How not to set your IT budget

If you have read my posts in the past, you will know that I advocate the use of the following formula for determining the ROI for any given improvement project (whether IT-related or not):

Where

• ROI = Return on Investment
• delta-T = Change in Throughput, and Throughput is defined as Revenues less Truly Variable Costs (TVC)
• delta-OE = Change in Operating Expenses
• delta-I = Change in Investment

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Incidentally, where there is no change in I (Investment, including changes in inventory) or the change in I is negative, then projects can be compared based on profit alone. That formula is simply:

Profit = delta-T – delta-OE.

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However, here’s what far too many IT project’s ROI calculations look like:

ROI (don’t know) = ((never took time to estimate it) – (never took time to calculate it)) / $200,000

 

The only figure the company knows going into the project is the estimated “investment” or “cost” of the project.

The common excuse

The common excuse for not calculating an ROI for an improvement project is that changes in Throughput and changes in Operating Expenses are “too hard to estimate,” and “if they are estimated, they will be wrong anyway.”

This argument is specious on the face of it. Think about it!
The $200,000 estimated “cost” or “investment” value of the project is likely to be wrong, too. But that does not keep the CIO and CFO from making their best efforts to calculate that value.

The Real Reason

Of course, the real reasons that CIOs and CFOs do not take time to calculate a real and measurable ROI for their IT (and other) improvement projects is likely two-fold:

1. Too many CFOs and CIOs are under the wrongheaded impression that the value of IT (or other improvements) is both “automatic” and “cannot be measured.” When it comes to new technologies they have succumbed to the strange notion that new technologies are like an engine additive for business—you just pour them in and somehow your business will run smoother, faster, longer and get higher mileage! And, just like people who buy engine additives, they never take time to calculate whether there was any real benefit from using the product.
   
2. They have never taken time to actually determine what root-cause they are attacking with the IT (or other) improvement project, so they do not really know whether the project will actually lead to increased Throughput or will, in fact, drive down or hold the line on Operating Expenses. In fact, they probably do not even know what the “weakest link” is in their customer-to-cash stream or whether that weakest link is internal to their organization or whether it lies somewhere outside their organization in their supply chain.

Isn’t it time to stop that kind of folly? Can businesses still expect to thrive and grow without taking a sound look at how and why they are spending their most valuable resources—time, energy and money?

I don’t think so.

Misleading allocations and how to fix it–Part 2

[This is a continuation that will make very little sense to you if you don’t go back to read Part 1. Sorry.]

ACTIVITY-BASED COSTING ALLOCATIONS

Well, the partners were disappointed with these results, for sure. So, they decide to try Activity-Based Costing (or ABC) allocations. The administrative overhead is allocated based on their analysis of the amount of activity that the partners must undertake with each job type.

The ABC allocation of non-administrative overhead was done based on production-hours ($9,000 divided by 1,000 hours = $9.00 per production-hour).

The results of the partners’ new calculations (based on the historical product mix) are shown in below where you will note that company profit remains the same ($4,100 per month).

However, new priorities emerge: now the most profitable jobs appear to be landscaping (at $35 per job) and gutter guards (at $28 per job).

Based on these data, the partners rearrange priorities to allocate resources (i.e., the 1,000 hours or production time available) to capture the available markets for these job-types first. The results of this change in priorities may be seen in the following table:

Like the previous example, at first things look good: “calculated profits” boost to $7,924, but after subtracting overhead not absorbed (by abandoned job-types), the results are disappointing. Only $1,300 per month in net profits.

HOW TO FIX IT: THROUGHPUT ACCOUNTING VIEW

Throughput accounting eliminates all allocations except those that are truly variable with the changes in revenue. Typically, those costs are things like raw materials, commissions (maybe), outside processing costs, piece-rate labor—but not much else.

When you look at these Throughput Calculations, you will see two critical factors:

1. Throughput per Job (Revenues less Truly Variable Costs or TVCs)
2. Throughput per Constraint-Hour (Throughput divided by the time used on the constraint—in this case, the 1,000 hours of production time from the workers is the constraint to making more money)

So, looking at the Current Business and Profitability, you will see that another column as been added that represents the company as a whole or “the system.” Throughput is totaled across the enterprise into this column and then operating expenses are deducted from Throughput.

“Direct Labor” is not included in TVC and is included in Operating Expenses. Why?

Because in most organizations, so-called direct labor is not a TVC. Many times the payroll expense for labor will be the same whether the firm produces 10,000, 12,000, or 8,000 widgets in a month. Not to mention the fact that the payroll for “direct labor” (falsely so-called) sometimes includes payments for PTO, training or other non-productive time.

Note, again, that using Throughput Accounting, we still get the same net profit calculations ($4,100 per month).

Now, with this new information in-hand, the partners decide to prioritize sales and production to capture the market in order by T/C-Hr (Throughput per Constraint-Hour) until they run out of constraint-hours (i.e., the 1,000 hours available to them each month). The results of these new priorities are shown in the table below marked as Revised by Throughput per Constraint-Hour.

Wow! Profits are boosted 230 percent—to $9,410 per month or $112,920 annually—after fully covering all of “the system’s” overhead. In this case, they sought out and captured the 250 plumbing jobs available to them in the market as a top priority. Their second priority was to capture the 145 gutter guard jobs available to them. They had a few of the 1,000 hours left, so they were able to also do 16 window cleaning jobs.

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Hopefully, this helps you see two things:

1. The inherent dangers in believing data coming from an ERP manufacturing (or project accounting) system where the profit figures are clouded by allocations of overhead.
2. The simplicity and clarity provided by looking at your clients’ organizations as “a system” and helping them view their goal as optimizing the entire “system,” not trying to make decisions based on data that may imperfectly represent “system” performance.

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Let me know if this is valuable to you. Thanks.

What’s wrong with EOQ?

Economic Order Quantity (EOQ) EOQ is essentially an accounting formula that determines the point at which the combination of replenishment costs and inventory carrying costs are the least. The goal being to minimize both the ongoing costs of carrying inventory and the expenses involved with replenishing inventory.

The basic EOQ formula looks like this:

As you can see, this formula attempts to balance (simultaneously) the following factors related to the business expense linked to holding and replenishing inventory:

1. Usage rates – how many are sold or consumed over a period of time (one year in the basic formula)
2. Cost of replenishment – how much it costs the firm to replenish a single inventory item (SKU) from the point of recognizing the need for replenishment through putting the quantities back on the shelf
3. Carrying costs – all of the costs and expenses related to storing and handling of the inventory quantities held

Let us take a look at how these factors interact in a practical example:

In our example, we have an item that has a cost of $25 per unit, and the average daily demand is five (5) units. For this firm, the cost of replenishment is slightly above average—sitting at $30 per PO line processed for inventoried goods.

