A Process Of On-Going Improvement (POOGI) - Part 18

We are continuing our series based on The Goal by Eliyahu M Goldratt.

You can also perform a sensitivity analysis to determine the breakeven level of T/CU. In this example, it would be the Operating Expense level of $615,000 divided by 2,912 which is $211.20.

Pricing with Throughput Accounting is much easier and potentially much more dangerous. It is easier because there is no such thing as “product cost” to calculate. Instead, each product is evaluated for its Throughput per Constraint Unit. And overall, for the business, the average T/CU must be enough to achieve the Net Profit goal. It’s dangerous because any amount of Throughput does contribute to the bottom-line, but there must be the discipline to maintain the T/CU average needed to achieve the Net Profit goal. Pricing to achieve incremental business is not for novices.

For example, say you are quoting a new job. You estimate it will take 50 hours of milling. The Truly Variable Costs are estimated to be $5,000. Here is your estimate:

Hours of milling 50
T/CU desired $258
Throughput desired $12,900
Truly Variable Costs $5,000
Total Estimate $17,900

We understand that this method is much different and you may have many questions. If so, and/or you would like help calculating T/CU for your business, please feel free to contact us.

If you’d like to learn more about Throughput Accounting, we recommend the following materials (which were also used in developing the discussion above):

• “The Haystack Syndrome” by Dr. Goldratt,
• “Throughput Accounting” by Corbett.
• "Maximizing Profitability" by Dr Lisa (hit the ground running w/ 3 hr audio and workbook)

...to be continued.

Here's to maximizing YOUR profits!
Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

Next GROUP Mafia Offer Boot Camp is July 30, 31, Aug 1 2008!Also check out our FREE Theory of Constraints videos. New videos added very week! http://www.scienceofbusiness.com/free-stuff/free-videos-audios.aspx

A Process Of On-Going Improvement (POOGI) - Part 17

We are continuing our series based on The Goal by Eliyahu M Goldratt.

Let’s apply this to your business. In order to do so, you’ll need to make some calculations. First, write down your annual sales. Second, subtract the Truly Variable Costs (these include raw materials, outsourcing, freight in and out, and sales commissions). The difference between the two is your dollar Throughput.

From throughput subtract all of your fixed costs which we call Operating Expense. The difference is your Net Profit.

For example:

Sales $1,400,000
Truly Variable Costs -$650,000
Throughput =$750,000
Operating Expense -$615,000
Net Profit =$135,000

Let’s further assume that you have lathes and mills in your machine shop. You have identified that milling is your constraint resource. You have only two milling machines operating one shift. You have calculated the available capacity as:

Number of mills 2
Hours per year 2,080
Percent available 70%
Available hours 2,912

The 2,912 hours is how many “Constraint Units” you have available.

The Throughput of $750,000 divided by 2,912 hours is $257.55. That is your “Throughput per Constraint Unit” (T/CU).

What is the meaning of this number? The Throughput per Constraint Unit is the amount of margin needed per operating hour of your limiting resource to cover Operating Expense and achieve your Net Profit. It is the rate at which you make money.
...to be continued.

Here's to maximizing YOUR profits!
Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.
Next GROUP Mafia Offer Boot Camp is June 25, 26, 27 2008!
Also check out our FREE Theory of Constraints videos. New videos added very week! http://www.scienceofbusiness.com/free-stuff/free-videos-audios.aspx

A Process Of On-Going Improvement (POOGI) - Part 16

We are continuing our series based on The Goal by Eliyahu M Goldratt.

Dr. Goldratt says it this way: “If a process of ongoing improvement is what we are after, which of the three avenues of Throughput, Inventory, or Operating Expense is more promising? If we just think for a minute the answer becomes crystal clear. Both Inventory and Operating Expense we strive to decrease. Thus, both of them offer limited opportunity for ongoing improvement. Both of them offer only limited opportunity for ongoing improvement. They are both limited by zero. This is not the case with the third measurement, Throughput. We strive to increase Throughput. Throughput does not have any intrinsic limitation; Throughput must be the cornerstone of any Process Of On-Going Improvement (POOGI). It must be first on the scale of importance.”

