Synchronous Management Principle 8: The Marginal Value of a Sales Order in a Non-Constrained Market | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to the value of a sales order. We hope you enjoy the information presented!
Speaker 1: (00:07)
In today’s session, we’re going to continue on the concept of synchronous management. Today’s session is on principle number eight, the marginal value of a sales order in a non-constrained market. So what is that marginal value worth? So we’ll dig into this concept a little bit deeper.
Speaker 1: (00:23)
First of all, let’s review what is throughput rate. So throughput rate is the rate which the organization generates value added through sales. It’s not by putting stuff in the inventory, it’s getting it out the door and in sales. So if we have a non-constrained market, that means the constraint is either internal to the organization or in the supply, upstream from the organization. When we look at throughput then, we’re looking at the value added, which is the selling price that the item sells for minus the totally variable costs. Those totally variable costs are not insignificant organizational costs that increase as a result of producing an additional unit. So typically what I see is of course material costs, if you outsource work to an outside vendor, that’s outsourced process, if we pay a sales commission to the sales team for the sales, and if we have freight that is paid by the organization. So those are the four things that I see as totally variable costs. We take the selling price, we minus those costs and that’s our value added.
Speaker 1: (01:32)
Now when we look at incremental sales, if we don’t have a market constraint, that means we have more sales that we can produce through the organization. In that case by definition, the constraint is internal or upstream like we said, and understanding the mix of orders that the organization chooses to accept will determine its success. So what we mean by that is bringing additional sales when we have an internal constraint isn’t going to add value to the organization, it’s just going to backlog more, it’s gonna push out lead times, in some cases make the performance and the effect for the customer actually worse. If we get longer lead times, we’re going to lose business because of that. If we can’t deliver on time, we’re going to lose business to that, and our customers will go someplace else. We want to be careful about what sales we take when we have an internal constraint.
Speaker 1: (02:29)
So let’s look at that a little bit deeper. So again, the throughput rate is determined by the capacity constrained resource. If we have a value stream, we have multiple streams, there could be multiple constraints if there’s no dependencies between the value streams, very rarely do I see that, but what we have is typically one internal constraint. So each order that’s processed by that constraint has a different throughput rate. So we look at the throughput rate of those items going through that resource, and then we look at the flow rate that those items can be produced. So if we understand the flow rate and the throughput value, now we can calculate the impact on the organization because the capacity constraint resource determines the output of the system.
Speaker 1: (03:15)
To go a little bit deeper, orders that don’t flow through this resource are considered free products. So what does free product mean? It utilizes our protective capacity of other resources to create additional throughput without any additional expense. We could look at each order and understand does that order go through our capacity constraint resource or our internal constraint or not? If it doesn’t go through that, we consider it free product, and we can use our protective capacity.
Speaker 1: (03:44)
So by managing the mix by the throughput and flow rate can have significant impact on the organization’s financial performance. So we understand what orders we accept, what we want to accept is ones that have high throughput and high flow rate. That’s the biggest impact and then we can rank order all the different products that we make and understand which ones are the best for us, which ones aren’t, and so if we have a choice of which orders to produce, we want to produce those ones that have high throughput value and high flow rate and of course there’s some strategy behind that because if there’s a new customer that we’re bringing on that could be potential high throughput numbers, we might want to accept orders at a lower throughput to gain that customer’s business and build their confidence as a supplier for them.
Speaker 1: (04:34)
So also understanding our protective capacity and how to best manage it also could have significant impacts. If we understand those free products and we understand how much protective capacity those free products take, of course we don’t want to take too much where the constraint shifts internally, that can cause problems for the organization and really put the system into chaos.
Speaker 1: (04:56)
So that’s our session for today. Our next session next week is going to be on the utilization of non-bottleneck resources and that utilization is controlled by the constraints of the system. We’ll dive deeper into that next week.