Observe what happens to the EOQ on this item as the cost of carrying inventory moves through the range from five percent (5%) to 40 percent.

When inventory carrying costs are very low compared to the cost of replenishment (five percent and $30, respectively), EOQ recommends big orders. In this case, each order would support more than 75 days of average demand.

On the other end of the spectrum, when carrying costs are quite high (40 percent) relative to the cost of replenishment, EOQ suggests smaller inventories (as the result of smaller orders) and the order cycle is slashed to almost one-third its former value (now, just over 26 days).

Underlying assumptions

The assumption being made in the construction of the EOQ formula is that the cost of carrying inventory is linear. That, at a five percent rate, a one dollar decrease in inventory on-hand will lead to a five cent reduction in carrying costs to the firm. Similarly, at a 40 percent carrying cost rate, a one dollar decrease in inventory on-hand will lead to a 40 cent decline in carrying costs.

Unfortunately, the linear relationship assumed by the EOQ formula simply does not exist.

When calculating the cost of carrying inventory, a large number of factors are generally considered:

1. Warehouse space rental (or equivalent)
2. Utilities expense
3. Property tax expense
4. Maintenance expenses on the warehouse and warehouse equipment
5. Inventory write-offs/write-downs
6. Other inventory shrinkage
7. Financing expenses for the warehouse, the equipment, and the inventory itself
8. Insurance expenses on the warehouse and the inventory
9. Labor expenses related to warehouse operations

When inventory is reduced $1,000 in a warehouse with a calculated 25 percent carrying cost, what are the likely real impacts on expenses for carrying inventory?

1. Warehouse space rental (or equivalent) – no change
2. Utilities expense – no change
3. Property tax expense – no change
4. Maintenance expenses -  no change
5. Inventory write-offs/write-downs – possibly some change, but not necessarily at the same “average” rate
6. Other inventory shrinkage – same as above
7. Financing expenses for the warehouse, et al -  no change
   Financing expense on the value of the inventory – some change possible
8. Insurance expenses on the warehouse, et al – no change
   Insurance expenses on inventory – some change
9. Labor expenses – no change

In short, only three of the nine items involved in calculating the cost of carrying inventory would likely change based on $1,000 reduction in inventory. That’s because increases or decreases in the volume and dollar amount of inventory held in a warehouse operations produce relatively large but non-linear changes operating expenses.

As inventory grows, changes like adding a second shift in the warehouse, acquiring additional warehouse space, or adding manpower to handle increased volumes happen incrementally. The EOQ formula has no way to account for these non-linear changes to operating expenses. Therefore, your EOQ decision-making my be entirely off the mark for success and increased profits.

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What’s the answer?

To manage your inventory quantities, I would highly recommend the application of Dynamic Buffer Management. [Click on the link and read the article there.]

To deal with non-linear changes in your enterprise—decisions that may lead to major changes in inventories (increases or decreases)—you need a broader formula that considers your system (your enterprise) as a whole. That would be this one:

Where,

• ROI = Return on Investment
• delta-T = Change in Throughput 
• delta-OE = Change in Operating Expenses
• delta-I = Change in Inventory or demand for other Investment

This formula would cover changes like adding a second shift (change in Operating Expenses) or building a new warehouse (change in Investment).

Think about. Contact me if you need further clarifications.

Finding Common Ground Between CFO and COO–Part 6

[Continuation]

Now that we have laid the groundwork, let us begin our turn now to some specific strategies for uniting the CFO and the COO in common and practical actions. First, let us consider the proper priorities for action.

Priorities for Action

The CFO and COO should agree on the following general priorities for actions to be considered:

1. Efforts to Increase Throughput, including efforts to increase revenues and/or efforts to reduce Truly Variable Costs (TVCs)
   
2. Efforts to Reduce Inventories (or investments) or demands for new investments
   
3. Efforts to reduce Operating Expenses

“Why this order?” I hear you ask.

The Detrimental Effects Cost-World Thinking

Let me begin by saying that this order is based on the solid assumption that most companies—especially at this present time—have already trimmed away obvious waste in operating expenses. And, while most CFOs and COOs are focused on the “cost-cutting” as the road to higher profits, this is almost never the long-term result.

A study done some years ago regarding Fortune 500 companies found a trend: Among companies self-assessed themselves as being “cost-cutters,” nearly 40 percent of such companies were no longer in the Fortune 500 a decade or so later. Clearly, the focus on “cost-cutting” is wrong on the face of it.

Consider this: Any company can successfully reduce its “costs” and “operating expenses” to zero. It the easiest and simplest of maneuvers to be carried out jointly by the CFO and COO. All they have to do is close the doors to the business, fire everybody, liquidate everything, and go home. It’s done!

But, if you think I am being overly dramatic, consider the fact that cost-cutting is—by it’s very nature—an action driven inexorably by the law of diminishing returns. If the CFO and COO successfully collaborate to reduce costs and expenses by, say, ten percent in year one; then it will be very difficult to reduce costs and expenses by even five percent in year two while staying healthy. In year three it may be difficult to eek out a two-and-a-half percent reduction in costs and expenses. Each successive year, increasing profits through cost-cutting becomes more and more difficult.

Too soon, despite their very best efforts, the COO and CFO focused on cost-cutting are soon cutting away protective capacity and damaging the ability of the organization to recover from the occasional attacks of “Murphy” (Murphy’s Law). This, in turn, leads to reduced revenues and higher marketing costs as customer retention becomes that much more difficult over time.

For all of these reasons, we must agree to put efforts to reduce operating expenses at the bottom of the list. And because increasing throughput has no theoretical upper limit and is not affected by the law of diminishing returns, efforts to increase throughput should remain foremost in the thoughts of the CFO and COO seeking unified actions for ongoing improvement.

Clarifying Throughput

As a reminder, our working definition of Throughput is not some generic concept of increases in volume or output. It is carefully focused on a financial formula that the strategic CFO should readily accept:

Throughput = Revenue – Truly Variable Costs

Where Truly Variable Costs (TVCs) are restricted to those costs that vary directly (not through allocations or some estimated factors) with changes incremental revenues. Typically, TVCs would be found in raw materials, subcontract or other outside services paid for on a batch or per-unit basis, commissions, piece-rate pay for employees, and little else.

