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We are in the business of making money. Yet we often make missteps when it comes to increasing profits.
Here are three factors that I see frequently cause suboptimal profit decisions: The first two are ignored and shouldn’t be, while the third is emphasized and should be ignored.
1. Bottlenecks
By definition, a bottleneck is any activity that limits profitability by limiting throughput. Identify your bottleneck and manage it. Be aware that the constrained work center may be in a department like engineering, your supply chain, specially trained personnel, or your own approval processes. It’s not always equipment.
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When there’s an unacceptable backlog at the bottleneck that’s impacting lead times and profits, take action to shift sales to products and services that don’t require the bottleneck. Those orders can keep moving while others wait their turn at the constraint.
Additional sales orders that require an overcapacity resource may be profitable once you get to them, but in the interim it will cost you cash flow and customer faith in your brand promise. Sell something else that you can get out the door and get paid for now.
2. Complexity
In the good old days we used to simply order a beer. Now we are asked to specify the storage and serving attributes (bottle, can, draft; long neck or short; size; glass chilled or not), the product attributes (lite, lime-flavored, gravity, color, alcohol content out two decimal points, and age), and the processor (one of the big boys or one of the hundreds of specialty imports or local brewers) before we can get a drink.
While mass customization can maintain or increase sales, there is a point at which customers get tired of answering questions or are simply overwhelmed. And all those choices for customers add complexity to the operations, sales, and order entry functions.
The costs of complexity are not easily quantified, but rest assured that the more variables that exist, the more opportunity for error and the more transactions required. In industries where shelf life or style is a consideration, the more risk of distressed inventory.
There is methodology to reduce the internal impact of complexity (modularity, for example), but don’t think a labyrinth ever comes for free. The costs may be worth it to your business, but don’t overlook them.
3. Standard costs
Many accountants reading this article will take offense and say I have no idea what I’m talking about, but let’s briefly summarize how standard costs lead to decisions that hurt profits.
First, standard costs are the sum of a bunch of guesses, regardless of how educated the cost accountants are and how many decimal points are shown. Resources that could have been better utilized “invest” hours and hours (often months) in making up the standards. We then send good money after bad by demanding key managers explain why they didn’t hit the made up numbers last month!
All of those misused resources are only the beginning of the detrimental impact on profits. Profit center managers look at gross margins as if they are true, emphasizing products with the highest alleged margins at the expense of those with lower margins. Just how well do those standard costs reflect either the bottleneck or the relative costs of complexity? Spend a minute understanding what happens to the gross margins of your “winners” if the “losers” go away.
Look into target costing and lean accounting concepts as more useful alternatives.
Profits are good. They provide the money to further invest in the future of the business. That’s why building them is important, and unwittingly making decisions that reduce them can’t be tolerated over time. Improve your understanding of your business, the real financial impact of decisions, and you’ll grow your bottom line.
