This is the eighth conversation in our Maximizing Profitability the Theory of Constraints (TOC) Way series. To read number 7, go here: https://www.scienceofbusiness.com/maxprofit7/
Brad: “Theory of Constraints (TOC) is unique with its emphasis on Throughput, the additional margin the company gains when it sells one more product or service.”
Dr. Lisa: “Yes; this ‘Throughput Margin’ includes no allocated costs – not even direct labor costs (which TOC considers a period cost).”
Brad: “Each product or service sold has a Throughput Margin. The Sales Revenue minus the Truly Variable Costs (material, outsourcing, freight, and sales commission) equals Throughput.”
Brad: “Now for the really cool, counterintuitive part. Add up the Throughput of all the products and/or services sold for the period (for example, a month, or a quarter, or a year), and you get the total Throughput. Throughput is cumulative.”
Dr Lisa: “And by this you mean that the cumulative Throughput of all the products/services sold in a period are equal to the Throughput of the company in that period.”
Brad: “Exactly! When allocation methods are being used, this is not the case.”
Dr. Lisa: “And this is totally separate from the period costs – the fixed costs or overhead costs. Overhead costs or fixed costs for a period are typically known with the exception of how much overtime might be needed. But if you work overtime, then this just increases these overhead costs in the period.”
Brad: “The overhead cost ‘bucket’ is what we in TOC call Operating Expense (OE) and in this bucket are all the costs that are not considered Truly Variable Costs.”
Brad: “ With these 2 simple buckets that account for all our costs – Throughput and Operating Expense – it is clear that we have to generate enough total Throughput for the period to equal Operating Expense to breakeven, and enough more to meet the profit objective for the period.”
Dr Lisa: “Yes and because there are no cost allocations based on volume assumptions, it really is that simple.”
Brad: “ERP systems normally muck this up. It is hard to isolate Throughput because of all the incorrect cost allocation assumptions build into these systems. Special reports usually have to be written to provide the correct information.”
Brad: “To better manage a company to higher levels of consistent profitability, this information is crucial. For someone used to cost accounting, it will give them a headache – or a migraine if he or she realizes the utter and complete fallacy of analyzing service or product profitability.”
Dr. Lisa: “When you work with a company to analyze their financials from a TOC Throughput Margin perspective, where do you start?”
Brad: “Throughput Margin varies, in most cases because it has not been visible and managed. In our Velocity Pricing System program we start working with a company to understand the total Throughput Margin and Throughput Margin percentage they have had annually over the last few years. That’s usually pretty quick and easy to do, and provides the business owner with a new and valuable insight into how money is really made in the company. It is also a good starting point for further analysis and decision-making based on what we find.”
Brad: “But we need to quickly get to management of the Throughput Margin of individual products and services. We dig into the heart of the pricing process at the customer-part level of detail.”
Dr. Lisa: “What is the objective?”
Brad: “It is helping the company quickly achieve a much higher Return on Sales, of course.”
Dr Lisa: “And for many of the custom job shops we work with, the target is a 20% Return on Sales up from 0 to 5%. Not bad! Sounds like every custom manufacturer, job shop and machine shop should check out Velocity Pricing System!”
To be continued.
>Dr Lisa Lang and Brad Stillahn
P.S. Ask questions or leave a comment below.
P.P.S. Custom job shops should check out www.VelocitySchedulingSystem.com (This is NOT software.)
P.P.P.S. Check out our Maximizing Profitability workshop to apply the concept to YOUR business!
Frequently Asked Questions
What do you mean by Return on Sales – in the article?
This is the very issue I am working on right now… how to price the sale price of a product???
Also, what KPI’s do I measure to know the performance of a business (using TOC/TA)?
Net Profit divided by Sales Revenue, expressed as a percentage. For example $600,000 of net profit divided by $3million equals 20%.
You said “This is the very issue I am working on right now…” how to price the sale price of a product???
Throughput, Inventory (used interchangeably with Investment), and Operating Expense. Throughput minus Operating Expense equals Net Profit. Net Profit divided by Inventory equals Return on Investment. Throughput divided by Operating Expense equals Productivity. Throughput divided by Inventory equals Turns.
Visit Velocity Pricing System for more information on pricing using Throughput Margin.