[To be continued…]

[Cross-posted at the Kinaxis Supply Chain Expert Community]

(c)2008, 2009, 2010, 2011 Richard D. Cushing

Finding Common Ground Between CFO and COO–Part 5

[Continuation]

A New Management Paradigm

Toyota’s success—despite Japan’s own significant recession in recent years—is attributable to management paradigms that differ significantly from traditional management practices in the U.S. Some of these are likely recognizable to you in the following table:

	Traditional Paradigm	New Paradigm
Customer requirements	Quantity	Quality – improved experience and results
Quality [1] improvement	Generally costly and tend to reduce productivity	Saves money while increasing throughput
Internal competition (through reward systems)	Produces conflict – a few win, but many lose	System-thinking eliminates internal competition leading to improved performance
Cooperation	Too frequently leads to reduced competitiveness	Brings improvement where many win – maybe, everybody wins
Management	Command and control	Creating a work environment that supports top performance of the system and ongoing improvement
Workers	Seek to satisfy or, at least, appease management	Work together with management to satisfy the customers’ demand for constantly improving quality
Worker evaluations and incentives [2]	Increases internal competition and produces little long-term improvement	Encourages better performance and ongoing improvement
Purchasing	Buy almost entirely based on cost metrics	Buy based on the system’s performance and build relationships with key vendors

Note: This table was adapted from work originally done by W. Edwards Deming.

[1] In the table above, we are employing the term “quality” just as it is described in the text [see Part 4]. However, the term “customer” may be an internal or an external customer. Work to improve quality coming from a vendor is an effort that improves the firm’s experience and results. Similarly, improving quality coming from operation ‘A', which hands off to operation ‘B’, improves the experience and the result of operation ‘B’ as the “customer” of operation ‘A’.

[2] With regard to “evaluations and incentives,” we are referencing the traditional individual performance metrics taken within silos of operations, rather than on the performance of the system as a whole.

All Profit Lies Outside Your Organization

Inside the four walls of your business, everything over which the CFO and COO have direct control can contribute nothing but cost or expense to the bottom-line. Every opportunity for making money lies outside the organization and, therefore, outside the direct control of management and executives.

You can make more money by buying smarter—raw materials, services, et cetera—thus reducing truly variable costs (TVC) and increasing throughput. And you can make more money tomorrow than you are making today by selling smarter to existing customers, new customers or both.

These actions can have other affects, as well. The affects are depicted in the figure below.

 

A side-affect of buying smarter—what you buy, from whom you buy, how (delivery terms) you buy, and when you buy—is reducing inventory. The wonderful side-affects of reducing inventories—when done wisely as a result of system-thinking—are improved profits, higher ROI, and faster cash velocity.

You probably recognize all of these factors as improvements—improvements you would like to see, perhaps.

The new management paradigm unifies the CFO and COO by turning the organization from it navel-gazing introspection to a recognition that the customer is the most important part of the production line. No matter how you fine-tune your company’s internals, if the internals are not focused on the externals as the only source of profits, you are far more likely to create internal friction and heat without actually lighting a fire that will produce increased throughput and profit.

One of the advantages of the accompanying figure is the systemic clarity—the inherent simplicity—it delivers. It helps CFO and COO begin easily translate financial goals (i.e., net profit, ROI, and cash flow) into day-to-day actions (i.e., increasing throughput, reducing inventories and reduce or hold the line on operating expenses while support significant growth in throughput). [Note: For organizations that don’t have to deal with inventories, per se, the “inventory” may be broadened into “investment” or demand for capital investment. For example, if it is possible to reduce, defer or eliminate the need for an investment in new office space, then that would qualify as a “reduction” in the demand for new investment.]

[To be continued…]

Finding Common Ground Between the CFO and COO–Part 2

[Continued from Part 1]

I do not believe there is any doubt about it. Cutting costs takes far less real and deep thinking than it takes to come to understand your marketplace better. Both the CFO and the COO can agree that cutting costs saved them money—even if the unspoken side-effect of the cost-cutting action was to also reduce revenues through lost sales, lost customers or both. (Of course, in really hard times, the CFO and COO can console themselves by saying, “Sales probably would be down anyway,” and thus ignore the damage done through cost-cutting.)

Making your move

Most firms—even with brilliant CFOs and COOs—are not going to make one giant step from “failing” to “leading.” It is far more likely that they will take incremental steps. So, let us now look at each of these quadrants in more detail.

Failing

The failing firms are those that are both ineffective at increasing Throughput and are also undifferentiated in the marketplace. These are the “also-ran” firms in which management has been unable to produce enough throughput to sustain profitability.

Throughput leads to profitability via this formula:

Profit = Throughput – Operating Expenses (OE)

Recalling the definition (see Part 1) of Throughput, and substituting, we get this:

Profit = Revenues – Truly Variable Costs (TVC) – Operating Expenses (OE)

Of course, the ineffectiveness in producing profits is also linked directly to management’s other failure: the failure to differentiate itself in the market. It is far more challenging to produce a profit when all you have to offer is a “commodity”—a product or service that is so generic as to make “price” the sole differentiator.

Risking

Risking firms are sometimes “bleeding-edge” companies. These firms have found ways to differentiate themselves, but have not yet discovered how to make a profit while doing so. Their differentiation leads to demand, but the demand just adds more risk because they are losing a bit on every unit while trying to make up the difference in volume.

Competing

The competing firms are also stuck dealing mostly with “commodities.” They find themselves competing based on price more than almost any other factor—due to their lack of differentiation in the marketplace. The good news is that their management has learned how to be effective at producing a profit, at least.

Some firms are very comfortable in this role. They do not seek market leadership. If they are, then all of their profit must be predicated on business volume. They are generally hurt by significant economic downturns that kill sales volume.

Leading

The largest rewards (on a per-unit basis) are reserved for “leading” firms. Companies in this quadrant have both differentiated themselves in their markets and their management has proven itself effective at producing and increasing throughput.

Even as overall markets shrink, it is possible for such leading firms to prevail by taking a larger and larger share of the shrinking market. While sinking or shrinking companies are giving up market share, prevailing or leading companies can grow by taking over what is surrendered by vanishing firms.

Increasing breadth of market

In 2006, Chris Anderson, a former journalist at The Economist and editor of Wired magazine, published a book entitled The Long Tail: Why the Future of Business is Selling Less of More. The term “the long tail” comes from the appearance of a sales graph where lots of products (x-axis) are sold in smaller quantities (y-axis) into lots of different market segments. This book talks about the why behind the product proliferation we are seeing in many, many markets.

Although I am not a smoker, when I was a young man a recall that there were only a couple dozen cigarette brands sold in the U.S. Today, the tobacco industry has proliferated cigarette branding to perhaps a hundred varieties or more. Similarly, when I was younger, there were a few dozen major soft drinks: Coke, Pepsi, Mountain Dew, and so forth. Today, that has exploded into almost a dozen varieties of Coca-cola, alone.

