Synchronous Management Principle 5: The Marginal Value of Incremental Sales | Operational Excellence Quick Hits

Speaker 1: (00:06)
In today’s session we’re going to continue on the concept of synchronous management and the various principles in synchronous management. Today’s session’s on principle five, which talks about the marginal value of sales in a constrained market and what is that worth to the organization. So we’ve talked about in the past sessions when we have the marginal value of sales from when we have an internal constraint, when we have a constraint upstream in the supply chain and today we’re going to talk about constraint in sales. So what’s that value of the order worth to the organization? From the statement it’s worth the throughput value of that order.

Speaker 1: (00:50)
So if we look at the organization and the constraint is in the market, and we look at incremental sales, so if we’re bringing on additional sales, what is that worth to the company? When we have a constrained market, we need a different mindset when looking at sales from the system perspective. What is the incremental value of sales when the market is constrained? So that’s an interesting question. We can’t use conventional cost accounting methods when we’re deciding to take on incremental sales in a constrained market. Because if you do that calculation, you would never take on work that has less margin or negative margin even because we’re looking at the cost in isolation. We can’t look at the cost in isolation. We need to look at the costs and the effect on the entire system. So what’s that incremental sales worth? What’s the increase in expense? Then what effect does that have on profitability?

Speaker 1: (01:50)
If we look at an organization, and we look at it from the global perspective and we take what the current company is doing in terms of sales. So of course, right now it’s whatever the sales are is what the sales are. So it’s 100%. If we take out the material cost on those sales, in this case, it’s 30% material. Then we calculate our throughput as the sales minus the totally variable cost. In this case, we get 70% throughput. If we take out the operating expense of the current company at 65%, then our net profit becomes 5%.

Speaker 1: (02:23)
The question is if we take on incremental sales and if the market is the constraint by definition, we have internal capacity that we can expose. If we can expose that internal capacity, what impact does that have on net profit? So if we look at the incremental sales in this case, I’m going to say we have an opportunity to take on additional work. That would be an increase in sales for 20%. But instead of being 30% material cost, it’s 50% material cost. So in this case, our material cost is 10%. So 20%, 50% materials, 10% the additional throughput is 10% to the organization.

Speaker 1: (03:06)
Now, if we have the capacity internal which by definition we do if the constraints in the market, then our operating expense doesn’t increase. So what’s the impact of that incremental sales on profit? It triples profit. So it adds 10% net profit, even though it looks like it’s a loser because it has high material content and it might have additional labor. But we need to look at it from a global perspective, not from an isolated perspective of what’s the impact of that product’s margin on the company. It’s not about margin of that product. It’s about the throughput of that product relative to the system perspective.

Speaker 1: (03:49)
So in this case, a 20% increase in incremental sales, even if it appears that, that from a cost perspective has negative margin or lesser throughput can increase profit of the organization. In this case, we’re going to increase it to 15%. So if you add these two together, sales goes to 120, material goes to 40. 120 minus 40 gives us 80% throughput, no change in operating expense. Net profit goes to 15%. So this is sort of mind blowing because everyone thinks that the incremental sales has the same margin as the current product. No it doesn’t because we’re going to leverage our resources differently to take advantage of that extra capacity and leverage that in the market.

Speaker 1: (04:37)
So when we look at improving company profitability, costs don’t change due to taking on more volume if the constraint’s in the market. By definition, we have that extra capacity. Don’t allocate costs to the products, look at the total cost of operating the business and understand the contribution margin of that incremental sales to the business. If we understand the impact of that incremental sales by measuring throughput, then we understand the impact of that incremental sales on the entire system. It’ll totally change your decision making.

Speaker 1: (05:12)
That’s our session for today. Next week we’re going to talk about the marginal value of time on non bottleneck resources and what is that worth to the organization.