Throughput Profit Multiplier

Throughput Profit Multiplier Throughput Profit Multiplier (TPM) A large fraction of the operating costs are fixed  small changes in throughput could be translated into large changes in profits. Throughput profit multiplier (TPM) = TPM = % Changes in Profit/ % Changes in Throughput % Changes in Profit = (Profit2-Profit1)/Profit1 % Changes in Throughput = (Throughput2Throoughput1)/Throughput1 TPM = (Prof2-Prof1)/Prof1]/[ (Q2-Q1)/Q1] Suppose fixed cost F = $180,000 per month. Sales price per unit P = 22, and variable cost per unit V = 2. In July, the process throughput was 10,000 units. A process improvement increased throughput in August by 2% to 10,200 units without any increase in the fixed cost. Compute throughput profit multiplier. 2 Financial Throughput and Fixed Operating Costs We define financial throughput as the rate at which the enterprise generates money. By selling one unit of product we generate P dollars, at the same time we incur V dollars pure variable cost. Pure variable cost is the cost directly related to the production of one additional unit - such as raw material. It does not include sunk costs such as salary, rent, and depreciation. Since we produce and sell Q units per unit of time. The financial throughput is Q(P-V). Fixed Operating Expenses (F) include all costs not directly related to production of one additional unit. That includes costs such as human and capital resources. In our example, F = $180,000 per month, P = 22, and V = 2. In July, financial throughput was 10,000(22-2) = 200,000. In August R increased by 2%. 3 Another Look at Throughput Profit Multiplier Financial throughput is (22-2)10000 = 200000 Fixed Operating Expense = 180000 In this example, Fixed Operating Expense is 90% of Financial Throughput. F= 0.9(P-V)Q Profit = 10% of financial throughput. Profit = 0.1(P-V)Q If Q increases by 1% Financial throughput increases by 1% too, and it is all profit because we have already covered all fixed operating expenses. Therefore increase in profit = 0.01(P-V)Q, and % change in profit = 0.01(P-V)Q/0.1(P-V)Q =0.1 = 10%. 1% change in Throughput, 10% change in profit. 2% increase in throughput  20% increase in profit. 4 Throughput Profit Multiplier Let us summarize our notations (these notations benefit from E. Goldratt and M. M. Srinivasan) Throughput: Q Fixed Operating Expenses; cost of human resources and depreciation of capital resources plus all other indirect costs: F Total Revenue: PQ Total Cost: VQ+F Profit Margin; the money generated by producing (and selling) additional unit : P-V Financial throughput. The rate at which the enterprise generates money: (P-V)Q Profit = (P-V)Q-F 5 Relationship Between Financial Throughput and Fixed Operation Expenses Suppose F/Financial-Throughput = y = F/(P-V)Q = y; 1>y >0 Therefore, F = y(P-V)Q Profit = (P-V)Q-F = (P-V)Q - y(P-V)Q = (1-y)(P-V)Q If % increase in throughput is x%. Then the increase in profit is x(P-V)Q. % change in profit = [x(P-V)Q]/[(1-y)(P-V)Q] % change in profit = x/(1-y) TPM = % change in profit /% changes in throughput TPM = [x/(1-y)]/x TPM = 1/(1-y) % Changes in Profit Fixed Operating Expenses as a % of Financial Throughput 10% 20% 30% 40% 50% 60% 70% 1% 1.11% 1.25% 1.43% 1.67% 2% 2.5% 3.33% 80% 5% 90% 10% 95% 20% 99% 100% 6 Problem 5.6 A company's average costs and revenues for a typical month are $15 million and $18 respectively. It is estimated that 1/3 of the costs are variable and the rest are fixed. What is the throughput profit multiplier? Total Variable Cost =VQ = 5,000,000 Fixed Operating Expenses =F = $10,000,000 Total Revenue = PQ = $18,000,000 Financial Throughput = (P-V)Q = PQ-VQ = $18,000,0005,000,000 = 13,000,000 F/(P-V)Q = $10,000,000/ 13,000,000 = 10/13 TPM = 1/(1-y) = 1/(1-10/13) = 13/3 If throughput increases by 1% profit will increase by 4.33%. 7 A Viable Vision A Viable Vision (Goldratt): What if we decide to have todays total revenue as tomorrows total profit. In our example, Financial Throughput in July was Q1(P-V) = 10,000(22-2). In order to have your profit equal this amount we need to produce Q2 units such that: Q2(P-V) – F = Q1(P-V) Q2(20) -180,000 = 10,000(20) Q2(20) = 380,000 Q2 = 19,000 In order to have your todays total revenue as tomorrows total profit. We should increase our sales by (19,000-10,000)/10,000 = 90%. If we almost double our sales, our current revenue becomes our tomorrows profit. 8 A Viable Vision- Goldratt Decide to have your todays total revenue as your tomorrows total profit. What should your sales be equal to? Todays Throughput =R, Today’s Revenue = PR Target Profit = (P-V}R2-F, Target Throughput =R2 = (1+x)R F= y(P-V)R  PR2-F = (P-V) (1+x) R-y(P-V)R (P –V)(1+x)R-y(P-V)R= (P –V)R[1+x-y)=PR 1+x-y = P/(P-V)  x = P/(P-V)-1 +y x = V/(P-V) +y If V= zP then, x = zP/(P-zP) +y = z/(1-z)+y In our example, P=22, V=2  z =1/11, z/(1-z) = 0.1, F = 180,000, R =10,000, F = 0.9(P-V)  y=0.9  x = 0.1+0.9 = 1. If R is doubled, todays revenue becomes tomorrows profit. 9 A Viable Vision Variable Cost as a % of Price Changes in Throughput Fixed Operating Expenses as a % of Financial Throughput 1 10% 20% 30% 40% 50% 60% 70% 80% 90% 95% 10% 0.21 0.31 0.41 0.51 0.61 0.71 0.81 0.91 1.01 1.06 20% 0.35 0.45 0.55 0.65 0.75 0.85 0.95 1.05 1.15 1.20 30% 0.53 0.63 0.73 0.83 0.93 1.03 1.13 1.23 1.33 1.38 40% 0.77 0.87 0.97 1.07 1.17 1.27 1.37 1.47 1.57 1.62 50% 1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80 1.90 1.95 60% 1.60 1.70 1.80 1.90 2.00 2.10 2.20 2.30 2.40 2.45 70% 2.43 2.53 2.63 2.73 2.83 2.93 3.03 3.13 3.23 3.28 80% 4.10 4.20 4.30 4.40 4.50 4.60 4.70 4.80 4.90 4.95 90% 9.10 9.20 9.30 9.40 9.50 9.60 9.70 9.80 9.90 9.95 95% 19.10 19.20 19.30 19.40 19.50 19.60 19.70 19.80 19.90 19.95 If Variable cost is less than 60% of the sales prose, the viable vision is achievable by incensing the throughput by less than 2.5x. 10