Applying the Theory of Constraints (TOC) to drive Economic Spread can be simple. Just look at customer and product profitability through a constraint-based lens. The key is knowing what the constraint is for the products and what the margin per minute is for each product that gets produced through that single, constrained unit. With that data in hand, organizations can quickly visualize which products, customers, markets, etc. generate (or destroy!) the most profit in the organization.
How can firms easily analyze their organization’s profitability? By using Profit Velocity Solutions’ Profit Topo Map --a tool which provides a margin per minute or cash contribution per hour (CCPH) view for products, customers, markets, regions, salespeople, production lines or plants. CCPH provides a common metric that gives a firm’s management team deeper insights into which product may be the most profitable.
Between the two products, B and C, which is better? The typical Sales & Marketing versus Production debate that could occur are turned into productive alignment, as each team is looking at and making decisions based upon the same metric. The contour lines representing profit per hour show an equal profitability of $900 – now it is a matter of difference between the one that provides a higher margin and the other that is made more quickly.
There’s another consideration that the Profit Topo Map can solve for. As shown, the map effectively separates out pricing issues from efficiency/product issues. But the approach of combining margin and velocity grows in complexity when a company is dealing with thousands of products rather than a mere handful. Fortunately, TOC works for asset-intensive/complex manufacturing with the same level of efficiency that it brings to companies with fewer SKUs.
Cash or profit per hour directly drives EBITA. In the above figure, each contour line represents a given level of ROIC. Thus, it is easy to begin to theorize the impact shifts in production would have on Economic Spread. Using PVS’ CCPH companies can start to evaluate the possibilities of “what if”:
If we shift 1% of the product mix from the lower left quadrant to the upper right quadrant, what impact will that have on Economic Spread?
What actions are needed to realize this shift?
Are there substitute products that can be leveraged to enable the shift?
If we can’t change the throughput across our bottleneck unit, can we change other factors that will raise the overall contribution margin?
Scenario-based decisions allow for quicker refinements and more accurate forecasting, which lead to the ultimate goal: increased profitability. Companies can typically capture a sustainable 2 – 3% increase on ROIC and Economic Spread over the next two to three quarters without making a material change to invested capital. They can realize that increase while reducing working capital at the same time. The benefits are there through the Theory of Constraints. Embrace and exploit the constraint and even the most complex manufacturing companies can capture this value. All it takes is a little time.
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