The Standard View Maximise Profit Profit = Sales – Operating Costs
We are all taught by practically every advisor or other source of advice that we should focus on the profitability of our business and that the number we should focus on is the level of profit it generates. Profit is important but to focus on it and use it as the fundamental (financial) guide on how we run the business is not only bad but fundamentally dangerous. This is not a marketing concept, an ethical concept or even a psychological idea. It is simply and as you will see mathematically flawed. And when you understand the demonstration and grasp its implications for business as a whole it will change your approaches to business. The demonstration is based on a manufacturing environment because it is the easiest way to make the proof but it is logic is equally applicable in any other business environment, be it project management (construction or computer programming for example) or service (e.g. solicitors or shops) It may take a little time to follow and perhaps seem a little complicated but bear with it – at the end when you have reflected upon it you will – like almost everyone else say: “Obvious really, just common sense!”
The Investors Decision How much interest will it pay? Building Society A
10%
Building Society B
5%
Where should I put my money?
The standard approach misses out the one thing that any Investor thinks about, the interest rate that their investment will enjoy. If you had a choice between two equally secure building societies but one offered you a 10% interest rate and the other only 5% you would not have too much difficulty deciding which one to place your money with. When we are considering the investment in an aspect of a business we call the interest rate Return On Capital Employed or ROCE for short
Return On Capital Employed ROCE =
Profit Capital Employed
This appears similar to the sum one would do to calculate the interest rate on an investment in a building society. Actually it is exactly the same! The profit is the amount of money you retain after your running expenses and the capital employed is the amount of money tied up in the operation. If I make £200 profit and I have to invest £10,000 to do so I will have made a 2% ROCE. If I only make £100 profit but only need to tie up £500 I will have made 20% ROCE. Clearly I would be sensible to invest my money in the second of these propositions and find somewhere else to invest my remaining funds. Obvious really, just common sense! It is curious therefore that most businesses tend to adopt the first investment simply because it makes the higher profit. And, in fact, there is one particular area of business that has spawned thousands of articles analysing the best approach to the first investment and entirely missing the implication.
Economic Batch Quantities Set up cost (for a printer) Half an hour to produce plates Put them on the press Add the ink and paper Running costs Labour for each hour Paper Ink Power
Getting the Economic Batch Quantity right is regarded as critical for any manufacturing company that produces its products in batches. Before a batch can be produced the machinery has to be set up. This takes time and therefore there is a cost before anything has actually been produced. Once you begin producing the goods you have to pay for the materials being consumed by the process, the electricity being used and the time of those people operating the machinery.
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This means that if you only produce one item it has to bear all the costs of setting up the machinery as well as the costs immediately associated with it. If you produce two items then they share the set up costs and therefore half the amount each is bearing and then have to carry their own immediate costs. If you produce three then the costs are similarly reduced. This results in a Cost curve similar to the one shown above.
Holding Cost Holding Cost 140
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Unfortunately there is a further aspect to consider. As I produce more I have additional costs simply to hold the volume I produce. I have to store the goods which means I have warehousing costs – space, heat and light, I have money tied up in the materials required to produce the goods on which I am either paying interest or foregoing interest. I have expended money on the labour used to produce them. I will have to pay insurance, I may lose some or get them damaged or I may find the market for them declines. As a consequence I have a holding cost that rises – this time in a straight line – as shown above.
Total Unit Cost 300
Lowest Cost 250
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Unit Cost
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This means I have to add the two costs (production and holding) to find the Total Unit Cost. This produces a graph that looks similar to the one above. The lowest total cost will be at the point where the two lines cross.
Profit 300
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Maximum Profit 200 Unit Cost Holding Cost
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Total Unit Cost Price
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We can also add to this graph a horizontal line that show the price at which we sell the goods. It is not difficult to see that the profit can be derived by measuring the difference between the Price line and the Total Unit Cost line. It also shows that the point of maximum profit falls at the point where the two cost lines cross. We can see that profit starts low, the rises rapidly to the point where the two cost lines cross and then gradually declines.
Profit Profit 100
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Following this fairly basic logic we can draw the profit graph as shown above. It is simply the Total Unit Cost Line inverted (turned upside down).
Maximum Profit Profit 100
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And we can see the point of maximum profit!
Return on Capital Employed Profit 100
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Now reflect on the fact that the X axis is a quantity of stock. This has a value (the quantity multiplied by the Unit Cost) and we have money tied up in it – Capital Employed. So the more we produce in each batch the more money we have tied up – or the more capital employed! And because, as we approach the point of maximum profit the slope of the graph does not change much it means that if we reduce the quantity we produce we make very little difference to the profit. Typically we can almost half the batch quantity and only sacrifice about 10% of our profit. So – produce at maximum profit and ROCE equals (say) 100/1000 = 10% Or 90/500= 18% Which do you want? And bear in mind this is not 8% more ROCE it is 80% more. And you still have 50% of your capital to invest in something else!
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And as you will see from the graph above the maximum return on your capital is always at a point well below the maximum profit level. And incidentally if you drift just a little to the right of the maximum profit level your Return continues to drop dramatically. The point about this explanation has not been to teach you about Economic Batch Quantities nor just to show that the focus on profit is wrong. It is wrong and, if you follow the implications through, it will change foundations of the way you approach your business, it obviously affects decisions on production quantities but changing the focus will also affect investment decisions on plant, on relations with suppliers, on staffing levels, on your sales propositions to your customers. Even More Important May I suggest that if the advice you have been receiving from your accountants, bank managers and from the mass of business books is so fundamentally flawed and potentially dangerous there might just be other basic concepts that have equally shaky foundations? I promise you there are, an when you see them your reaction will be: “Obvious really, just common sense!”