Throughput Thinking | Operational Excellence Quick Hits
Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to Organizational Performance Part 2: Isolated Margin Decisions . We hope you enjoy the information presented!
Speaker 1: (00:06)
In this week’s session, we’re going to talk about the management decision model and how to make product or service decisions more effectively. In most cases, companies look at products or service in isolation. But we don’t produce products or services in isolation, we produce them together. How do we make decisions more effectively? What I have here is two products, product P and product Q, that are made up of different components, go through different resource steps to produce a product, and have different demands and different selling prices.
Speaker 1: (00:45)
If we take this model and we look at each product in isolation, such as calculating profit margin, we can go through and use a cost accounting method for determining margin on each product. If we take product P and do the calculation, product Q and do the calculation, you can see that the margin on product P is only 9.1%, where the margin on product Q is much higher at 40.4. Our preferred product is product Q.
Speaker 1: (01:16)
Now if I take this and I run this through a weekly P and L statement, determine what’s the impact of producing each of these products on the company’s profitability, and since the capacity is limited inside the organization, I can’t produce all of both products. I have to produce the preferred product and then whatever capacity I have remaining, I produce the non-preferred product.
Speaker 1: (01:45)
In this case, when we produce all of Q and the remaining capacity to produce P, I run through my P and L calculate my sales revenue, the materials I need to buy to produce each one, the direct labor that I spend to produce, and I come up with a negative profit at the end of the week. The question is, “Now what do we do to improve the profitability of the organization?”
Speaker 1: (02:13)
To check to see if there’s a different way, what if I switched my mix? What if I switched the mix and said, “Well, I want to produce all of P, which is the lower margin, and less of Q, which is the higher margin. And when I run the P and L statement, what I find is a $300 profit. Just by changing the mix, I can get a different profit margin, but this doesn’t make sense because we produced more of the non-preferred product, the product with the lower margin and got higher profits. How is that possible?
Speaker 1: (02:50)
Part of it is because of our isolated decision-making based on cost accounting methods. Dr. Goldratt developed what is called throughput accounting. He said, “It’s not just the price of the product alone, or the value added of the product alone, you also need to consider the flow rate.” Throughput accounting looks at both the value added and the flow rate.
Speaker 1: (03:14)
If you look at this example, we take the selling price of each product, we back out the material cost of each product, and we can calculate the value added. The value added for P is $45, the value added for Q is $60. But then we need to look at the flow rate. The flow rate, it takes 15 minutes to produce P and 30 minutes to produce Q. That means I can only do four units per hour of P and I can do less of Q of only two. Now if I take the value added to $45 times the four per hour, I get $180 per hour, versus $120 for Q. That explains why we can change the mix and focus on product Q and get much better profitability. If we look at it from a throughput perspective, product P is actually the preferred product.
Speaker 1: (04:12)
Now, what happens if I could take my labor, cross-train them, and expose some hidden capacity, and take that time and dedicate it to producing product Q? I’m going to add additional labor to produce product Q. And in this case, I used the rate twice as slow. Instead of 30 minutes to produce it on one resource, it’s going to take 60 minutes for the cross-trained people. What’s the impact on the product alone? The impact here, you can see the margin goes to 15.9. The product margin goes from 40.4 to 15.9. The profit margin of the product goes down.
Speaker 1: (05:01)
Now, if I look at that from a weekly P and L statement, I’m able to produce all of P, all of Q. When I calculate the profit loss, profit goes up five X. The margin on the product went down, but the profit margin went up five X.
Speaker 1: (05:19)
How is that possible? When the individual product margin is reduced, but profit increases. How can it be? Because we’re better utilizing our resources, that excess capacity, or what we call hidden capacity to make products that we can sell, not to build inventory, excess inventory. And we call that over production. Making product decisions in isolation. Sometimes it works. Sometimes it doesn’t. You need to understand the impact of each of the products on the profit margin of the organization.