Therefore, to make decisions according to Theory of Constraints (TOC) and Throughput Accounting, we need to quantify a decision’s impact on these three measurements and then we will be able to determine the change in net profit and return on investment.

The role of the company’s constraint is fundamental for quantifying the decision’s impact on the three measurements. Thus, to identify which products contribute the most to the company’s net profit, TOC also advocates the use of the measurement of “Throughput per time of the constraint (T/CU)”. This method is much simpler than the product costing and it allows for fast decisions that are directly linked to the bottom line.

...to be continued.

Here's to maximizing YOUR profits!

Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

Next GROUP Mafia Offer Boot Camp is June 25, 26, 27 2008!

A Process Of On-Going Improvement (POOGI) - Part 14

We are continuing our series based on The Goal by Eliyahu M Goldratt.

Throughput is the rate at which the system generates money. It is similar to Gross Margin or Contribution Margin, but it is also different in that TOC (Theory of Constraints) does not consider direct labor as a variable cost, but rather as Operating Expense.

The role of the company’s constraint is fundamental for quantifying the decision’s impact on the three measurements. Thus, to identify which products contribute the most to the company’s net profit, TOC advocates the use of the measurement of “Throughput per time of the constraint”. This method is much simpler than costing methods. It allows for fast decisions that are directly linked to the bottom line.

Next month we will explore Throughput Accounting in more depth, and explain how implementing its concepts will help you understand the rate at which your company makes money. We will also discuss how Throughput Accounting affects pricing decisions.

If you’d like to be better prepared for the discussion, we recommend one or more of the following books:

• The Haystack Syndrome by Dr. Goldratt,
• The Theory of Constraints and Its Implications for Management Accounting by Noreen, Smith, and Mackay, and
• Throughput Accounting by Corbett.

You can also search this blog for Throughput Accounting.

...to be continued.

Here's to maximizing YOUR profits!

Dr Lisa Lang
(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

Pricing using Theory of Constraints – Q&A

I have not yet finished Blue Ocean Strategy. I will explain why when I post my review.

I have, however, received a pricing question and have written an answer. Enjoy.

Q: What about companies that have a market constraint and use S-DBR?

A: For companies that have a market constraint, I still recommend that they strategically place an internal limiting resource (control point) and use this strategic constraint to determine pricing and product mix.

We find that there is huge variation (+/- 50%) in pricing amongst and between competitors. So determining what is competitive is even a challenge. We use catalogs, industry studies, etc to help with this determination when those are available. Most of the time, we don’t have this information, so we use the technique we were all taught (TVCs + allocated OE + reasonable margin = price). We then ask our prospects/customers by how much did we miss the order or how far off was our closest competitor. Purchasers don’t typically tell us what the other prices were, but they will tell how by what % we missed it or got it.

How/when you modify pricing (in my opinion) depends on the type of offer you have. If you have an offer where you get premium pricing (like the Rapid Response mafia offer) you need to ensure that your standard price (at standard lead-time) is competitive because no one will pay a multiple of a price they perceive to be too high. We have had some situations with this offer where the standard price was not attractive to us (low T/CU) but we needed to offer this product to get the higher T/CU products. In that case we raise the price as much as we can but to still be considered competitive and then we also increase the standard lead-time. So, if we don’t like the price, but it is competitive, we increase the lead-time.

If we are dealing with a VMI type mafia offer than we typically start by matching the current pricing (assuming it is competitive a close to our target T/CU) then getting an increase after proof of concept. We have been successful at getting 2 to 12% increase.

When we consider increasing prices we take into account: T/CU of the product, total $T of the product, weighted average T/CU for the customers buying this product, and total $T for the customers buying this product. If we lose the sales of the product or sales of an entire client we need to understand by how much our T will go down.

