In every business there are hidden profits waiting to be exposed. Like with anything the way we look at our business determines what we see. Most of us use the lens of “cost” to look at and mange our business. We see everything we do, including people’s actions, where we look for improvements, and ultimately the decisions we make.
But there is another, more powerful, lens through which we can see our business. If you read last week’s post; Moneyball, Measurements and the Bottom Line; I showed a great example of how a different perspective can change entirely the decisions and the results that a company gets. Now I want to share with you the process that will help you see how to do this in your business.
Let’s first lay a little groundwork on the key measurements that drive profitability in any business and why we struggle to see these hidden opportunities.
Throughput and Making Money
The goal of our companies is to make more and more money. While sometimes it seems that we have to have an accounting degree to understand the intricacies of the financial statements, in reality it is pretty simple. There are really only three fundamental components of making money:
- Throughput- the money we generate from sales (the difference between sales and the totally variable cost of those sales which includes raw materials, parts and sales commissions).
- Investment- all the money tied up in things we can sell, including inventories, capital goods, real estate, etc.
- Operating Expense- all the money we spend to turn inventory into throughput—all costs that don’t vary directly with throughput
Understanding these measures is also pretty straightforward. We want more Throughput, less operating expense, and less investment. Actions which drive these measures in the right direction (or which produce a net gain) will increase the company’s bottom line. Actions that don’t will cause the company to stay the same or get worse.
Why We Focus on Cost
Cost is another term for Operating Expense and based on working with thousands of managers over the past 25 years, it is clear that the overwhelming majority of businesses tend to focus their efforts here. There are very good reasons for this. First of all cost is very tangible to people. It is pretty easy to calculate what we spend on things and its real money (in most cases). Second it’s assignable, so it can be controlled. We can readily measure individual departments on what they spend on things and even put it into categories that we can budget for and monitor.
We also focus on Operating Expense because Throughput is much harder to achieve this level of tangible control. Throughput is only achieved at the end of the company’s process when the product or service is delivered and we get paid. So it’s not easily assignable to any one department or function, everyone has to be involved.
Throughput is Number 1
While managers overwhelmingly say that companies tend to make Operating Expense the main focus, they unanimously say that Throughput should be the most important measure. After all we build our companies to “make money”, not because we want to “save money.” It’s quite a paradox, and the key to escaping it was created by Eli Goldratt when he developed the TOC principles.
Since Throughput is a team sport we can use the analogy of a chain. Any chain is only as strong as its weakest link. Goldratt called the weakest link the constraint, and he suggested 5 steps that any business, any organization really, could follow to increase its Throughput.
- Identify the Constraint- If we don’t know what dictates our throughput, how do we know what to manage, and what to improve?
- Decide how to exploit the constraint- The weakest link determines the Throughput for the entire company so it’s vital to everyone’s success that we maximize or squeeze the most out of it.
- Subordinate everything else to the constraint- Strengthening the non-constraints won’t strengthen the chain, so rather than optimizing their performance we should look for ways they can help the constraint do more.
- Elevate the Constraint- Every time we improve the weakest link, Throughput goes up.
- Go Back to Step 1- If we strengthen the weakest link enough, another link will become the weakest.
Hidden Profits in Throughput
People usually say these steps are common sense. The key to understanding the real potential of looking at your business with the Throughput-lens is recognizing that this common sense is far from common practice. Very few companies have done even the first step to identify the constraint. And even fewer have taken the steps to focus on their constraint and subordinate the rest of the business to it in a meaningful way. We have beaten cost to death in most businesses, but Throughput is almost completely untilled soil, waiting for someone to work it.
There’s another vital aspect to Throughput that magnifies its impact—leverage. Costs are spread out everywhere in the company so making a meaningful impact on the bottom line requires an awful lot of cost savings everywhere. And in any event costs can only be cut a certain amount before the reductions impact throughput. This is why people tend to believe that it’s not possible to make large improvements in the bottom line quickly.
Throughput offers enormous leverage to move the bottom line, and since we haven’t already tried to mine it like we have cost savings, it’s far easier to make large and rapid gains. Companies who just start to shift their focus to Throughput (to their constraint) routinely are able to increase it 20%, 30% or more in a matter of months through surprisingly simple changes. Even a 10% increase in performance at the constraint has a profound impact on the bottom line–a company making 5% profits, with 50% Throughput (selling price minus raw material costs) will double its profits. Such a jump would take years of cost cutting if it could be achieved at all.
Unlocking Your Profit Potential
The first step in taking advantage of this hidden source of profits is to look differently at your business. Start with Goldratt’s first step—identify your constraint. What limits your business from getting more throughput?
Many companies feel that their constraint is not having enough sales. If this is your situation, first look to see if you are delivering every order on-time, are not turning away any potential orders, and are not losing orders based on price or delivery. If so you are not fully exploiting the sales that are readily available to you. Taking steps to deliver on-time or faster will usually increase Throughput right away. Since having a market constraint means you have extra delivery capacity, even if you have to discount a little bit to get more orders, everything above the truly variable costs (raw materials mostly) goes straight to the bottom line.
If you cannot keep up with your current orders, then your constraint is somewhere inside the company. So find out where in your delivery chain things get stuck or slow down. Opening up the output of this area will increase your Throughput. Almost always this can be done without hiring or investing. The key is to look for how capacity gets wasted and focus your efforts on fixing it, so your constraint can produce more with the same people and equipment.
The key to uncovering new opportunities in anything is by looking at things in new ways. When you start to look at your business through the lens of Throughput, you’re bound to see a new world of potential avenues for increasing your profits.
I’d love to hear what you see when you look at your organization this way, so let us know what you find. Next week I have a great example to share with you of how one very traditional company found the courage to look at their business in a new way, using Throughput. It’s a great story that led to record profits and a promotion to the CEO position for the division manager. Sign up now to be sure you don’t miss it.