December 5, 2018
From a financial perspective, throughput is defined as the revenues generated by a production process, minus all completely variable expenses incurred by that process. In most cases, the only completely variable expenses are direct materials and sales commissions. Given that only the true direct costs of the order are used, throughput dollars tend to be quite high.
Manufacturing velocity is defined as a measure of how fast the materials under process are moving toward a finished state—usually measured in units per hour or minute.
One can certainly argue that the way to increase profitability in a manufacturing or converting environment is to increase either or both on every order. There you have it, BoxScore readers, the holy grail of manufacturing profitability. The other method that is guaranteed to work is to reduce fixed costs, but most of you find that fixed costs increase each year, unless you can take very drastic action such as closing a plant or eliminating a shift. Now that you know the secret, let’s talk about how to make this actionable in your operating environment.
An order with high throughput that has very low velocity may be profitable, but low velocity means that it is clogging up your plant and not allowing you to take additional orders. Conversely, an order with high velocity and low throughput may look to be unprofitable on the surface, but could absolutely be a good order for you to take because it generates a good amount of throughput dollars. To make this decision, you need to evaluate the results against time. Time is the ultimate equalizer because, due to the laws of physics, it cannot be altered. You have only 24 hours in a day and 60 minutes in an hour. So, you need to plot your throughput divided by your velocity against time to make a meaningful decision.
At the end of the day, your most finite resource is machine hours, and most converters have embarked on initiatives geared toward maximizing the availability (uptime) of their equipment and minimizing defect loss. This is certainly a major factor in improving velocity, but certainly not the only one. Converters must evaluate whatever is slowing down (constraining) their overall processes so that the time from quote to cash is as small as possible and the overall number of units that the plant can convert is as high as possible. A large part of this results from being more selective in the order acceptance process and considering how an individual order can affect overall plant and machine capacities.
The primary obstacle preventing most converters from achieving far more of their true profit potential is the widely held belief that product unit margins fairly reflect the relative profitability of the various products that they make. The assumption is that ranking products by margin per unit ($/msf, contribution percent, fully loaded implied ROS) will ultimately translate into more total profit and better shareholder returns. This is a myth—an incredibly costly myth. Ranking products based solely on their margin per unit assumes that units of all products are equivalent (a ton is a ton), and that their primary difference is their relative margin dollars. In fact, margin per unit overlooks a crucial product attribute that drives that product’s ability to generate asset profitability: its production speed or flow rate (i.e., velocity). Most converters measure and record machine efficiency data. However, it is rare to find a converter who goes the extra mile of relating this data on an order-by-order basis to the throughput generated by the order.
Converters have large sums of money invested in their productive assets, yet they don’t look at their profitability as a function of return on those assets. Asset profitability is the result of both cash per unit and the unit flow rate. Together, these determine the profit velocity of each product, its ROA. Unless both margin and velocity are considered, profit analysis is skewed and leads to choices that cut dollars from the bottom line. With the metric of profit velocity, companies can identify their “hidden winners,” and instead of ignoring or rejecting low-margin (but high-PV) orders, management can start taking that business from the competition. By preferentially loading their machine capacity with these “hidden winners”—using price reductions and other techniques—plant utilization and profit can rise despite those price reductions. Additionally, management teams can also identify products that have high unit margins, but are so slow through the equipment that they have a low-profit velocity, also known as “false profits.” Instead of pursuing more volume from these high-margin/low-profit velocity items, management can rethink their approach.
To be able to see their previously invisible profit-gain opportunities, manufacturers need to measure the profit generated per hour for every order as it moves through production. Simply put, management teams must look beyond traditional cost-cutting and productivity-improvement programs to achieve and sustain superior shareholder returns. In today’s challenging economy, success depends on the ability to identify and capture hidden opportunities to extract greater profit from existing assets. So, consider changing your definition of contribution to one closer to the concept of throughput, and develop a system to accurately compare this to machine hours on a regular and systematic basis, and you will have a decided advantage over your competitors who continue to cling to the more traditional measurements.
Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or mitch@klinghernadler.com.