In the 1950s and into the early 1970s, automobile makers produced a fairly limited range of options available for U.S. made cars. Many cars were sold out of the showroom or out of dealer inventory simply because they had a model in stock with all the options a particular customer might want.

Today, however, the number and variety of options available for U.S. made cars has grown to the point that one automaker claims that “no two cars delivered” are identical—even if they are inventoried by the dealer and sold out of dealer stock. Choices in colors, sound systems, trim kits, accessory “packages,” engines, seating, and more have led to satisfying “markets of one.”

[To be continued…]

Finding Common Ground Between the CFO and COO–Part 1

It seems as though many organizations are at war within. During boom-times, the war is more subdued, but is still there. But in tough—really tough—economic times the war is more evident than ever.

What is that war?

The war is that age-old dispute between meeting customer service level demands and holding inventory levels within reason. In really tough times, keeping inventory levels down becomes even more critical to the CFO—and the organization’s survival, perhaps—because cash held in inventory for long periods of time puts a real crunch in the vital cash-flow of the firm.

Now, it is likely that the COO will surrender in times like these. He or she will understand that (too frequently) it really is a matter of survival to maintain the cash-flow. So, the COO might say something like:

“Okay. I get it. I’ll reduce inventories as much as I can. But don’t blame me if we can ship orders or keep our customers happy.”

What are your options?

Some have put it this way: In tough economic times you firm is going to

1. Sink,
2. Shrink, or
3. Prevail.

I prefer to put that into four categories. Furthermore, I do not believe that those four categories are applicable only in tough times. I believe that they are fully applicable to every business enterprise all of the time. Here they are shown in the figure below: 1) failing, 2) risking, 3) competing or 4) leading.

I believe the determining factors in every business enterprise are inherently simple and are only two in number:

1. Effectiveness – The measure of how effectively the firm employs the monies invested and how effectively does it spends its working capital in the process of turning inventory (or services) into throughput? This is a measure of managements effectiveness in managing its internal workings and the inbound side of the supply chain.
   
2. Differentiation – This is the measure of effective management is in dealing externally in the outbound side of the supply chain. This measure covers everything from R&D (research and development) through to marketing, sales and customer service.

The problem with these two terms (i.e., effectiveness and differentiation) is not that they are hard to grasp. Everyone seems to know in a very general way that they need to manage the firm to be effective in using its resources and that, in order to be profitable, they need to differentiate themselves in the marketplace.The problem is that many people seem to have difficulty these two words into concrete and effective actions.

So, let me restate the same figure using a different set of terms.

Note that I have redefined the two factors as follows:

1. Effectiveness = Increasing Throughput
   
   and
   
2. Differentiation = Breadth of Market through Irrefusable Offers

But, in dealing with my clients, I go beyond that. I use Eliyahu Goldratt’s definition of throughput:

Throughput (T) = Revenues – Truly Variable Costs (TVC)

Now, simplicity is at the root of this whole approach.

I know the CFO needs to do certain things to satisfy other executives, the bank, investors, and others. I know he needs to do some relatively complex allocations of operating expenses to costs for various reasons.

But, the COO needs to have a way to tell his people—from sales to shipping—how to easily differentiate good actions from bad actions. And, those fancy allocations just get in the way—muddying up the waters—when it comes to decision-making in operations.

We will take a look at that relatively simple equation for throughput again. But before we do, we need to define another term: TVC.

Truly Variable Costs (TVC) are limited to those costs that vary in an absolute way with incremental changes in revenues. Typically, TVCs are limited to a few categories:

1. Raw materials
2. Contract labor or outside services paid for on a piece-rate or batch-rate
3. Commissions

You will note that so-called “direct labor” is not a part of TVCs. Here’s why: If your company sells, on average, 100,000 widgets a month, does your labor actually vary if, in month one you sell only 80,000 widgets and in month two you sell 130,000 widgets? In month one was your labor bill on 80 percent of “average,” and was it 130 percent of “average” in month three?

Probably not. Labor is an operating expense that does not vary directly with changes in revenues.

Given that premise for TVCs and going back to our formula, there are really only three (3) ways to increase throughput:

1. Increase revenues
2. Decrease TVCs
3. Increase revenues and decrease TVCs

Meanwhile, back at the war…

One of the problems with (the many times unspoken) “war” between the CFO and the COO is that when they do reach common ground, it is all too often found only in “cost-cutting” rather than looking at ways to increase revenues.

The reason for this leap to common ground, of course, is made most clear by my first figure: typically, both the CFO and the COO feel more prepared and confident in dealing with the internal operations than with all the nebulous factors that lie outside the organization. So, dealing with internal effectiveness trumps trying to achieve higher levels of market differentiation—especially in challenging times.

[To be continued…]

Simpler is better: Metrics not working? Check your complexity.

Are your metrics working against one another?

In the former Soviet Union (USSR), an professional weight-lifter was promised a bonus every time he broke a world record. So, being a shrewd “capitalist” (I guess), he decided to break world records one at a time—one or two grams at a time. Naturally, he got many, many bonuses, but it isn’t exactly what his handlers had in mind.

Some organizations pay rewards to their marketing department based on a “new customer” metric—the number of new customers garnered over a specific period of time. Of course, the idea is to build the customer base.

Meanwhile, many of these same businesses reward their sales department to meet or beat quarterly sales goals. So, in far too many cases, their salespeople are out burning through customers—alienating them through high-pressure sales techniques—in order to make their quarterly bonuses.

They may also reward their inventory managers to keep their inventory lean. So, while the salespeople are out making customers angry while getting their end-of-quarter orders (to get their sales bonuses), the warehouses are leaning out their inventory to meet end-of-quarter inventory numbers in line for their own bonuses. So, when many of those orders need to be delivered, they will be late—making the an already alienated customer all the more angry with the treatment endured.

I could go on, but I won’t. I’m sure you get the idea and you’ve suffered (or at least heard of) some similar well-intentioned reward systems go awry.

Some have suggested that these are “reward-motivated abuses,” seeking to blame the employees for doing exactly what management has told them to do, and for which management has agreed to reward them. How, then, can these be “abuses”?

Too much complexity

The problem here is not that the intended goals are not worthy: of course companies want more customers, more sales and lower inventories. The problem is the inherent conflicts evoked by the presence of too many “levers” being offered without linkages.

What’s lacking is a unified goal upon which the whole “system”—the whole organization—can be measured and each participant in the process of reaching that goal might be appropriately rewarded.

Simpler really is better.

