Many complex manufacturing businesses have come to understand that operational excellence is an on-going process in which companies strive to produce better results. It has an inherent collaborative nature and typically includes participation from all parts of the organization. But the challenge in manufacturing today is that the metrics upon which the business silos of sales & marketing, production, and finance are measured are all different which makes collaboration nigh on impossible. The outcome of this, in Lean parlance, is waste in the form of time not being used efficiently to sell and manufacture orders that produce the most profit with the existing production capacity, thus constraining the flow of profits to the shareholders.
A closer look at this issue reveals the following metrics used by each of these silos and the underlying problems at the heart of this muda*.
Sales & Marketing
- Metric – Revenue, Margin per unit
- Not sure sales effort is focused on most profitable customer opportunities
- Not sure how much profit each product or customer generates
- Too many products, not sure which to grow or which to rationalize
- Metric – OEE: Availability*Performance*Quality
- Hard to link productivity gains to sales and marketing decisions
- Not sure production lines are loaded to maximize profit
- Hard to communicate why Sales should sell the products we can make quickly
- Metric – Return on Equity, Margin per unit
- Limited visibility into which products and customers really drive Cash Contribution, EBITDA, & ROA
- Changing prices and costs weaken control over results
- Hard to project and track returns on capital expenditures
* Muda (無駄) is a Japanese word meaning “futility; uselessness; idleness; superfluity; waste; wastage; wastefulness”,and is a key concept in the Toyota Production System (TPS). Waste reduction is an effective way to increase profitability.
Profit per Machine Hour – The Missing Metric
Effective collaboration requires the use of a metric that all silos can agree upon. Today product unit margin is the metric most widely used to make decisions about pricing, production, and sales management. The margin per unit metric is necessary, but not sufficient, because it doesn’t take into account the speed the margin is flowing through the manufacturing process. As a consequence, companies find themselves with suboptimal capacity utilization; excessive equipment investment leading to overcapacity, and over-pricing that drives away profitable orders and lowers utilization. More muda.
In order to capture the speed at which margin is flowing though machines, it is necessary to use the time-based metric of cash contribution per machine hour. The profit per machine hour metric allows visibility into hidden pockets of profit in products that are low margin but move faster through the manufacturing process. When armed with this metric, sales and production have a common framework to make collaborative decisions about what to sell and produce to make the highest profit. For the first time, everyone is aligned in a new understanding of what drives profit in the business. The common metric drives alignment, breaks down the silos, reduces arguments, and can serve as a starting point for more effective pricing strategies and tactics.
To illustrate this point, consider a company with two products that have identical direct labor and materials inputs – but Product B is priced higher and requires twice as much processing time in the company’s facilities as Product A. Since Product B has a higher margin/unit, manufacturers typically view B as the better product to sell and produce. Although product B generates a higher cash margin per unit, Product A generates a higher return from the assets.
If the company only makes Product A, it can generate more profit per year compared to producing Product B. For many reasons (such as limited market demand or long-term strategic considerations), selling only A is likely to be an infeasible solution. Yet this analysis illustrates that the company is better off emphasizing A in its selling efforts and giving it priority in its production plans.
The metric of profit per machine hour enables management teams to understand the opportunity cost of producing different products on the machines based on how much cash contribution each product or customer delivers per machine hour. The management team now has the ability to optimize capacity utilization and manufacturing cash flow. Moreover, these insights are a crucial driver of organic growth for companies not at full capacity, as they pinpoint opportunities to reduce the price of high profit velocity products and capture additional market share. Less waste, and increased flow of profits to shareholders.
Profit per Machine Hour Metric is an Operational Excellence Roadmap
Understanding where to prioritize efforts in an Operational Excellence program will have a meaningful impact on the ROI of initiatives – the quicker you can reduce the muda, the faster profits will flow.
The following “profit topo map” shows how the common metric of profit per hour gives decision makers new insights. The two bubbles, B and C, represent different products. (They could also be customers, markets, regions, salespeople, production lines or plants). Which product is better? Sales and marketing would say B – because it has a higher margin. Production would say C – because it runs faster through the plant. But both products generate $900 of cash per hour – one has a higher margin, the other is made more quickly.
This is the finance view of the world – neither product is better than the other, they both generate the same amount of cash per hour. We can see that looking at margin alone could cause us to prioritize Product A and devote more sales and marketing dollars toward it. The contour lines representing profit per hour thus align all departments along a common metric, avoiding the sales & marketing vs. production, and margin vs. units per hour debates. The profit topo map separates out pricing issues versus efficiency/product issues. In addition, since cash or profit per hour directly drives return on assets (ROA), each contour line also represents a given level of ROA.
The profit topo map gives a simple yet powerful view of profitability that is much different from the margin-only view, and makes it easy to see possible strategies that will maximize overall company profitability. Most importantly, the profit topo map reveals the products that can be termed, “Hidden Winners:” those that are below the average unit margin, but are above the average cash contribution per hour. Normally Finance would resist selling more of these Hidden Winners because they would bring the average unit margin down.
But the profit topo map lets us see that these products are actually more profitable than average, that margins will rise if Hidden Winner volume expands, and that we should consider making precise price cuts to profitably gain volume and share on the Hidden Winners.
Who can Benefit from using this Metric?
The approach of using profit contribution per unit of time as the core principle for driving decisions about pricing, production, new capacity investments, customer and account management, and sales management is a superior approach to managing profitability over traditional cost accounting methods that present a distorted measure of profitability. Industries such as specialty chemicals, electronic components, metals and fabricated parts, packaging, and building products all have high opportunity costs of production capacity and represent businesses that have benefited most from using this metric.
By Tim Raven
Tim Raven leads Profit Velocity Solutions business development activities leveraging his more than 20 years corporate finance and business strategy experience. Tim has worked with both private and public companies ranging in size from middle market to Fortune 1000, and across a wide range of manufacturing industries including chemicals, metals, industrial, and consumer products. Tim was formerly a Director with Ernst & Young Corporate Finance and earlier in his career held positions with Barclays Capital in its Mining & Metals Group and with Arthur Andersen. Tim earned his B.A. Honors in History from the University of London.
Profit Velocity Solutions is a global, San Francisco-based software company with offices in New York, Chicago, Singapore, Shanghai, and Taipei. PVS has pioneered a unique platform for continuous profit improvement called PV Accelerator™.