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.

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]

Considering Project Accounting for Increased Profit

Many folks confuse the terms “project management” with “project accounting.” These terms are not synonymous. As might be inferred from their distinctions, project accounting is all about tracking the monies associated with projects. Project management is related to managing project tasks, time and resources.

While there are some software applications that handle both the project accounting (PA) and the project management (PM) aspects, most common applications handle only one side or the other. For example, Microsoft® Project™ is a very commonly used application for project management. It is worthless, however, for anything related to project accounting.

Why aren’t project management and project accounting found in the same application?

In most organizations, the fact that project management recording and project accounting transactions do not occur in the same application typically poses few hurdles to operational effectiveness. The reason for this is simple: typically the personnel intimately involved in managing tasks, time and resources (i.e., the project managers) are not the same folks who are intimately involved with handling the accounting aspects of the project (e.g., calculating, printing and sending the project invoices, making payments to project vendors, or assuring that expense or payroll transactions are processed on time). Therefore, the ability to share data via simple integrations or even via ad hoc queries or reports is quite frequently sufficient.

In fact, not infrequently, organizations actually prefer to have project managers and their activities kept separate from project accounting and its related activities. Doing so functions as a double-check and adds control in itself.

“We don’t do projects?” we hear you saying

You don’t think you’re in a “project”-type industry? Well, maybe you’re right. But consider these possibilities:

• Internal projects – Does your organization do internal projects for which you’d like to track costs accurately, even if you never bill anyone for the services? Do you do advertising campaigns? IT projects? Opening new locations? If so, then it is possible that your business could benefit from the additional controls provided by a project accounting solution.
  
• Engineer-to-Order – If you are a manufacturer in an engineer-to-order (ETO) industry, then project accounting might be applied to track your costs leading up to the manufacturing. Professional services and related costs and expenses can be tracked and managed using project accounting’s capabilities.
  
• Installation or After-Market Service – If your manufacturing or distribution operations extend themselves into the fields of installation, configuration or after-market service, then chances are project accounting is not the right solution for you. In such cases, you should read the section on Service Management.

What can Project Accounting do for you?

There many time-saving functions brought to you through the project accounting capabilities that dramatically reduce the time, energy and effort that would otherwise be required. Here is a sampling:

Profit Recognition

Projects may recognize profit/(loss) in several different ways. Most PA solutions allow users to assign the profit recognition method by project. The typical profit recognition methods include:

1. Manual
2. Cost-to-cost percent
3. Percent of revenues
4. Non-WIP
5. Project completion
6. Percent of elapsed time

“Percent of elapsed time” is a profit-recognition method commonly used with prepaid date-limited service contracts. If this is a common method in your firm, be sure to investigate Service Management solutions as well. In some circumstances, service management may be the more appropriate solution to apply.

Project Billing Methods

Project accounting software typically offers several options for billing and projects may be of different billing types:

1. Time and materials
2. Fixed price
3. Fixed price plus

When a project is designated a “time and materials” billing type, most project accounting systems allow the materials items to be passed through at cost to the customer, or billed with a mark-up add to designated materials and other non-labor charges.

Billing for Employee Time

Businesses that bill their clients for employee time spent on various projects often face the daunting task of keeping the billing correct based on agreements with their various clients. Not infrequently such agreements may involve complexities that would require considerable time and care if attempted without the support of a project accounting system.

For example, clients may negotiate different rates for different specific employees when working their projects. Indeed, they may end up negotiating different rates for the same specific employee on different projects—several of which projects may be underway at any one time with the same client. As you can imagine, assuring that project billings are assigned the right rate for the right resource on a project by project basis could become a difficult task. Project accounting systems handle such billings effectively and simply with little effort.

Add to the potential complexity described above the ability to also bill different rates to different projects or different customers based on the employees’ titles in their assignments to different projects and you can readily see that manually tracking all of the potential combinations could become a nearly impossible task. Here, for example, employee Jim Smith might bear the title “Project Manager” on one project for one client and, as the Project Manager be billed at $225 per hour. However, due to Jim’s lack of experience in another type of project, he may bear the title “Developer” on that project and be billed to the same client (or a different client) at a rate of only $150 per hour.

Increasing throughput and profits

Now, you might say, “I don’t need all that complexity in my projects. We’re content with billing just one rate per project, one rate per client, or one rate per employee across all projects and clients.

Our question in response is this: “Why wouldn’t you want to make more money tomorrow than you are making today if you could do so without adding significantly to your operating expenses by doing so?”

We ask this because this is precisely what a project accounting solution could do for you and your firm.

Chances are your client’s aren’t stupid. They know that a good and effective project manager is more valuable to them than a heads-down programmer or a project secretary or, perhaps, a QA staffer. Right now, you are likely charging the same for each of these, which mean you must be using an “averaged” rate.

By adding project accounting’s flexibility, you are also adding the low-cost option of further segmenting your market and closing more deals. You can charge clients more or less based on how your crack sales team identifies the prospect’s or client’s view of “value.” Two projects that are virtually identical in their execution may have two significantly different values to two distinctly different clients. Consider the following chart:

Project ID	Est. Project Cost	Est. Project Revenues	Est. Project Profit
A	$ 165,000	$ 260,000	$ 95,000
B	$ 165,000	$ 220,000	$ 55,000
C	$ 165,000	$ 200,000	$ 35,000

Here we see virtually identical projects on the “cost” side. However, three different clients perceive the “value” of the efforts differently in their businesses. One is willing to pay $260,000 for the work; another is willing to pay $220,000 for it; and third sees only $200,000 in value and won’t pay a cent more.