“Simple” levers and the “simple” linkages

The linkages are simple, but in order to prevent your organization—or any part of your organization—from sacrificing tomorrow’s profits for today’s bonuses, your (for-profit) organization’s singular goal should be simple as well. Eliyahu Goldratt set it forth so clearly years ago: The goal is to make more money tomorrow than you are making today.

This simple goal is very easy to understand and very measurable—and it will help prevent improper actions like the following (an many, many more):

• Burning through customers to make short-term sales goals—because of the reduced long-term Throughput and the added operating expenses required to capture new customers
  
• Slashing inventory to reach inventory goals at the risk of alienating customers—because it drives Throughput down and operating expenses up
  
• Using company politics to cover or support inefficient or ineffective work efforts or policies—because it drives operating expenses higher (among other things)

Think about it. I think you’ll really like “simplicity” compared to “complexity” once you understand how it can drive your whole “system”—your whole organization—toward improvement (instead of piecemeal).

What do you think?

[Cross-posted at Kinaxis Supply Chain Expert Community]

What does technology project “success” mean to you?

I’m sure many of you are familiar with the common Venn diagram of “project management success.”

PMI (Project Management Institute) and others advocate that a project is successful if it is on-time, within the budget, and of high quality (or, at least, meeting the project’s original standards for quality). Of course, this is true when compared to the alternatives of over budget, late or of poor quality.

But, in the business world, we shouldn’t undertake projects—any kind of improvement project—for the sake of the project itself. So, while this might a satisfactory view of the project manager’s or the project team’s performance, it really doesn’t tell us very much about the net effect on the business.

Another popular Venn diagram used relative to technology deployments is the processes-people-technology one.


Here the aim is assure that the technologists involved in the project carefully consider the business processes that must be supported by the technologies deployed. Furthermore, the IT folks should also understand the people involved and they will desire to apply and benefit from the new technologies.

However, once again, we should be reminded that a business enterprise should never undertake any kind of improvement project merely to automate business processes for automation’s sake. Nor should they undertake an improvement project with the sole aim of people-pleasing.

In a for-profit organization, there are proper metrics to use for IT decision-making, but these are not the ones.

Consider, for example, the business that spends $150,000 on an IT project. The project is deemed to be “a resounding success” based on the following results:

1. The project was completed on time
2. The project was completed under budget
3. The project met all of the initial quality requirements
4. The project’s technology deployments properly supported the intended business processes
5. The project’s new technologies were well accepted and utilized by the people involved
6. The company was no worse off after this major undertaking (and everyone has heard the horror-stories of huge IT failures)

So, the project management team all got big pats on the back and a few VP’s got bonuses and all the stockholders and stakeholders are pretty happy about the whole “successful project” thing.

But, my question is: Should they be happy?

They just spent $150,000 with an admitted ROI (return-on-investment) of a big fat ZERO!

To me, that’s just not good business!

There is a Venn diagram that I, personally, have never seen, but it is the one Venn diagram that makes sense for business investments of every kind because it includes the three factors that should always be considered for “success.” Here it is.

Here are the questions that should be asked about every improvement project—IT-related or not:

1. How much does the project increase Throughput (where Throughput is defined as revenues less truly-variable costs directly linked to producing the revenues)?
2. What affect does the project have on Operating Expenses? Do they go up or down? If so, by how much? Is the change “real” or a calculation based on “savings” when no one will actually be laid-off or no additional Throughput will consume the man-hours “saved”?
3. How much will our Investment change? Besides (as in our example) the $150,000 we will invest in the project itself, will our inventory go up or down? Will we need to invest in new buildings, or can we sell off some capital equipment and increase our cash?

When you have the answers to these questions you will have the answer as to whether your technology project was just a “project success” or a “business success.” And, while the numbers may not be precise, knowing that they are approximately right will give you far better understanding of your company’s success or failure than not considering them at all.

What do you think?

[Cross-posted at Kinaxis Supply Chain Expert Community.]

The Dangerous Dichotomy—Part 2

[Continued]

In the preceding article we discussed how—all too frequently—management inadvertently creates a schizophrenic organization by assigning responsibility for increasing revenues to one part of the organization while assigning cost-cutting to another part of the organization. Usually the other part of the organization is everyone else—everyone not assigned to the task of increasing revenues.

What happens in such cases, is that the business is driven to a dichotomy that tends to pull the organization apart.

Of course, this effect of pulling the organization apart is entirely unintentional. Management wants to move the business toward greater profits and profitability. Sales and marketing—those generally commissioned with increasing revenues want the organization to succeed and grow. And, all the others, whose marching orders are to cut costs also really want the company to find success. So they are doing their best to keep costs down.

Nevertheless, seeming unreasonable demands made by sales and marketing are a nearly constant irritation to inventory and production managers. And what appears to be the simple inability of folks in purchasing, production, scheduling, warehouse and shipping to get their house in order so that sales and marketing can achieve their goals of increasing revenues is a cause of very real frustrations.

So, even though everyone in the organization really wants to move the organization toward success, it is clear that no one in it has a view of what it takes to make the whole organization—the whole “system”—move in the desired direction. Those who are instructed to “increase revenues” have no real view or interest in holding the line on costs or operating expenses. But, what is worse, those who have been instruction to “cut costs” generally have no visibility into what it might take to increase revenues. They are not privy to the “levers” that might affect increasing sales. Plus, the various departments involved in “cost cutting” are quite often, themselves, fragmented in their view of what it takes to be effective.

A simple example

Let’s take one simple example relative to supply chain thinking.

Most businesses vastly underestimate their losses from what they too frequently believe is a good thing. When they say, “Folks, we sold out of product X!” they are frequently thinking: “This is great! ‘Sold-out’ means we have lower inventories! It means we sold more than we expected to sell!” or similar thoughts.

But look at the results of out-of-stock conditions in the example above.

First, everyone needs to recognize that the things that “sell-out” are the most popular items. Second, because these are the most popular items, there is no reliable way to know how many more units the firm might have sold if they had had more units in stock. Certainly extrapolating from “average sales” is insufficient.

In our example (above), a product comes in five styles (‘A’ through ‘E’). The firm chose to stock 280 of each of these five styles and the quantities actually sold are found in the “Qty Sold” column.

In our scenario we are supplying what cannot actually be known—that is, the actual market potential (“Mkt Potential”) for each style. In this case, the firm ended up selling-out of two styles (‘C’ and ‘D’), while being overstocked on Styles ‘A’, ‘B’ and ‘E’. Extrapolating from “Average Sales” one might believe that the firm lost $5,400 in revenues. However, when calculated from “market potential” for each style, the actual amount surrendered in lost revenues due to being sold-out calculates to $12,900—more than double the estimated losses from averages.