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

P.S The next open to the public Maximizing Profitability event is Aug 28 in Denver, Colorado. This is a no charge half day event. To register go to http://www.viable-vision.com/

P.S.S The next mafia offer boot camp is August 29, 30, 31 in Denver or schedule a private one at your place, on your time frame! http://www.mafiaoffers.com/ We’re coming to New Zealand and Australia for boot camps in December!

P.S.S.S. Check out our new Theory of Constraints Pricing Project! http://www.scienceofbusiness.com/Default.aspx?tabid=144

Mafia Offer Podcast #1: http://www.podcasternews.com/programs/87/better-process-podcast/3574/?A=1

Purchase Dr Lisa’s book, Achieving a Viable Vision: http://www.scienceofbusiness.com/Default.aspx?tabid=133

Pricing Using Theory of Constraints Part 6 of 6

This is the final installment on Theory of Constraints pricing. At least for now. Goldratt's Theory of Constraints, The Goal, and Throughput Accounting don't address pricing specifially. So, I tried to summarize what we do with our clients. This pricing exercise has resulted in 10 to 20% increase in profits for our clients, so I would expect the same for you. So let's summarize what we covered about pricing.

• Part 1: We discussed the importance of and how to calculate the Throughput per Constraint Unit (T/CU) for each of your current products or services.
• Part 2: We discussed how to calculate a minimum T/CU which is like the minimum price you need to charge to cover your operating expenses and make a profit.
• Part 3: We then compared the T/CU we get for each product/service to the minimum T/CU we calculated.
• Part 4: Next we discussed how to handle products/services that are priced below the calculated minimum T/CU.
• Part 5: And finally we discussed how to handle products/services that are priced above or well above the calculated minimum T/CU.

With this additional information, I hope you can determine a price that 1) will help you to achieve your financial goals; 2) meet or exceed the value perceived by the market place (will customers buy at that price?); and 3) establish the position, brand and image you desire in your supply chain.

Here's to maximizing YOUR profits and setting your prices!

"Dr Lisa" Lang

P.S. Check out our new Theory of Constraints Pricing Project! http://www.scienceofbusiness.com/Default.aspx?tabid=144

(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Pricing using Theory of Constraints Part 5

For the products that are well above the T/CU you need to look into the following things:
- what is your close rate on these items, is it low?
- have your customers/prospects told you that you were over priced?
- do you want more of this type of business?

The products that are slightly above the T/CU you calculated are probably fine. And some of them that are well above the T/CU are probably OK too. But the ones that you would like to sell more of, but are not, due to too high pricing, these are the ones you should consider lower the price on.

...to be continued...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Pricing using Theory of Constraints Part 4

Let's look at the products that are currently priced below the mininum T/CU that you calculated. You can have some products priced below your min T/CU because the weighted average just needs to be at the minimum. To determine if this is one that should be below the minimum or raised you need to take into account the following:
- where is the competition priced?
- does selling this product, help you to land higher T/CU products with the same customer?
- typically you have more than one of your constraint -- like have multiple printing presses. Does this particular product run on one of your more loaded ones or does it run on a less loaded one?

...to be continued...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Pricing using Theory of Constraints Part 3

Compare the minimum T/CU to the T/CU for each product. You will find current prices that are too low and too high relative to the min T/CU.

Now look at your quotes and calculate the T/CU for all your quotes. What is the T/CU for the ones your winning versus the ones your losing?

...to be continued...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Pricing using Theory of Constraints Part 2

Now that we have our current T/CU for each product/service we calculate the minimum T/CU we need to cover all of our Operating Expenses plus make the profit we want. Here's how we do that:

Min T/CU = (annual OE + annual profit) divided by annual available constraint units

Operating Expenses (OE) are all the costs that don't change when you sell just ONE more of your product/service. They are all the costs not captured in the TVCs (Truly Variable Costs) and typically include rents, utilities, selling/marketing, general admin, all labor including direct, maintenance, and warehousing expenses.

To start, you can use your current annual profit, then increase it to see where you need to price to meet your profit goals.

