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. Last time, 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 this installment I want to discuss another type of wrong thinking – the allocation mind-set.
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.
The allocation mind-set is where we believe that in order to ensure we are going to make a profit, we have to allocate some portion of our overhead to “product cost”. The idea is that if every product we sell absorbs some of our costs, then we will know at what point we are making money and we can better ensure that we cover all our costs.
So when we calculate the “gross margin” (GM) of a product it looks something like this:
Selling price: $100
Gross Margin: $40 (also called Gross Profit)
Where COGS (Cost of Goods Sold) typically include raw materials and the direct labor used to create the product or deliver the service. (Some companies may allocate more than direct labor, but this is the most common allocated cost.)
But if you think about it, direct labor really is NOT a variable cost, unless you pay piece rate. And this is true for both manufacturers and service providers (again unless you pay piece rate – which is very rare). You are going to pay your employees this week whether you sell something or not.
It is this allocation of direct labor to COGS that is what I’m referring to as the “allocation mind-set”. The amount of direct labor allocated to a product/service is usually based on annual volume assumptions and the estimated time a particular job will take.
This means that the allocation of direct labor costs to a job or opportunity influences your decisions:
· Which jobs/projects you take.
· Which markets you go after.
· Which customers get preferential treatment.
· How much you charge.
So far, you’re probably thinking – yeah, that’s what we do, what’s the problem? The problem is that the allocations you do are based on a volume assumption and time estimates. Both of which we know one thing for sure about – they are wrong. The question is by how much and in which direction.
Not only will the amount you allocate be wrong, more importantly, it can lead you astray. The best way for me to demonstrate that is with an example.
Let’s say that you have a customer who wants to give you more business. They are one of your best customers and in exchange for the additional business they want a volume discount. The volume discount is reasonable and something you do all the time. The problem is that the way they want the product delivered along with their low inventory requirements it’s going to require you to do 3X as many set ups as you would normally do for that volume.
Using the allocation mind-set you would calculate the gross margin of this new business. And you would allocate the additional setup time to opportunity. Your COGS would include the cost of the additional setups.
Now, let’s say that the result is that the gross margin percent is slightly NEGATIVE with these additional setups. What would you do? Pass on the additional business? Take the business but give that customer lower priority and complain about that customer every time you run their job? What decision will you make with this cost allocation mind-set?
Who knows since this isn’t a real situation, but before you continue reading, please give it some thought. How do you generally feel about more setups or about lower margin work?
If you’re like most people you would probably pass on the business or try to negotiate with your customer to take more products at once so that you could reduce the number of setups you would do. And you may even find yourself saying “the cost of those setups makes this business unattractive for us”.
Let’s challenge our thinking with Theory of Constraints and Throughput Accounting concepts. Let’s challenge the allocation mind-set. First, how much throughput would the additional volume generate? Throughput = Sales – Truly Variable Costs. Truly Variable Costs (TVCs) are all the costs you pay as a result of selling one more. Typical TVCs include raw materials, purchase parts, outside services, subcontracted services, freight, and sales commission. The Theory of Constraints definition of TVCs do NOT include direct labor unless you pay piece rate. So when we calculate the “throughput” (T) of a product it looks something like this:
Selling price: $100
Next, determine if you will need to increase your fixed costs (operating expenses) if you take this additional volume? Will you need to hire anyone or buy any equipment? If so, how much?
Let’s say we do not need to hire anyone or buy any equipment. And if this is the case, we don’t currently have an internal constraint. We most likely have a market constraint.
The way we recommend you think about this decision is by comparing the change in Throughput (ΔT) versus the change in Operating Expense (ΔOE) as a result of this additional business. And if the ΔT is greater than the ΔOE, the difference goes to covering all your operating expenses and helping you make a profit.
The fact is that, in most cases, a setup doesn’t cost ANYTHING (or they cost a little raw material to get the machine lined out). They do, however, take time. But it is imperative that you differentiate between cost and time. If additional setups would consume so much capacity that you would need to add equipment or people, then it would be reflected in the change in OE.
But to deliver that offer you need to do more setups. But because YOU understand that set-ups do not cost anything you are willing to do it. And your competitors are not! Which means you can make thinking differently pay off by taking market share.
I’m not saying that if ΔT > ΔOE that you must take the business, but I am trying to get you to look at the real situation and understand the real bottom-line effect. Because in this example we would potentially pass on business that would add incremental Throughput and if you do have a market constraint then don’t you need more business? Shouldn’t you be trying to determine what you would need to offer your market to take market share instead of trying to talk your customer out of doing more setups?
The allocation mind-set has you striving to reduce YOUR setups so that you can reduce YOUR costs. Notice that it’s all about you. Not a good place to be if you have a market constraint.
Now imagine that it’s not the customer coming to ask you to increase your set-ups, but instead you created a Mafia Offer that better served your customers needs by:
· increasing availability of the right products
· by reducing overall inventory
· by reducing the amount of cash they have tied up in inventory
You can hear an example of such a mafia offer here: http://www.scienceofbusiness.com/free-stuff/free-videos-audios/video-player/videoid/20.aspx
So if you improve your operations by eliminating the efficiency mind-set we talked about in Part 1 and then challenge your thinking about allocations to create a great Mafia Offer – what would happen to your business? How much more money could you make?
The combination of our Velocity Scheduling System Coaching Program (for custom job shops) or Project Velocity System Coaching Program (for your engineering department) with our Mafia Offer Boot Camp will accomplish just that.
In Part 3 we will cover the cost mind-set. If you have questions or comments on Part 2, please click on the “Leave a Comment” link at the top of this post.
Wishing you Success!
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