Our Biggest Constraint: How We Think

You buy the same equipment as your competitors. You hire from the same labor pool. The only difference is how you think. Unfortunately, you and your competitors also think the same way. So you are left to compete in a market where, from your customers’ perspective, you’re all the same. So they make decisions mostly based on price. Here are some of the common ways our thinking goes wrong and the negative effect this wrong thinking can have on your business.

We have worked with companies around the globe and the constraint is always the same. It’s how we think. In particular, it’s how the business owner or leader of the company thinks. Last time, in “Job Shop Scheduling: The Secret to Getting On Time & Reducing Lead Times“, we discussed the efficiency mind-set and how focusing on efficiency can lead you astray. I made the case that efficiency is NOT a precursor to improved performance, but a by-product.  In this installment I want to discuss another type of wrong thinking – the allocation mind-set.

You buy the same equipment as your competitors. You hire from the same labor pool. The only difference is how you think. Unfortunately, you and your competitors also think the same way. So you are left to compete in a market where, from your customers’ perspective, you’re all the same. So they make decisions mostly based on price. Let me explain some of the common ways our thinking goes wrong and the negative effect this wrong thinking can have on your business.

The allocation mind-set is where we believe that in order to ensure we are going to make a profit, we have to allocate some portion of our overhead to “product cost”. The idea is that if every product we sell absorbs some of our costs, then we will know at what point we are making money and we can better ensure that we cover all our costs.

So when we calculate the “gross margin” (GM) of a product it looks something like this:
Selling price:       $100
– COGS:             – $60
————————-
Gross Margin:       $40 (also called Gross Profit)

Where COGS (Cost of Goods Sold) typically include raw materials and the direct labor used to create the product or deliver the service.  (Some companies may allocate more than direct labor, but this is the most common allocated cost.) But if you think about it, direct labor really is NOT a variable cost, unless you pay piece rate. And this is true for both manufacturers and service providers (again unless you pay piece rate, which is very rare). You are going to pay your employees this week whether you sell something or not.

It is this allocation of direct labor to COGS that is what I’m referring to as the “allocation mind-set”. The amount of direct labor allocated to a product/service is usually based on annual volume assumptions and the estimated time a particular job will take. This means that the allocation of direct labor costs to a job or opportunity influences your decisions:

· Which jobs/projects you take.

· Which markets you go after.

· Which customers get preferential treatment.

· How much you charge.

So far, you’re probably thinking – yeah, that’s what we do, what’s the problem? The problem is that the allocations you do are based on a volume assumption and time estimates. Both of which we know one thing for sure about: they are wrong. The question is by how much and in which direction.

Not only will the amount you allocate be wrong, more importantly, it can lead you astray. The best way for me to demonstrate that is with an example.