Constraints Units (CU) are the annual number of hours or minutes you have available. So you you work one shift then use the time from one shift times about 70% which takes breaks and other misc downtime.

Now you have 1) your current T/CU for each product (see Part 1) and 2) the minimum T/Cu you need for each product.

...to be continued...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Pricing using Theory of Constraints PART 1

Deciding on pricing for your products or services tends to consume a lot of time and can even be stressful. Typically we are looking for a price that 1) will help us to achieve our financial goals; 2) meet or exceed the value perceived by the market place (will customers buy at that price?); and 3) establish the position, brand and image you desire in your supply chain.

The Theory of Constraints approach to pricing adds a slightly different perspective. When we first start working with a client we calculate the Throughput per Constraint Unit (T/CU) for each product/service. Here's how you do that.

1) List each product or category of products. If you have custom products, then use product categories. If you sell the same products multiple times, then list the individual products.
2) Calculate the Throughput(T) for each where T is the selling price minus the truly variable costs (TVCs). Typical TVCs are raw materials, sales commission, outside services, and freight.
3) Estimate how much of the constraint each product uses, how many constraint units. This is typically a time measure.
4) Divide #2 by #3 and you have T/CU for each product e.g. Throughput $ per minute.

Do this and now you have some information about your current pricing.

To be continued ...

Here's to Maximizing YOUR Profits!
"Dr Lisa" Lang

P.S. Check out our new Theory of Constraints Pricing Project! http://www.scienceofbusiness.com/Default.aspx?tabid=144

Increase Throughput -- Increase Sales cont.

Continuing our cash velocity discussion started on March 16, 2007

Increase Sales cont.

Last time we ended our discussion with this question: So how do you increase your throughput without going into cash trouble?

The first step is to examine your product mix. Calculate the T/CU for each product. With this information you can devise a strategy to sell more products with higher T/CU and drop those with a lower T/CU. This will allow you to maximize your throughput without investing additional capital or having to tie up more cash in the form of raw material.

Then once again, we must decrease our cash-to-cash cycle time which we have already covered.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increasing Throughput -- Increase Selling Prices

Continuing our cash velocity discussion started on March 16, 2007

Increase Selling Prices

Changing the selling price for a product or group of products is difficult to cover in few words. Presumably you already have pricing policies and strategy that represent some equilibrium point in the market you serve and getting some minimum T/CU across your mix of products/services. If you understand the perceived value by your customers for the products/services you offer, then to increase prices you must stay within this perceived value or increase your customer’s perception of value. A mafia offer[1] is the Theory of Constraints (TOC) method to increase your customer’s perception of value even in industries considered to be commodities.

In addition, Market Segmentation should be considered. Identify segments of markets that have different values for the products and services you offer, then set selling prices for these markets that are consistent with their perception of value and your mafia offer. Segmentation should help you to match selling price with customer’s perception of value and allow you to maximize your selling price while ensuring that you’re meeting your customer's needs.

[1] We will discuss more about mafia offer in #1 below. Also, see http://www.mafiaoffers.com/ for more information on creating a mafia offer.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Sales Commission -- Effect on Throughput

Continuing our cash velocity discussion started on March 16, 2007
We last left off on Friday April 6, 2007.

Deceasing sales commission is not necessarily where we want to focus either, but make sure that the commission you’re paying is in alignment with where you’re making your money and/or with the products/services with the highest cash velocity. If you have varying T/CU[1] across your products/services, but you are paying sales people a commission on selling price or gross margin, you may not be motivating them to sell the products that provide the highest throughput for the least amount of your most precious resource. In addition, the traditional way of paying sales people does not take into account the cash velocity either. The ideal commission structure would motivate sales people to sell the highest T/CU combined with the best velocity products/services.

[1] Thoughput per Constraint Unit. This is the amount of money you generate on a sale divided by the amount of your limited resources capacity consumed in order to produce the sale. See Throughput Accounting as part of Goldratt's Theory of Constraints.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.