Of course, this lost-sales number is a guess—since there is no reliable way to know the actual market demand for a sold-out item. But, what is not a guess is that when a business is out-of-stock on a popular item, it is almost certainly also losing sales on other items when customers go elsewhere for the items they are seeking. Plus, every time a customers goes shopping somewhere else, the “out-of-stock” business stands a good chance of losing the customer to another supplier.

Doubtless, reducing out-of-stock occurrences will increase revenues. That will help satisfy the sales and marketing team in our troubling dichotomy above. But, the question remains, can that be done in such a way that will satisfy what should be everyone’s goal: helping the business make more money tomorrow than it is making today?

[To be continued]

On Seeking Success

In a recent informal poll I conducted, I asked "Which ERP success is most important to your organization in the long run?" I offered the following options:

1. An ERP project that is on-time and within budget
2. An ERP project that increased throughput (i.e., revenues less truly variable costs)
3. An ERP project that reduces inventories or the need for other investments
4. An ERP project that reduces operating expenses

I was somewhat dismayed when the results were that fully two-thirds of respondents count success in ERP as a project that reduces operating expenses. The only worse answer, in my opinion, would have been "An ERP project that is on-time and within budget."

Here's why I believe that is true.

First, consider that I can dramatically reduce the operating expenses of any business enterprise virtually over night -- saving the organization, perhaps, millions of dollars every year -- and I can guaranty those results. All I have to do close the business. That automatically reduces operating expenses to zero.

If an organization is seeking "success," and they are making progress in that direction. It would seem to me that they would want more and more of whatever it is that they are calling "success." That would just make common sense, would it not?

But executives and managers that pin their "success" hopes on "reducing operating expenses" want only "partial success." Few of them are really endeavoring to reduce operating expenses to the "ultimate prize" of zero dollars.

What is worse is that they constantly face the law of diminishing returns. If they reduced operating expenses last year by five percent, the chances that they can reduce costs this year by another five percent are pretty slim, and even if they do, this year's five percent will still be a smaller actual dollar amount than last year's five percent. And next year will require even more effort for less dollar-savings.

However, for people caught in cost-world thinking, this does not seem foolish. They see no contradiction or futility in these efforts (sadly), ususually because that is all they know or have been taught to think.

On the other end of the spectrum are those one-in-three executives and managers who have discovered that real and enduring success comes from the "throughput" side of the business. If you can increase T (Throughput, which is Revenues less Truly Variable Expenses) this year by five percent -- all else being equal -- then you have made gains. In fact, if operating expenses have not increased, then that five percent increase in T falls directly to the bottom line just like a five percent reduction in operating expenses does.

What is even more exciting is the fact that there is no law of diminishing returns at this end of the enterprise. If you are able to increase T by five percent next year, that five percent will bring more dollars of profit to the bottom line than last year's five percent increase did. And next year's five percent will make an even larger contribution to stakeholders in the business.

Success on this end of the business -- if repeated year after year -- leads to real success, not "closing the business" (as "ultimate success" in reducing operating expenses does).

So, why are not more managers and executives seeking ERP success differently?

Why Small Businesses should invest in an integrated Excel-based Business Intelligence solution: Reason No. 3 | The BI Blog - Powered by Alchemex

 Business intelligence investments should always be made with the goal of using the information supplied for one of three purposes (listed in priority order):

1. Increase Throughput
2. Decrease Inventories or other demands for (new or increased) Investment
3. Slash or hold the line on Operating Expenses while sustaining significant growth in Throughput

Making more money in the service business

If you’re a regular reader of my writings, you will know that I do not endorse many products. And, even if a product delivers many outstanding benefits, I will give you the straight scoop about delivering on R.O.I. (return on investment).


Well, I just finished reviewing an outstanding product for the SMB (small-to-mid-sized business) service industry. If your company sells, installs and/or services high-value technical or industrial products – or even if you service products sold and installed by others (such as swimming pools and hot-tub systems) – SM-Plus(tm) from Single Source Systems could help you start making more money.

A study done by Aberdeen Group indicates that service companies that adopted end-to-end solutions that aided managing their business as a “system,” rather than in silos, saw an average of 14.2% increase in revenues over a two-year period. Since, for many service companies, their service revenues carry very little in Truly Variable Costs (TVCs), that means that almost all the dollar increase in revenues drops directly to the company’s bottom-line.
 
So, how does an service management end-to-end solution create this increase in revenue – and profit?
Here are a few of the key factors:

• Elimination of inter-departmental silos increases visibility of “bottlenecks” and helps executives and managers take effective action to increase Throughput.
• Integration with mobile computing devices reduces time lost for data-entry or trips back to the job site or warehouse. This means more available service hours are actually used performing billable services.
• End-to-end solutions are able to handle complex contract-based billing calculations, thus virtually eliminating “islands of information,” manual calculations and redundant data entry. This, in turn, means the enterprise can grow revenues without adding to operating expenses.

So, how would you determine if Single Source Systems’ SM-Plus would be a good investment for your service-centric enterprise?

The formula return on investment remains the same:
You and your team need to calculate how much your Throughput (T) (i.e., Revenue less TVC) might increase (see average of 14.2% over two years above, but calculate your own numbers) and any net effect on Operating Expenses (OE). Then, figure out what your investment would be to get started with a product like SM-Plus. Put those numbers into the formula for ROI (see illustration), and you can calculate your ROI simply and easily.

Give it some thought.

Drop me and email at rcushing(at)GeeWhiz2ROI(dot)com if you have further questions.

©2010 Richard D. Cushing

Technorati Tags: service management,SM-Plus,Single Source Systems,ROI,return on investment,Throughput,bottleneck,TVC,Truly Variable Costs,mobile computing,operating expenses,SMB,SME,Aberdeen Group

The Right Cost-Cutting Formula

The formula above is the only real formula that should be considered by companies considering cost-cutting during this recession.

Here is what the formula means.

The upper-case Greek letter delta (the triangle-shaped character) is used in mathematics as a symbol meaning “the change” or “difference.” Therefore, we read this formula as follows:

The change in P = the change in T minus the change in OE,

where P = Profit, T = Throughput and OE = Operating Expenses.

Throughput (T) is defined as Revenue (R) less Truly Variable Costs (TVCs), and TVCs are further clarified as only those costs that vary directly with incremental changes in Revenues. For example, raw materials probably vary directly with changes in unit sales of a manufactured item. However, production payrolls do not vary directly with changes in Revenues. If your firm produces 1,000 widgets this week and only 850 next week, but 1,200 last week; chances are the production payroll was substantially the same for each of these weeks.  Therefore, production payroll cannot be classified as a TVC.

