A Better Way to Understand Product Profitability

Many companies calculate product profitability by subtracting a Standard Cost from the Price and calling it a Margin. But this calculated margin does NOT tell you how much money you are making. It tells you almost nothing about the profit you are making because the standard cost is made up from a lot of tenuous allocations.

So what’s a better way to look at this? We have had some good success with calculating Contribution per Minute. This method gives you real information about how much money your products bring into the business in comparison with other products. It also works well for figuring out customer profitability.

What Is Contribution Per Minute?

Here’s the equation:

Contribution/Minute = (Financial Contribution / #Minutes through the Bottleneck Operation)

A simple example: if you have a product that sells for $1,000 and the Material Cost is $400 and the cycle time through the bottleneck (or constraint) operation is 10 minutes, then the Contribution/Minute is = ($1000-$400)/10 = $60

You can calculate this for each of your major products and then compare the relative financial impact of selling those products. You can accumulate these numbers across product families, and you can calculate the true financial impact of servicing particular markets and customers.

There’s a Little More To It Than This

Strictly speaking, we calculate financial contribution as the revenue received minus the variable cost of making the product. The variable cost includes the material costs and any other costs paid for outside of the company. An outside process (like heat treatment, for example) would be a variable cost. Labor time and machine time would NOT be variable costs because these costs are largely fixed from one day, week, or month to another give or take some overtime costs. Your company is paying your people irrespective of what they make; and similarly for the machines.

If you manufacture in batches and have significant change-over or set-up times, then you may need to add (change-over time/batch size) as an extra amount of time in the bottleneck minutes.

There is sometimes a need to make adjustments based on other processes outside of the bottleneck if there is a wide variation of process choices beyond the bottleneck. But this is usually not the case when you have well defined Value Streams.

How Does This Help Me?

photoI have been working with a company that makes large forged components used in industrial machines and vehicles. They have two value streams; one for large forgings and another for smaller forgings. The production process has 7 or 8 steps and the bottleneck operation in each of the value streams is the actual forging process itself. The forging process determines the rate of flow of the product through the whole value stream.

This company calculates the Contribution/Minute for each item (or batch) that flows through the value streams, and sums these up throughout the day. This enables them to monitor the amount of money being generated for the business in a very dynamic way.

Their sales and marketing people use the same information to understand the financial impact of their sales plans and marketing campaigns. They strive to optimize the production mix based on the markets, the customers, and the financial contribution. They also keep track of the cumulative Contribution/Minute for their major customers and specific markets.

The people designing new products use the same information when target costing the products and this leads them to design for maximum flow and maximum contribution.

Why is This Better Than Standard Margins?

This is a much better way to calculate the relative profitability of your products, markets, and customers because the Contribution/Minute is a REAL number. It actually shows you how much money is going into the bank as a result of your work.

A Standard Cost Margin does not tell you anything about how much money is going into the bank. In fact, Standard Cost Margins almost always lead to poor decisions. Companies take orders that make very little money but show a good margin, and also turn down good profitable orders because the margin is too low. These decisions (made in good faith but with poor information) are damaging to the company. Similarly, these companies often outsource production and others services when in fact the most financial benefit would come from making them in house; and vice versa. I have seen these dangerous misunderstandings occurring in many different companies large and small, lean and non-lean.

Another thing Contribution/Minute does for a lean company is to focus attention on the flow. Everybody from sales to operations, purchasing and accounting is consistently making decisions based on flow rate. Contribution/Minute motivates lean improvement to eliminate waste and free up capacity so that more product can better flow through the value streams. Standard costing methods have the opposite effect; they undermine lean.

Important Conclusion

Measuring Contribution/Minute is a smart way to run a production business because it is one simple calculation that everybody can understand; it give you real bottom line numbers that lead to greatly improved financial results; and it drives solid lean behaviors and improvement.

Lean Accounting in the Defense Environment by Vince Trnka

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Brian Maskell writes:  This is another in our series of “guest” blogs.

I first met Vince Trnka at the University of Kentucky. I was teaching a 3-day class on Lean Accounting and Vince was palpably excited about the work. Soon after, he became a Lean Accounting Pioneer CFO in the context of defense industry suppliers.

What made this a Lean Accounting success story?  Strong leadership and vision from the company’s senior management team. 

Mr. Trnka writes: I have worked in the defense industry for 35 years and have been engaged in Lean Accounting since 2006.  My company is a large defense contractor.

Some Background

At my company, we were running a typical MRP system and assigning cost to specific contracts.  We placed emphasis on making large batch buys to reduce material costs and ran large lots through the factory to spread the set up cost over a large batch run.  Cash management was largely driven by direct procurements on cost-reimbursable contracts and by assigning inventory to contracts having the progress payment clause.  This approach was typical with U.S. defense contractors in the early 2000’s.

Within the company, we talked about moving to a Lean manufacturing environment, but most of our business was sole-source and we were achieving a decent profit. Getting motivated to change was a struggle. Then, along came competition, defense cuts and a change in control.  The acquiring company was a “Lean” company and our management was strongly encouraged to move in this direction.

