   Ev 68 Back

55   OECD Economic Outlook (1999) Back

56   Economist Intelligence Unit (2000), as cited in Ev 207 Back

57   The European Commission's Internal Market Scoreboard can be found at Back

58   Ev 207-10 Back

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