Substituting for T

Since T = R – OE, we can substitute into our formula and make it read like this:

The change in P = the change in R minus the change in TVC minus the change in OE

Thinking about cost-cutting

Based on this formula, we can safely state the following:

• An increase in R will result in an increase in P, provided there is no change in TVC or OE
• A decrease in TVC will result in an increase in P, provided there is no change in R or OE
• A decrease in OE will result in an increase in P, provided there is no change in R or TVC

Where executives get into trouble during recessions

Pay attention to the “no change” clauses in the three statement above. These are critical, but all too frequently overlooked by executives and managers in making cost-cutting decisions. We just saw a terrific example of this with Toyota.

Some executives at Toyota thought that they could increase P (profits) by reducing TVCs through the purchase of lower-priced components for their automobiles. For a while, it probably worked. However, in February 2010, Toyota’s year-over-year sales for the month were down 43%, and for the first time in several decades, Ford Motor Company sold more units than Toyota in a calendar month. This is not to mention the fact that some billions of dollars will be expensed by Toyota over the coming months and years due to the recall.

So, what were the affects of Toyota management’s decision to reduce TVCs in order to increase Profits?

1. Revenues down 43% year-over-year
2. Several billion dollars added to Operating Expenses (OE) due to recall effort
3. Lost customers, which will require additional expenditures in OE (marketing) to reclaim
4. Additional expenditures in OE (public relations, legal, etc.) for damage control

Think it through

It is a simple thing for executives in a firm facing recessionary pressures think, “We will cut our operating expenses (OE) by laying off some people,” without considering the long-term affects that the move may have on customer satisfaction, for example. How many customers will be lost due to the cut-back in staffing? How much more will need to be spent in OE (sales and marketing, for example) to maintain the same levels of revenue as a result?

Use the formula

If, as an executive, you are considering cost-cutting, then consider the whole formula. Go over it with your management team. Carefully consider any short-term and long-term impact on Revenues and Operating Expenses. Do not simply assume that you can change one factor and the others will remain unchanged.

Contact me!

©2010 Richard D. Cushing

Taking the Easy Way (Down and) Out

In a LinkedIn group discussion today, many people were offering advice regarding how to save a small business that has been struggling due to the recession.  There has been no shortage of advice.  However, one comment today really stuck out to me. Here is what the contributor had to say:

A company is making 1 million a year.
From that it makes 10,000 profit (1%).
Each sale yields 25% return - i.e. if you sell 1,000 250 is profit.
To double its profit it can:
1. Reduce costs by 10%
2. Increase sales by 40%
Do the math(s). Which is easier?

Now, perhaps this example was intended to demonstrate what a clearly bloated and, likely, wasteful company really looks like. After all, the firm is grossing $250,000 on $1 million in revenues, but net profits are only $10,000 (1%).  That means that the firm is spending $240,000 (99%) on “expenses.”

If this is true – that the company really is bloated and wasteful – then, by all means, the quick and easy way to making more money is to “reduce costs by 10%.” It may even be likely for a $1 million revenue company that is spending $240,000 in expenses that $24,000 could be cut out and not do a bit of damage to the firm’s ability to survive and thrive.

The real state of things

For better or for worse, most small businesses today do not have a profit-and-loss statement that looks anything like that – at least not in terms of being bloated and wasteful. Most of the SMBs (small-to-mid-sized businesses) that I encounter are already running a pretty tight ship. There is no extravagance left in the firm’s operating expenses and, typically, they have already cut back on staffing so that many of the folks in the organization are working long hours and have taken on multiple duties so that fewer people are needed to keep things running. These organizations do not have any “fat” left to trim away. If they seek to cut expenses by even five percent (5%), it would mean cutting away “muscle and bone” – the strength that has allowed the organization to survive until today.

Cost-cutting may have gotten here

If management in such organizations are trapped in cost-world thinking, it could be that cost-cutting is what helped bring them to the brink of destruction, as it is. Here is how cost-world thinking can take a executives and managers astray and lead them to make decisions that are damaging to the organization:

Misleading allocations of overhead expenses

Using the figures offered by the contributor to the discussion (above), this company believes it has a gross profit of 25% ($250 for every $1,000 in revenues). Let us say that this is being calculated in the following (traditional) manner:

Cost Classification	Cost Amount
Raw materials	$250.00
Direct Labor	$100.00
Allocation of indirect costs and overhead	$400.00
Total Calculated Cost of Product	$750.00

For the sake of simplicity, let us say that each “widget” sells for a price of $1,000, so we have the following:

	Amount
Unit Revenue	$1,000.00
Unit Cost (incl. allocations)	$750.00
Calculated Gross Profit per Unit	$250.00

Also, let us assume that, due to the recession, this company also has excess capacity at this time.  (Otherwise, how could their operating expenses possibly be $240,000 on revenues of $1 million?)

Opportunity knocks

Now, one of this firm’s salespeople comes back from a long discussion with a potential new customer in Europe. This firm wants to buy up all the remaining capacity at the firm. That means 1,200 units. However, they are only willing to pay $650 per unit.  What should the company do?

Far too many executives caught up in cost-world thinking would turn this offer down. They would say, “We can’t take a loss of $100 per unit and ‘make it up’ in volume! That’s crazy!”

But, let us look at what is really happening. The company already has excess capacity. It could produce the additional 1,200 units without investing in any new facilities or equipment. Furthermore, it would not add to operating expenses, because no additional back-office staff would be required and no overtime is expected to meet the new demand. So, here is a contrast between cost-world thinking and reality:

COST-WORLD THINKING	Amount
Unit Revenue	$650.00
Cost-world Cost	$(750.00)
Gross Margin per Unit	$(100.00)
Number of Units Sold	1,200
Gross Profit from Offer	$(120,000)
Gross Profit from Current Operations	$250,000
Total Gross Profit	$130,000
Operating Expenses	$(240,000)
Net Profit	$(110,000)

Throughput Thinking

THROUGHPUT THINKING	Amount
Unit Revenue	$650.00
Truly Variable Costs (TVCs) (Raw Materials)	$(250.00)
Throughput per Unit	$400.00
Number of Units Sold	1,200
Change in Throughput from Offer	$480,000
Throughput from Current Operations	$250,000
Total Throughput	$730,000
Operating Expenses	$(240,000)
Net Profit	$490,000

Escaping from cost-world thinking

Here is a simple formula to help rescue firms from making the error we have illustrated above:

Where ROI = Return on Investment,
delta-T = Change in Throughput, where T = Revenue less Truly Variable Costs (TVCs),
delta-OE = Change in Operating Expenses, and
delta-I = Change in Inventory or Investment

In this case, we have determined that the change in OE = zero, and for simplicity’s sake, we have also assumed that the change in Inventory or Investment is zero (or negligible).

