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And when you understand the demonstration and grasp its implications for business as a whole it will change your approaches to business. and as you will see mathematically flawed. 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.g. It is simply. solicitors or shops) It may take a little time to follow and perhaps seem a little complicated but bear with me – at the end when you have reflected upon it you will – like almost everyone else say: “Obvious really. be it project management (construction or computer programming for example) or service (e. just common sense!” Profit =Sales – Op .The Standard Maximise Profit 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. an ethical concept or even a psychological idea. The demonstration is based on a manufacturing environment because it is the easiest way to demonstrate it but the logic is equally applicable in any other business environment.
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.The Investors De The standard approach misses out the one thing that any Investor thinks about. 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 How much interest will it pa Building Society A 1 0 Building Society B 5 Where should I put my mon . the interest rate that their investment will enjoy.
If I only make £100 profit but only need to tie up £500 I will have made 20% ROCE. And 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.000 to do so I will have made a 2% ROCE. If I make £200 profit and I have to invest £10. 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. Prof ROCE = Capital E . 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.Return On Capit This appears similar to the sum one would do to calculate the interest rate on an investment in a building society.
Add the ink and paper Once you begin producing the goods you have to pay for the materials being consumed by the process.Economic Batch Set up cost (for a printer) Getting the Economic Batch Quantity right is regarded as critical for any manufacturing company that produces its produce p Half an hour to products in batches. the electricity being used and the time of those people operating the machinery. Running costs Labour for each hour Paper Ink Power . Before a batch can be produced the machinery has to be set Put them on the press up. This takes time and therefore there is a cost before anything has actually been produced.
Uni If you produce three then the costs are similarly reduced. 250 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. 1 50 200 1 00 50 0 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 . This results in a Cost curve similar to the one shown above.Production Cost 300 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.
1 have to store the goods which means I I20 have warehousing costs – space.Holding Cost 1 Unfortunately there40 a further aspect to consider. 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 may lose some or get them damaged or I may find the market for them declines. 80 As a consequence I have a holding cost that rises – this time in a straight line – as shown above. I will have to pay insurance. is Holdi As I produce more I have additional costs simply to hold the volume I produce. I have 1 00 expended money on the labour used to produce them. 60 40 20 0 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 .
Total Unit Cost 300 This means I have to add the two costs (production and holding) to find the250 Total Unit Cost. This produces a graph that looks similar to the one above. 1 50 1 00 50 0 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 . The lowest total cost will be at the point where the two lines 200 cross.
It also shows that the point of maximum profit falls at the point where the 200 cost lines cross.Profit 300 We can also add to this graph a horizontal line that show the price at which we sell the goods. the rises rapidly to the point where the two cost lines cross and then gradually declines. 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. two We can see that profit starts low. 1 50 250 1 00 50 0 1 2 3 4 5 6 7 8 9 1 1 1 1 1 0 1 2 3 4 .
It is simply the Total Unit Cost Line inverted (turned upside down). 50 Pr 0 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 -50 -1 00 -1 50 .Profit 00 Following this fairly 1 basic logic we can draw the profit graph as shown above.
Maximum Profit 00 And we can see the1 point of maximum profit! 50 Pr 0 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 -50 -1 00 -1 50 .
as we approach the point of maximum profit the 0 slope of the graph does not change much it means that if we reduce the quantity we produce we make 5 6 little difference0 very 1 2 3 4 7 8 9 1 to the profit. This has a value (the quantity multiplied by the Unit Cost) and we have money tied up in it – Capital Employed.Return on Capit Stock Pr 1 00 Now reflect on the fact that the X axis is a quantity of stock. Typically we can almost half the batch quantity and only sacrifice about 10%-50 our profit. And you still have 50% of your capital to invest in something else! . of So – produce at maximum profit and ROCE equals (say) 100/1000 = 10% Or -1 00 1 1 1 2 1 90/500= 18% Which do you want? -1 50 And bear in mind this is not 8% more ROCE it is 80% more. So the more we produce in each batch the more money we 50 have tied up – or the more capital employed! And because.
on staffing levels. it will change the foundations of the way you approach your business. if you follow the implications through. and when you see them your reaction will be: “Obvious really. just common sense!” . And incidentally if you drift just a little 50 to the right of the maximum profit level your Return continues to drop dramatically. It is wrong and. The point about this explanation has not been to teach you about Economic Batch Quantities nor just to show that the 0 focus on profit is wrong. on relations with suppliers. Even More Important -1 00 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 May I suggest that if the advice you have been receiving from your accountants. on your sales propositions to your customers to name but a few.ROCE 1 00 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. 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? -1 50 I promise you there are. It obviously affects decisions on production quantities but changing the focus will also affect investment -50 decisions on plant.
com And find out more about using this type of knowledge to make your business fly! .Visit us at www.obviousreally.
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