Theory of Constraints POOGI Part 56: We lost money on that job!

We are continuing our series based on The Goal by Eliyahu M Goldratt and the Theory of Constraints. {This series was co-written with Brad Stillahn.}

Cost accounting is alive and well in American business (and around the world really), even though it is an invalid, old technology. The continued—and unquestioned—use of cost accounting has led directly to the loss of competitiveness and long-term decline of American manufacturing. Stop using it!

Brad: You give a lot of speeches to business owners. Tell me again, what drives you nuts?

Dr. Lisa: When someone says “We lost money on that job” or “We lost money on that project".

Brad: That’s cost accounting talking. It’s amazing the owner is still in business, saying something like that. If his competition didn’t all think the same way, he would be out of business.

Dr. Lisa: Truly variable costs—materials, outsourcing, freight, sales commissions—are normally just a fraction of the selling price. There are only two ways to lose money on a job: 1) charge less than your truly variable costs; or 2) re-work a job over and over again causing you to incur the truly variable costs multiple times and the total of all the truly variable costs are more than the price you charged.

Brad: The all-industry average for truly variable costs (TVCs) is 40%. And machine shops are usually much less than that, depending on the type of work they do. So why does the business owner think he “lost money on that job”?

Dr. Lisa: It’s the allocation of overhead cost, the number one conceptual mistake of cost accounting. Remember, cost accounting was invented back at the turn of the last century, when labor was paid piece rates and overhead was less than 10% of total costs.

What really happened was that the job took more time than estimated. And since cost accounting allocates “cost” to that time, the job “cost” more than expected, perhaps more than the price. But this is a mirage. The margin received — the sales price minus the truly variable costs — is the same no matter how long the job took to produce.

... to be continued.

Here's to maximizing YOUR profits!

Dr Lisa Lang

(c)Copyright 2009, Dr Lisa, Inc. All rights reserved.

A Process Of On-Going Improvement (POOGI) - Part 32

We are continuing our series based on The Goal by Eliyahu M Goldratt and the Theory of Constraints. {This series was co-written with Brad Stillahn.}

To make managing a complex organization easier, we break organizations into pieces. Many of the current measurements have the purpose of measuring local performance, under the erroneous assumption that the overall performance of the organization will be maximized if each department maximizes its performance.

The role of measurements is to induce the parts to do what’s good for the organization as a whole. What’s good for the organization as a whole is achieving the three objectives stated above.

In previous articles, we’ve referred to some of the measurements used by TOC practitioners:

• Throughput (T) is rate at which the system generates money through sales.
• Inventory (I) is the money invested in purchasing things which it intends to sell.
• Operating Expense (OE) is the money the system spends to turn Inventory into Throughput.

To determine Throughput, subtract truly variable costs (TVC) from Sales dollars. Truly variable costs include raw materials, outsourcing, freight, and sales commission. Throughput is most similar to Gross Profit, except that direct labor is considered an Operating Expense in Theory of Constraints (TOC). It’s not that direct labor does not vary, but it is a period expense and does not necessarily need to vary with sales. Dramatic improvements in Net Profit can be gained when Throughput increases without a proportionate increase in Operating Expense.

...to be continued.

Here's to maximizing YOUR profits!
Dr Lisa Lang
(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

Excess Capacity for a Viable Vision

Question: How much excess capacity do you need to have to make a Viable Vision viable?

Answer: It depends. Squeezing more capacity out of your existing operation without investment is relatively easy (you read about it in The Goal, Its Not Luck, and Critical Chain). The hard part is selling it. You need an unrefusable market (a “mafia offer”) offer in order to sell all your capacity (you read about this in Its Not Luck). The Viable Vision is the specific strategy and tactics necessary for you to uncover your capacity and the market offer that will bring your company to have a profit level equal to your current sales level.

What percent of sales are your truly variable costs (TVCs)? Remember that we define TVCs as those costs that change when an additional product or service is sold. TVCs include raw material, sales commission, freight, subcontractors, and the like.

The higher your TVC or lower your throughput (T = sales – TVCs), the more excess capacity (or price premium) you will need to make it possible to turn your current sales level into your profit level in 4 years.

Here’s an example: If you currently have $10 million in sales and TVCs at 30% you will need $23 million in sales. This assumes that you could add these sales with your current labor and/or operation expense (OE). And, in many cases this is quite possible.

If you will need to add labor or other OE, then for each million in those costs that you add you will need to sell another $1.43 M (amount OE added divided by throughput). This is typically not a big deal (we have a client right now with about 65% TVCs), it is just something we have to take into consideration.

So, the more you can sell with your existing resources and investments, the quicker you can turn your current sales level into your profit level. And, your specific mafia offer will also play a big role in the amount of excess capacity you will need. If you can get a price premium, then you will need less capacity and less sales.
The smallest company on a Viable Vision right now started at $1.2 M in sales and the largest started at $4 B (billion!).

But this is way more information than you need because we will collect the data for your company, develop your Viable Vision, and spend 2 hours with you discussing your company and your Viable Vision for FREE, no strings. The only catch is that the CEO, President, or business owner must have attended one of my Maximizing Profitability events to be eligible for the free offer.

And if you decide that you would like guidance from us in achieving your Viable Vision, then 100% to 90% of our fees are based on YOUR results. If you don't get the results, you don't pay! And yes there is a 100% results based option!

Here's to maximizing YOUR profits!
"Dr Lisa" Lang

Should I factor my receivables?

Question: Should I factor (sell) my receivables? I could use the cash, but the cost seems too high.

Answer: This question is hard to answer without more information, so let’s look at an example:

Let’s say it costs you $40 to make a product you typically sell for $100. If you could get $100 dollars in 60 days from your customer or $80 dollars in 10 days from selling the invoice, which would you prefer?

To compare the 2 options, let’s calculate the amount of Throughput that each option would generate in 60 days. Remember, Throughput = Sales Price – Truly Variable Costs.

Option 1: We wait to collect the accounts receivable in 60 days. Therefore in 60 days we generate $100-$40 = $60 in Throughput.

Option 2: We sell the invoice and receive $80 in 10 days. Therefore we have generated $80-$40= $40 in 10 days. But we still have 50 days to go, so we invest our $40 in more raw materials and sell another product. For that product we also sell the invoice and generate another $40 in Throughput. We now have 40 days to go, so we repeat the process 4 more times. In 60 days we generate $240 in Throughput.

So the answer is “it depends”. If you have a use for the money that will generate additional Throughput, then you’re on your way to maximizing your cash flow and your profitability! If you have plenty of cash, then it doesn’t really make sense.

Another way to accomplish the same thing is to offer very deep discounts if your customers pay very quickly. However, if you decide later that you don’t want to offer this option anymore, then you have to explain that to your customers.

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
P.S. Happy birthday to my sister Tammy!