Essentially, when looked at properly this offer to “sell below cost,” actually increases the firm’s net profit by $480,000 with virtually zero investment. (In a real situation, some change in inventory is likely, but the effects would still be small.)

I trust this sheds new light on your business situation. Contact me at rcushing@GeeWhiz2ROI.com if you’d like to have help getting a better view of your business and how to make more money.

©2010 Richard D. Cushing

3 Ways to Make More Money

There is an old “saw” that that gets way overworked, and that is: “Every dollar of cost cutting falls directly to the bottom line.” Now, while this is true, most firms today are already operating in a fairly “lean” state – that is to say, they don’t have much “fat” to trim away. Maybe they don’t have any fat at all. If that is the case, then cost-cutting means trimming away at the “meat and bone” of their operations. Doing so will, inevitably, lead to a reduction in the ability of the organization to make more money in the future than it is making today.

Let me show you a better way.

Some definitions

Revenue (R)                               Income from sales

Truly Variable Costs (TVC)   Costs that vary in a direct way with specific incremental revenues where the relationship can be clearly stated in a mathematical formula (e.g., x dollars per unit – as in raw materials; or n% per unit as in sales commissions) but not an estimate (such as an allocation of overhead expenses that are not truly and directly variable with incremental revenues)

Throughput (T)                         Revenue less Truly Variable Costs (T = R – TVC)

Operating Expenses (OE)     All other monies paid out by the organization in support of the production of Throughput that cannot be classified as TVCs

Inventory or Investment (I)        All the money tied up in the organization in support of the production of Throughput

Increasing Revenues

Besides the risk of cutting away “meat and bone” during cost-cutting operations that are so prevalent during economic down-turns, there is another very large down-side to cost-cutting in general. That is this: If you can cut costs or expenses to save – let us be generous – 5% this year, will you be able to do the same thing next year, or the year after that?  Likely the answer is no.

After all, there is a finite limit to cost-cutting. The ultimate in cost-cutting is to simply cut your costs to zero, close the company and go home!

However, there is no theoretical upward limit to increasing revenues. No company has ever become an industry leader through cost-cutting. Companies gain industry leadership through finding and leveraging a competitive advantage that provides value to customers while employing labor and capital effectively.

So, let us consider what happens when a company increases revenues by five percent in lieu of cutting costs by that same five percent:

Scenario Number 1: A Five Percent (5%) Increase in Revenues
All Values in 1,000's
	Year 1					Change		Year 2
Sales	$      50,000						5.0%		$        52,500
Direct Materials	$      20,000		40%						$        21,000
Operating Expenses	$      26,000								$        26,000
Inventory	$      10,000								$        10,000
Total Assets	$      30,000								$        30,000
Net Operating Income	$        4,000						37.5%		$          5,500
Metrics
Net Profit	8.00%						31.0%		10.48%
Return On Assets	13.33%						37.5%		18.33%
Cash Flow (Note 1)	$        4,500						33.3%		$          6,000
Note 1: Assumes $500 in amortizations

Here we have a $50 million-a-year company that grows its revenues by five percent. They have direct materials costs (read: TVCs) that average 40% and operating expenses of $26 million annually. To complete the picture, the firm carries $10 million in Inventory and has total assets of $30 million. Increasing their revenues by 5% increases the firms bottom-line by a hefty 37.5% (from $4 million to $5.5 million). Net profit zoomed upward 31% and $1.5 million in cash was liberated in the firm. (Cash is always good – especially in a recession.)

Leaning the inventory

Now we will take another look at how to make more money even if you do not believe that you can presently increase revenues. What happens if our example company reduces their inventory by 20 percent?

Scenario Number 2: A 20% Decrease in Inventory
All Values in 1,000's
	Year 1						Change		Year 2
Sales	$      50,000								$        50,000
Direct Materials	$      20,000		40%						$        20,000
Operating Expenses	$      26,000						-2.0%		$        25,500
Inventory	$      10,000						-20.0%		$          8,000
Total Assets	$      30,000								$        28,000
Net Operating Income	$        4,000						12.5%		$          4,500
Metrics
Net Profit	8.00%						12.5%		9.00%
Return On Assets	13.33%						20.5%		16.07%
Cash Flow (Note 1)	$        4,500						66.7%		$          7,500
Cash flow includes (a) cash liberated from inventory, plus (b) cash savings in operating expenses based on 25% carrying cost of inventory reduction.
Note 1: Assumes $500 in amortizations

This looks pretty good, too, does it not? By reducing our inventories, we also reduce our carrying costs. Carrying inventory at this company costs about 25 percent annually (or about $500,000 per year). This alone adds 12.5 percent to the bottom line. But here is the big gain: $2.5 million in cash is liberated -- $2 million from the inventory reduction itself and another $500,000 from the reduction in Operating Expenses. (Remember: Cash is a good thing – especially in a recession!)

The double-whammy

What does this company look like if they both increase revenues by five percent and are able to cut their inventories by 20 percent?

Scenario Number 3: A Five Percent (5%) Increase in Revenues + A 20% Decreae in Inventories
All Values in 1,000's
	Year 1						Change		Year 2
Sales	$      50,000						5.0%		$        52,500
Direct Materials	$      20,000		40%						$        21,000
Operating Expenses	$      26,000						-2.0%		$        25,500
Inventory	$      10,000						-20.0%		$          8,000
Total Assets	$      30,000								$        28,000
Net Operating Income	$        4,000						50.0%		$          6,000
Metrics
Net Profit	8.00%						42.9%		11.43%
Return On Assets	13.33%						60.7%		21.43%
Cash Flow (Note 1)	$        4,500						100.0%		$          9,000
Cash flow includes (a) cash liberated from inventory, plus (b) cash savings in operating expenses based on 25% carrying cost of inventory reduction.
Note 1: Assumes $500 in amortizations

These numbers sing, don’t they? A 50 percent increase in Net Operating Income as it soars from $4 million to $6 million, showing a 42.9 percent increase in Net Profits and liberating an astounding $4 million in cash.

What does it take?

Get these kinds of results takes nothing more than understanding your business in ways you have not previously understood it – as a system. All you need to do is get you and your management team to understand and fully agree upon those few things that need to change in order to:

·         Increase Revenues or Throughput

·         Decrease Inventories or other demands for new Investment

·         Cutting or holding-the-line on Operating Expenses while supporting substantial growth

I can help.  Contact me at rcushing(at)geewhiz2roi.com and get started today.

©2010 Richard D. Cushing