PART 3: Products Do NOT Have Costs or Profits!
Being Theory of Constraints consultants, we have worked with companies around the globe and the constraint is always the same. It’s how we think. In particular, it’s how the business owner or leader of the company thinks.
You buy the same equipment as your competitors. You hire from the same labor pool. The only difference is how you think. Unfortunately, you and your competitors also think the same way. So you are left to compete in a market where, from your customers’ perspective, you’re all the same. So they make decisions mostly based on price.
Let me explain some of the common ways our thinking goes wrong and the negative effect this wrong thinking can have on your business.
In Part 1, we discussed the efficiency mind-set and how focusing on efficiency can lead you astray. I made the case that efficiency is NOT a precursor to improved performance, but a by-product. In Part 2 we tackled the allocation mind-set and instead of allocating I suggested that you consider the ΔT versus ΔOE as you decide which jobs to take, how to price, and select markets. In Part 3 I want to address the cost mind-set.
The cost mind-set is related to both the efficiency and allocation mind-sets. The cost mind-set is what causes us to say things like “we lost money on that job” and also is why we don’t want to make additional tooling for a job.
First, what is the situation that typically causes us to exclaim “we lost money on that job/project”? Usually it is because the job or project took more time than we estimated. And, of course, our price was based on this time estimate. If your time estimate is off enough so that the number of hours you go over multiplied by your hourly cost rate is more than your margin – you might think that you lost money on that job or project.
However, that is wrong thinking. The money you make on a job or project is the same no matter how long it takes you to do the job. The money you make on a job is called Throughput. And Throughput is Sales minus Truly Variable Costs (TVCs). TVCs are any cost you incur when you sell one more of your product or service. They typically included raw material, purchase parts, freight, and sales commission. They do NOT typically include direct labor unless you pay piece rate.
So if your Throughput on a job is:
Selling price: $100
then you are going to generate $80 of Throughput no matter how long it takes. Only rework could further reduce your Throughput. Throughput is what we generate to help us cover all our Operating Expenses and then make a profit. So we need to generate enough Throughput to cover all our Operating Expenses. And if a job or project takes too long, then we may not have enough time left to generate enough Throughput in total.
But the amount of money we generate, the Throughput (that’s what we call it in Theory of Constraints Throughput Accounting), is the same no matter how long it takes us to do the job or project.
While that may sound like semantics, it’s an important difference. It’s the difference between thinking like everyone else or really understanding the situation to allow you more or different opportunities.
And that brings me to the second example. Sometimes when we are working with a custom job shop and focusing on increasing flow (velocity through the shop), I will often suggest that they run a job across several machines. And this can require additional work holding fixtures and/or additional tooling.
This additional tooling cost is calculated as follows:
Raw Material + Outside Services (like heat treating)+ Direct Labor = Tooling Cost
E.G. $200 +150 +$5000 = $5350
So I will often hear “it would cost us $5350 for that additional tooling and we can’t afford that”. But then I ask if they make this tooling in house. They confirm that they do. So my response is “then it only is going to cost you $350 for this additional tooling. And while it will take some of your capacity to do this, it will not cost you more than that.”
If taking this time, does not create a bottleneck or cause you to have to work overtime, why wouldn’t you do it? Particulary if you will run the job again.
And if you did it, and you could now get that job through you shop in half the time — what would that be worth? Could you gain market share if your lead-time is shorter than your competition? Don’t let the cost mind-set cause you to miss huge opportunities!
Do you see how thinking differently can really be the path to more sales and more profits? Everyone says to “think differently”, but no one tells you HOW to do it ….. until now! Your products/services do not have costs or profits.
If you’re ready to think differently, our Velocity Scheduling System (for job shops) and Project Velocity System (for your engineering department) help you to increase the velocity of work through your company so that you reduce the chances of not getting enough done to cover operating expenses and make a profit. Then our Mafia Offer Boot Camp will help you to capitalize on the competitive advantage you’ve created in operations and by thinking differently.
If you have questions or feedback, please post your comments by clicking of “Leave a Comment” at the top of this post or call me 303-909-3343 .
Wishing you Success!
P.S. And remember if you participate in the program and take action, and if VSS doesn’t work for you – you get your money back. So why hesitate? The 14 sessions are an investment of just 24 hours.
(c)Copyright 2010, Dr Lisa, Inc. All rights reserved.