As our manufacturing systems were undergoing Lean transformation, a number of issues needed to be addressed, among them: we needed to measure the efficiencies we were experiencing in the factory; and government contracting did not lend itself to Lean Accounting as an acceptable cost recovery system.

I had some false starts looking for a method of accounting for Lean; everything said Lean Accounting was nothing more than activity based costing.  After some research I came across Brian Maskell’s book Practical Lean Accounting [i] and attended his seminar in Kentucky.  After this three day course, I knew this was exactly what I was looking for, but I needed to bring the training back to my facility.

I knew the Lean transformation was not strictly a finance function, but that it needed to be totally supported by all areas of the company.  Brian came to our facility and provided the same training to my management team and key value stream members.  It was not an easy sell, but the logic and simplicity of using the techniques Brian was teaching made believers out of our most entrenched MRP people.  Don’t get me wrong. I do think MRP is a good tracking tool for our cost-reimbursable business, but we found most of the business could benefit from Lean Accounting.

Next, we sent a number of our key finance and manufacturing people for more specialized training.  We selected to pilot Lean in a product area where we were having quality issues, costs were increasing, and we had a large inventory investment. But even more importantly, where we were losing market share.  This product area was unique and widely-used in a very sophisticated and growing market.  Competition was strong and not just from U.S. businesses.  As in most government business, the low bidder would get the award.  We were considering dropping this product line if we could not improve quality and reduce cost.  Perfect for incubating Lean techniques!

What we Did

We moved all the stock out of the stock room and on to the factory floor.  This created a big supermarket of parts, but made visible all the stock we had, as well as the task in front of us: reducing the cash investment in stock and flowing this stock into the production cycle.

At this time we took a leap of faith and removed these parts from MRP (for planning) and went to a visual kanban system.  As a word of caution, we found out later on a different product line you cannot run MRP and kanban on the same parts at the same time.

We also physically moved the buyers to the production area and expensed material and labor as incurred.  This is an act of heresy in the government accounting world, but our overall objective was to improve quality, throughput and cash flow.

This also meant that we needed to do a physical inventory count during the closing process. This is where upper management support was very important because we had to change how we counted inventory.  WIP inventory on the floor was assigned a value-added labor amount which was predetermined based on where the product was staged.  We needed to modify the pricing model used for the government contract and went to a value stream pricing model.  Making these changes took strong management support.

After three months, our inventory turns went from 2.5 to over 10. Capacity more than tripled because we eliminated the stock room and reorganized the production line.  Profitability improved. We moved to weekly income statements, eliminated non-value added (aka wasteful) functions and addressed quality issues immediately during the production process not at the end. And we reduced lot sizes.  All these actions allowed us to compete successfully in the market place and significantly pick up more market share.

In Conclusion

I am very sure if we had not converted to Lean manufacturing methods and used Lean Accounting to measure how we were doing, we would have discontinued this product line.

The success of this product line using Lean Accounting and Lean manufacturing techniques had very profound effects on the company.  We expanded this approach into other product lines and achieved more favorable results.  And, we expanded Brian’s methods into two other sites.

Lesson learned:  To achieve real success, the management team needs to be totally engaged and visible throughout the whole process.

 


[i] Maskell, Brian H.,  Baggaley, Bruce, and Grasso, Lawrence, Practical Lean Accounting: a proven system for measuring and managing the lean enterprise, now available in its second edition  (Boca Raton. FL, Taylor & Francis Group, CRC Press, 2012)

Untangling Complexity with Lean Accounting by Eldad Coppens

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 First, a note from Brian Maskell:   
 Eldad Coppens is the CFO of Qfix.  Mr. Coppens  holds an MBA from the Wharton School of the University of Pennsylvania and a BA in Economics from Princeton University. Before becoming an investor in and officer of Qfix, He was Managing Director of Credit Suisse First Boston, a leading global investment bank.
 

Dan Coppens (CEO) and Eldad Coppens (CFO) with Qfix positioning device.
Dan Coppens (CEO) and Eldad Coppens (CFO) with Qfix positioning device.”Qfix is a world leader in the design, manufacture and marketing of patient positioning and immobilization products for radiation therapy, located in Avondale, PA, just west of Philadelphia.  Our business is characterized by a high degree of vertical integration, a broad portfolio of products manufactured both by us and by others which we distribute worldwide, and a significant level of organizational complexity involving managing everything from an intensive research and development program for new products, 24/7 manufacturing facilities, a full-fledged customer service operation, a direct sales force spanning the continental U.S., and a global distribution network everywhere else.”Qfix is a world leader in the design, manufacture and marketing of patient positioning and immobilization products for radiation therapy, located in Avondale, PA, just west of Philadelphia.  Our business is characterized by a high degree of vertical integration, a broad portfolio of products manufactured both by us and by others which we distribute worldwide, and a significant level of organizational complexity involving managing everything from an intensive research and development program for new products, 24/7 manufacturing facilities, a full-fledged customer service operation, a direct sales force spanning the continental U.S., and a global distribution network everywhere else.

