Manufacturers are finding it increasingly difficult to maintain or increase profits, as pressure on margins, rising costs of raw materials and global competition all threaten corporate financial performance goals. To meet these challenges, production in the manufacturing environment typically focuses on increasing productivity, reducing costs, increasing yields and in some cases, offshoring a product all together.
These initiatives can all contribute to increasing profitability for the company. However, the products that are targeted by these initiatives are not necessarily prioritized by profitability; that is, they constitute the entire portfolio of products that sales and marketing teams have found markets for, but it does not mean they are profitable.
Sales and marketing attempt to maximize company profitability by recommending and promoting products which, when designed and manufactured, can command a price in the marketplace which will produce an attractive profit margin per unit. In other words, they take the competitive landscape plus supply and demand into account and then set prices accordingly, with the goal of generating an attractive profit margin. The profit margin is, of course, the selling price minus all relevant costs - many of which manufacturers seek to minimize with the aforementioned initiatives.
This is the process that manufacturers use to maximize profits and return on assets (ROA). However, it does not lead to optimal profitability. Why not? The problem lies in the fact that margin alone is not a metric which will maximize profitability. Margin per unit does not take into account how fast a product flows through production processes. A high margin product that runs slowly through a plant may actually generate less profit per year than a lower margin one that runs very quickly through the plant.
Consider the following scenario. As shown in the table below, Product A has a larger margin than Product B, but when production speeds are taken into account, Product B is seen to generate twice as much profit as Product A over the course of the fiscal year.
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This simple example shows the importance of incorporating production velocity, as profit per minute, with margin when determining profitability. Products which might have been viewed as the most profitable and prioritized for productivity improvements or marketing programs are actually not the ones that should be targeted. With only two products as in the example above, it would be quite easy to take production velocity into account. However, for an asset-intensive manufacturer making hundreds or thousands of products in multiple plants and on multiple production lines, the challenge has until recently been insurmountable. Many manufacturers have long known the importance of production velocity to profitability, but they have had to settle for margin alone as the best available guide when making decisions to maximize profitability.
Using Profit per Minute provides an Operational Metric Aligned with Profits and ROA
Since profits and ROA are reported on a time basis, typically over a year or quarter, it makes perfect sense that individual products are evaluated on profit per unit of production time. Profit per minute is therefore the ideal operational metric to use as a guide to a product’s contribution to overall company profit and ROA goals. Furthermore profit per minute provides a common metric which can be viewed by production, sales, marketing and finance together to make day-to-day operational decisions. It does away with the “This product has a higher margin vs. this product runs faster through the plant” arguments.
Using Profit per Minute to Make Operating Decisions
When production run-rate data are incorporated with margin per unit information, we can generate a graph, or topographical map, as shown below. The y-axis shows margin per unit and the x-axis units per minute. The contour lines represent equal values of profit per minute. The bubbles represent individual products. With a margin-only view, Product A would be deemed far superior to Product B. However, due to its greater production rate, Product B actually generates as much profit per minute as Product A. Since ROA (while typically reported as a percentage) is a measure of profit over time, a given level of profit per minute will translate to a specific ROA. In this particular example $600 of profit per minute equates to an ROA of 10 percent.
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Assuming Product B was not targeted for elimination due to its lower-than-average margin (a big mistake since it meets the company target ROA of 10 percent), it would not make sense to prioritize productivity improvement for this product since it would take a very large increase in units per minute to increase its profit per minute and ROA values. However, Product C, which was formerly considered a great product due its above-average margin, can be seen to be not nearly as profitable as Product B. It comes in below 5 percent ROA. But Product C is a great candidate for productivity initiatives since a small increase in run-rate could produce quite a dramatic increase in profit per minute and ROA.
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Using profit per minute as an operational metric rather than margin alone thus makes it possible to see clearly not only the value of individual products, but also the most logical strategies to adopt for each. It enables production to prioritize their efforts in a way that will guarantee optimal profitability.
Using Profit per Minute to Increase Profitability in Production Scheduling
Let’s consider another example. Quite often a particular product will run more quickly on one production line than on another. Using profit per minute as a guide enables decisions such as changing production from one line to another as a way to increase overall company profitability.
In the topographical map below, the blue bubbles represent Product A and the red ones Product B. The topo map shows each product made on each of two different production lines 1 and 2. It is apparent that Product A is more profitable, i.e. exceeds the company ROA target, when it is produced on production line 1. On the other hand, Product B is more profitable when produced on production line 2.
