Maximizing Profitability using Theory of Constraints #2
Brad: “Just what should a highly custom job shop or machine shop company set as a profitability goal? What is reasonable? How high is up? Is there a way to know what’s possible?”
Dr. Lisa: “I’ll give you Dr Eliyahu Goldratt’s answer and then I’ll give my more direct answer. Dr. Goldratt stated that profitability goal of the business should be a level of return on sales that top management of a company agrees is definitely impossible to attain.”
Dr. Lisa: “For example, if everyone agrees that 5% Return of Sales is definitely possible, that is too low of a goal. If everyone feels the same about 6%, 7%, 8%, and 9%, they those levels are also too low of a goal. But if everyone agrees that 10% is not achievable, that then becomes the goal.”
Brad: “That would be an interesting exercise for any CEO to do with his or her top management team.”
Dr Lisa: “My answer: How high is up is going to be dependent on 1) what percent your Truly Variable Costs (TVCs) are of sales. And 2) how much capacity you can undercover – meaning how much productivity you can gain with the same people and resources.”
Dr Lisa: Knowing both of these numbers (better to be approximately right, than precisely wrong), will allow you to arrive at a very feasible goal and yet one that most will agree is not attainable based on previous experience.”
Dr Lisa: Using the same example from our last conversation, I’ve added the Return on Sales:
We’ve gone from 0% Return on Sales to 8.3% Return on Sales by being able to sell the 20% productivity gain that was achieved.
Brad: “Many job shops and machine shops that we work with have 20 to 35% TVCs (which typically includes raw materials, outside services, and sales commission if any). Some more some less, but this is common. When I initially analyze the financials of a company, I’m looking for the actions and implementation steps required to bring the company to reliably make a 20% Return on Sales month in and month out, year in and year out.”
Dr. Lisa: “Ha! Be careful, you’ll scare some business owners with that goal. He or she will definitely think that goal is unattainable!”
Brad: “A small business making 20% Return on Sales is a lot more fun to run than a larger business barely managing to reach breakeven.”
Dr. Lisa: “For sure. A company with sales of $2.5 million and a 20% Return on Sales has $500,000 of net income. And so does a company with $25 million of sales with a measly 2% Return on Sales”.
Brad: “Now the nifty thing is that TOC ‘silver bullets’ can be used with that same company with $25 million in sales to bring them to achieve a 20% Return on Sales – a jump from $500,000 to $5 million of net profit.”
Dr. Lisa: “Yes, no wonder that Merger & Acquisition and Turnaround Management Professionals are showing a lot of interest in TOC.”
Brad: “Okay, so let’s discuss more about how this fantastic improvement just might be possible…”
To be continued.
Dr Lisa Lang and Brad Stillahn
P.S. Feel free – please- to leave comments and questions on this post.
P.P.S. To find out more about improving productivity in highly custom job shops and machine shops, watch our How to Get More Jobs Done Faster webinar.
P. P.P.S. If you have plenty of capacity, but can’t sell it, visit www.MafiaOffers.com.
P.P.P.P.S. For help putting YOUR financials in throughput accounting terms, pricing and making decisions, visit www.VelocityPricingSystem.com for one on one help or TheoryofConstraintsCPE.com for self study courses.