If your PA system only allows you to charge these clients one rate—or if you don’t want to burden your accounting department with manually managing different billing rates per client—you may be tempted to turn down Projects ‘B’ and ‘C’.

Why give up the profits?

But, if your firm has the capacity to do projects ‘B’ and ‘C’, and no more profitable project prospects stand in your way, why would you turn down an extra $90,000 ($55,000 plus $35,000) in project profits simply because your accounting system makes it too difficult to manage. (Actually, that is not the reason such profits are all too frequently passed by. Instead, it is because executives and the sales team—hemmed in by preconceptions about their accounting limitations—never think of making these offers. Instead, they offer their ‘bids’ using the firm’s standard costs and markups and end up losing the deals for Projects ‘B’ and ‘C’.)

Leveraging new capabilities for new profits

In short, leveraging the new flexibilities delivered by a project accounting solution may allow your firm to dramatically increase revenues and profits through market segmentation. However, doing so means bringing to your firm new ways of thinking (as seen above) and an understanding how newly delivered capabilities can, in fact, be applied to create new markets or extend existing ones. This means finding the right implementation partner is essential.

It is imperative that you not make the common mistake made by some many executives and managers when considering the purchase and implementation of project accounting software. Typically they spend more than 90 percent of their time and effort in what the process of “software selection,” carefully considering a long list of features and functions. Then, when this is all done, they simply take whatever consulting firm and consultants come along with the software. We believe this is a wrong-headed approach and many firms to make investments in software with little return on their investment.

There are three critical aspects necessary for a project accounting implementation leading to rapid and high return-on-investment:

• The ability to unlock “tribal knowledge”
  
• The ability to reduce complex problems to simple solutions
  
• The ability to help your organization “design” new ways to leverage new capabilities for increasing throughput and profit

If the software reseller cannot bring to your firm these critical elements, perhaps you should look elsewhere.

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?

Collective Fixation on Short-Term Profits

Vivek Sehgal brings up an important point in the post Putting Your Money Where Your Mouth Is (3 March 2010) here at Supply Chain Expert Commnity. Even though, at GeeWhiz To R.O.I. I talk a lot about the the goal of business being to make more money, I generally add ...tomorrow than you are making today. Making more money "tomorrow," should not be predicated on actions that will diminish the long-term prospects for making more money. Nevertheless, a lot of companies -- especially publicly traded companies -- have a fixation on short-term profits that is damaging to the long-term health of the enterprise.

W. Edwards Deming diagnosed this issue early and brought it to our attention about 30 years ago. He called it "paper entrepreneurialism." The investing relationship of real entrepreneurs looks like this:

Entrepreneurs sitting in this relationship have a vested interest in the ability of the firm to produce profits over the long term. Such investor-entrepreneurs seldom intentionally make decisions to reap short-term profits at the expense of the long-term prospects for the business.

Speculative investors have a slightly different relationship with the firm(s) in which they take stock. That relationships looks like this:

The most connected investors are those that hold a relationship similar to that of the real entrepreneurs. They invest in shares directly with the company (or at least have an more intimate relationships with the firm and knowledge of its management, even if they must make their stock acquisitions through a broker). However, most of the investors agreed to buy stock in the specific firms based on the advice of their broker. They may know little or nothing about the firm or the firm's management directly. They trust the advice of their broker.

The intervention of the broker/brokerage house makes buying and selling of stocks easier, and the brokers are typically incented to produce results (return on investment) for their customers (the shareholders) over both the short-term and long-term. The focus of the broker and the guidance given to the investors will vary based on personal preferences. Nevertheless, it is easy to see that the investors are abstracted from their investments by the borkers and management at the publicly held companies must satisfy the short-term expectations of the brokers or, in the interest of their customers, the brokers are likely to shift investment away from companies performing poorly in the short-term in favor of those with better short-term returns on investment.

Paper entrepreneurs are even further abstracted from their holdings as shown in the following diagram:

With the introduction of mutual funds and government-incented retirement plans, more capital has moved into the markets, but at the price of having the investors abstracted from the companies in which their dollars are invested by three or four layers, which layers tend to be focused entirely on short-term performance and profitability. By a huge factor, a majority of the investors in today's capital markets do not even know the names of the companies in which they hold stock. How can they be anything but "paper entrepreneurs"?  They seek the highest return on their investments without any concern for the long-term viability of the companies providing the returns.


Consider that the mutual fund manager. He care not one whit for the companies in which the fund he manages invests beyond the companies' ability to provide solid growth for the mutual fund over the next reporting period. He will gladly shift millions from company A to company B at the hint that company B's short-term return will outstrip company A's performance.

Next in line come the brokers and the brokerage houses. They are willing to recommend mutual fund C over mutual fund D on the basis of their likelihood of producing short-term returns to the investors. The brokers and brokerage houses are incented to provide this kind of advice without consideration for the long-term survivability of the companies which their investments ultimately reside.

Then, of course, for the vast majority of investors, there are the corporate retirement and pension fund managers. They, too, have only one incentive: to see good performance in the funds they manage. They, like the investors themselves, quite often have no knowledge -- ultimately -- about the companies in which their investments ultimately are put to use.

All of this leads to the boards of directors in publicly-held companies providing incentives to their chief executives to provide short-term profitability so as to keep market capitalization up -- which is almost entirely based on stock prices. So, how do CEOs and CFOs react to all of this? They are willing to sacrifice the long-term prospects of their own organization for short-term performance during the particular CEO's or CFO's term in office -- and their successors will do the same.

This constitutes a grave danger to publicly-held companies in the U.S.  What is the answer?

Contact me!

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