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Many years ago, I visited a business school I was considering and sat in on a class.
I arrived a few minutes early and introduced myself to the professor. He told me class would be getting started in two minutes. Then he handed me a copy of the case discussion for the day.
It was thick — clearly there was no time to read it. So I just gave it a quick scan.
The essence of the case centered on whether the company in question should make or buy a particular part.
The case was overflowing with information and data. So much so, in fact, that as class got underway, I learned the students had worked in study groups the prior evening for about three hours, trying to come up with the answer.
Over the next 90 minutes, I listened as the class debated the ins and outs of the make vs. buy decision, delving deep into the cost accounting specifics. By the end, it was obvious most students believed the company should make the part.
I didn't… I thought they should buy it.
Why? Because it was clear there was a constrained manufacturing resource. The way I saw it, it was less a question of the specific cost details of making the part than it was the broader issue of how to maximize profits given the constraint.
Happily (for me) the professor confirmed my point of view at the end.
Resource constraints pose three business challenges:
- Identifying the constraint
- Maximizing profits given the constraint
- Deciding whether to invest to remove the constraint (i.e., increase capacity)
#1. Identify the constraint
In the business school example, the constraint was machine time.
During the pandemic, however, a manufacturing client of mine did not have the staff to produce all the orders in a reasonable period. In this case, the constraint was people.
And it’s not just manufacturing where people can be the constraint. Deciding where to focus a sales force is a similar type of decision. People constraints can also exist in administrative processes, such as call centers.
Sometimes the critical constraint is not so obvious.
Many years ago, a division I was working in proposed a significant acquisition to senior management. By buying the company in question, substantial shareholder value could be added. The company generated tremendous cash flow, so the company's cost of capital was very low.
The division's analysis was solid and each stage approved the deal up the line. Then it reached the Chairman.
He said no and for a very good cause:
The organizational resources that would be consumed by fixing and growing this company could create
more
shareholder value doing something else.
The true constraint was not capital — it was organizational time and focus. In his view, we would end up foregoing bigger opportunities around the corner.
Time is inherently limited.
So anything with time involved — including your own! — is constrained. Maximizing your value requires deciding what
not
to do as much as it does deciding what to do.
#2. Maximize profits given the constraint
If you have a manufacturing operation running at capacity,
you need to know the profit contribution per hour of the various things that operation does.
This might be profit contribution, revenue minus variable costs, or some other factor per unit of constraint. Profit per machine-hour is an example. With a formal reoccurring process, you can then review profitability by whatever the relevant constraint is.
In the pandemic example mentioned earlier, I helped my client understand the profitability of its products and customers by man-hour of its key manufacturing lines. That meant taking into account the incremental profitability of each item and customer per unit sold
and
how fast the machine ran based on that particular product run (some products ran much faster than others).
Needless to say,
an analysis of this type requires an investment in good data and the institution of formal processes.
This client invested in an ERP system that could accurately track profitability by product and by customer.
Additionally, always consider outsourcing, as in the business school case. For example, the owner of a small business may outsource bookkeeping and use that internal staff for other things. For individuals, outsourcing may mean delegating.
Above all, judgement is required!
That is what the Chairman used when he decided not to pursue that acquisition. But it is often required in much simpler cases, too. For example, the least profitable product for an operation might be needed to keep the most profitable customer.
#3. Invest to remove the constraint
For most businesses,
the investment sweet spot of good returns and low risk occurs when the business invests to remove the constraint.
After all, you have the demand (so that is low risk) and you should know the profits that can be had by meeting it. Just make sure your analysis shows a return that
exceeds your cost of capital.
Final thoughts
Every business faces resource constraints, whether in the form of time, people, money, or something else of a critical nature.
The ability to make sound resource allocation decisions requires a clear understanding of the constraints in question and well thought out steps to maximize value given the constraint.
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