Can Production Constraints Actually Result in a Profit?
A Chain is No Stronger Than its Weakest Link. That Goes for Supply Chains Too.
By Dale Rabenek, Principal SCMO2
Maybe I should restate my title—how do I look at the constraints in my manufacturing network to find where we have constrained profit? Maybe we need to go back one step further. When you have multiple products, how do you know which one drives the most profit?
Conventional wisdom would send you to cost accounting for the answer, where profitability is determined by subtracting cost from the per-unit sales price to arrive at a per-unit cash margin. Subtract operating expenses and you arrive at net profit. Simple, right? Yes, but not necessarily the best way to make decisions for your operation.
It’s About ‘Time’
Cost per unit fails as a standard against which to measure the most profitable product. Why? Because an operation’s cash generation is directly tied to how efficiently the most profitable products move through the primary bottleneck resource. And to know that metric, you have to take time into account—the one variable that matters most to manufacturers when it comes to profit-based decision making.
Enter the Theory of Constraints (TOC) developed by Eli Goldratt, which claims that any manageable system has a very small number of constraints that limit it from fully achieving its goals. Using a focusing process to identify these constraints, organizations can restructure the rest of their operations around them. There is always at least one constraint, thus there is always a mechanism to improve the likelihood of success. TOC adopts the common idiom, “A chain is no stronger than its weakest link.” Find the weakest link, and you find the lever to pull that will increase Return on Invested Capital (ROIC.)
As Goldratt notes, cost accounting was a powerful solution to a significant problem when it was invented—to settle the value of a company and its products by calculating the margin per unit at the end of each accounting period. That does no good when we are trying to understand how to generate more profit.
Follow the Constraint
Instead, constraint-based accounting will better serve management of manufacturing organizations that have a significant number of products to identify and capture value from. How? Shift the focus from a “margin per unit” to a “margin per minute” measurement to locate the constraint. Follow the constraint; increase the profit.
Why is this such a game changer? Because at the end of the day, how much cash we are able to generate each minute over the year is the true metric for the business. AND. Any operation’s cash generation is directly tied to how efficiently the most profitable products move through the primary bottleneck resource. While many companies use cost accounting as a tool for identifying which products are most profitable, it can’t do the job as effectively as TOC accounting.
Take a Minute, Literally
Compare the two methods, and TOC clearly speaks for itself. The below figure shows the profitability of two products through traditional cost accounting versus TOC accounting.
Product Y sells for $100 more than Product X, and they both appear to have the same variable cost per unit. Standard costing would suggest that Product Y is more profitable on a per unit basis, with a $300 margin over Product X’s $200 margin.
Rather than look at the cash margin per unit though, TOC accounting looks at units of time as the core metric for driving decisions. Under TOC, Product Y requires twice as much processing time in the company’s facilities as Product X (Y can only process four units per hour compared to X’s eight). Although Product Y generates a higher cash margin per unit, Product X generates a higher return from the assets when expressed as cash per machine hour ($1600 compared to Product Y’s $1200).
If the company can sell more of Product X, it can generate more profit per year compared to Product Y. To get same amount of profit out of Product Y in a year’s time that you could achieve through Product X over the same time period would require 33% more machine time for Product Y, which could be a much costlier decision over the long term.
TOC accounting helps make profit-based decisions easier and clears the way for better asset use, saving operating expenses while driving profit. All it takes is a little investment of your time.
Don’t Destroy Your Profit
Applying TOC to drive ROIC can be simple. Just look at customer and product profitability through a constraint-based lens. The key is knowing what the constraint is for each product and what the margin per minute is that gets produced through that single, constrained unit. With that data in hand, organizations can quickly visualize which products, customers, markets, etc. generate (or destroy!) the most profit in the organization.
Nearly all complex manufacturing enterprises are still in the dark when it comes to optimizing ROIC. When embracing the time-based profit metrics, they will correctly allocate precious production hours from their slow money-makers to the fast money-makers.
What industries most benefit from this approach? Specialty chemicals, metals, pulp and paper, building products, electronic components, packaging and plastics to name a few. What is the thread that ties these industries together? Large SKU volume, complex manufacturing routes and processes, specification-based manufacturing requirements, and very expensive production lines which most products flow through. Leveraging time-based profit metrics will enable companies to deliver investor returns well above their peers.
Wrap Your Head Around This
A study of time-based profitability metrics for a typical complex manufacturer reveals that 20% of production hours consumed making the highest profit-per-hour products generate profit more than EIGHT TIMES faster than the 20% of production hours spent producing the lowest profit-per-hour items.
In other words, complex manufacturers make about 70% of their total margin dollars in just 20% of their production hours. A rather astounding realization, isn’t it?
Graphic credit: San Francisco-based Profit Velocity ebook ‘Hidden Profits’. Visit them online at www.profitvelocity.com
Cash or profit per hour directly drives ROIC. Using time-based profitability metrics, companies can start to evaluate the possibilities of What If:
- If we shift 1% of the product mix from the lower left quadrant to the upper right quadrant, what impact will that have on Economic Spread?
- What actions are needed to realize this shift?
- Are there substitute products that can be leveraged to enable the shift?
- If we can’t change the throughput across our bottleneck unit, can we change other factors that will raise the overall contribution margin?
Gain Immediate Benefits
Scenario-based decisions allow for quicker refinements and more accurate forecasting, which lead to the ultimate goal: increased profitability. Companies can typically capture a sustainable 2–3% increase on ROIC over the next two to three quarters without making a material change to invested capital. They can realize that increase while reducing working capital at the same time. The benefits are there through the Theory of Constraints. Embrace and exploit the constraint and even the most complex manufacturing companies can capture this value.
Have I piqued your curiosity? If so, let’s have a conversation to best determine how SCMO2 can help you develop time-based profitability metrics to capture more cash per period by harnessing your constraints to generate profit.