“Qfix is a world leader in the design, manufacture and marketing of patient positioning and immobilization products for radiation therapy, located in Avondale, PA, just west of Philadelphia.  Our business is characterized by a high degree of vertical integration, a broad portfolio of products manufactured both by us and by others which we distribute worldwide, and a significant level of organizational complexity involving managing everything from an intensive research and development program for new products, 24/7 manufacturing facilities, a full-fledged customer service operation, a direct sales force spanning the continental U.S., and a global distribution network everywhere else.

If you look at our website at www.Qfix.com, or download a catalog there, you’ll understandQFix_Products the breadth of our product offering.

Before we discovered Lean Accounting and BMA, we were already deeply engaged in implementing Lean Manufacturing and the Lean mindset in our organization.  As a manufacturer, the initial appeal was to maximize the efficiency of our production lines, and so we were already busy creating value stream maps and introducing visual management tools such as kanbans and charts for various productivity-related metrics.  In all of our reading and learning about Lean, we occasionally came across the concept that accepting the Lean framework also implies abandoning traditional financial and accounting paradigms.

We were eager to learn more.  Frankly, we had never been satisfied with the quality and utility of financial information produced by using the traditional cost and financial accounting approaches.  Trying to understand the cost of a production unit by allocating/absorbing such fixed overheads as rent, back office, utilities, etc. or even direct labor, which is also essentially a fixed cost, never seemed satisfactory either as a foundation for tracking costs or for pricing products.  And traditional financial reporting might be a guide to overall profit and loss, but was useless for answering the question we were always asking ourselves, which was “why and where do we make (or in some instances, perhaps unaware, lose) money, and how can we use that information to make good decisions and improve our results?”

Anyone who has ever taken an introductory course in Microeconomics is indoctrinated with the concept that while the average cost of a product is a function of both fixed and variable costs, rational economic decisions are made at the margin.  Profitability is maximized with increasing output as long as the marginal (variable) cost is less than the price that the marketplace will offer for a product.  So why is it that traditional cost accounting focuses so much firepower on time-consuming and misleading calculations of average costs by endlessly determining the fixed cost “content” of a unit of production and deviations from “standards” determined in circular fashion by the same methodology?  Lean Manufacturing teaches us that running an efficient process is all about smooth flow and removing bottlenecks which produce unnecessary inventory, poor resource utilization and wasted effort.  In other words, you maximize efficiency/profitability when you optimize the exploitation of your fixed costs.  This is an approach entirely consistent with sound Microeconomics, but at odds with traditional accounting.   Lean Accounting not only addresses this conceptual flaw – it also eliminates a great deal of accounting drudgery that is costly, counterproductive and anything but lean.

Having experienced the epiphany of our initial encounter with the concept of Lean Accounting, we were thrilled to be able to work with BMA, the Lean Accounting Leaders (yes, they really are), to bring its advantages to Qfix.  In 2011, we happened to be in the process of implementing a new ERP system, so we decided to take the opportunity to create an entirely new Chart of Accounts mapped tightly onto our identified value streams.

The benefits of implementing Lean Accounting in our company have already been manifold.  To list a few, we now have:

  • Financial data that provides a quantitative “x-ray” of our operations along all of its major dimensions
  • Timely reporting in a straightforward, actionable format – rather than wait to close out a month, by which point one is increasingly staring in the proverbial rear-view mirror, we receive bi-weekly reports of real-time information that highlight variations in performance and spending in a palpable manner.
  • Financials that are consistent with GAAP without the distortions of traditional GAAP accounting – in fact, one of the benefits of Lean Accounting is that it provides increased insight into both the strengths and weakness of GAAP accounting.  Lean Accounting, because of its focus on tracking the flow of resources and spending in real time, is a superior tool for monitoring cash-flow generation (though it is decidedly not cash based accounting).  Lean Accounting also clarifies inventory measurement and valuation by dispensing with the notion that fixed costs are somehow absorbed in inventory and sitting on a shelf (with the perverse distortion that profits are actually magnified in the process of inventory accumulation!).  In theory, GAAP accounting’s approach of matching revenue accruals with associated costs is designed to provide a more faithful guide to actual performance, by adjusting out timing effects related to cash inflows and outflows.  However, adjusting out flows weakens GAAP as a tool for controlling – flows!
  • Greater diffusion of financial results within the company.  Lean Accounting creates data that is useful for managing the business and therefore valuable to place in the hands of managers.

QFix ProductsWbLgWe are only beginning to reap the potential benefits of this powerful management tool.  Already, it has helped us to have a much deeper understanding of the true economic characteristics of our various value streams and resulted in better management of our working capital.  One of the major goals of Lean is to free up capacity that can be redeployed to grow the business.  Because of Lean Accounting, and through the application going forward of capacity analysis tools and box scores for decision making at the margin, we will increasingly be in a position to see how operational decisions that improve flow in the value streams impact our financial results and to maximize our returns on capital invested.”

Visit Qfix on the web at www.qfix.com.  Qfix is located at 440 Church Road, Avondale, PA 19311 USA Phone: 610-268-0585610-268-0585 Fax: 610-268-0588