Part 2 of a series on using T, I and OE for key decision making
Opportunities present themselves in various ways. Only seldom we see an opportunity which is so good that there is no point asking any more questions. Most of what looks like a potential opportunity comes with the doubt embedded in: is it really an opportunity or a trap?
A typical managerial conflict happens when Sales proposes a promotion, offering several products for a certain price reduction. Sales managers believe this would significantly enhance the sales of those products next month, and this belief is backed up by past experience.
A promotion creates huge pressure on the shop-floor, reduces the sales of other products and mainly reduces the sales for a certain period after the promotion is over. Yet, sometimes the extra revenues (minus the variable costs) generated, especially selling to new clients and gain their future purchases, more than compensate for the damage.
- How can we truly check the net financial impact of a promotion?
- How can we check the financial impact of penetrating into another market segment?
- How can we check the financial impact of launching a series of new products?
- How can we check the financial impact of purchasing a new production line as an elevation of our current capacity constraint?
We are aware that cost-per-unit is not the right tool to support sound decisions. So, how should we make such decisions?
The most straight-forward way is to assess the financial impact of the decision-at-hand on the bottom-line without relying on some funny ‘per-unit’ fabricated measures. It looks quite difficult objective due to the complication of the various expenses. However, when we look on the decision as an optional addition to the current level of sales we can see two clear factors that simplify the situation:
- The change in the incoming flow of money: the revenues from the change in sales, both the additional sales and possible loss of other sales, minus the truly variable costs of those sales. This is what we call Throughput (T).
- The change in the outgoing flow of money (all the other operating expenses called OE). Note, those additional expenses are all due to the required changes in the available capacity! This insight was revealed in the previous posts about the behavior of the cost of capacity.
What we get is: Delta(P) = Delta(T) minus Delta(OE)
Delta(P) is the change in net profit before tax. For the decision-at-hand we like to know whether delta(P) is positive or negative.
What information we need in order to get a good estimation of the above equation?
One obvious problem is the impact of uncertainty, which includes everything we don’t know at the time of the decision. We should come back to this issue in later posts.
From the general direction described so far the first step has to define the current state of the organization, as we like to evaluate the difference between the state with the additional decision and without.
There are two main categories of information describing the current state:
- The current sales. The items sold, their respective quantities, prices and truly-variable-costs (mainly cost of materials). We can then calculate the generated throughput (T) per item and the resulting total T – the flow of incoming money.
- The available capacity and the load generated by the current sales.
- In order to calculate the load we need to know how much capacity, for every resource, is required for every product sold!
Then we need the following categories of information for every new opportunity / deal / idea:
- The new sales / T to be generated by this idea, including longer term impact
- The impact of the new sales on the current sales – would some current sales be reduced?
- The updated load versus capacity – do one or more resources lack enough available capacity?
- When one or more resources lack capacity what special options are open?
- Purchasing additional capacity for extra cost (how much?)
- Reduce some sales, provided it can be practically done without tampering with other sales!
Critical questions for advancing ahead:
- Is it possible to gather all the above information?
- How long into the future we need to look in order to make a decision?
- How can we handle many different opportunities for the same time frame?
- How do we consider the impact of uncertainty?
- What is the structured process to make a sound decision?
- Is it too complex? If so, can we simplify it without distorting the decision process?