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Throughput Price Setting
The controller of a small medical equipment distribution firm asks how to construct a pricing model that ensures a sufficiently high gross margin to allow for a proper level of funds re-investment and company growth.
Throughput analysis is helpful for determining proper price points. Throughput analysis focuses on management of the company bottleneck in order to maximize profits. The distribution firm noted above likely has a unique bottleneck, so let's address that one last. First, the classic bottleneck is a work center somewhere in a company's production area that does not have sufficient capacity to meet all sales needs. The bottleneck operation is readily evident from the large queue of unfinished work located just upstream from it. To maximize profitability, a company should accept jobs that have a combination of the highest throughput margin (price minus the cost of direct materials) and the lowest use of the bottleneck operation. For example, a product with a throughput margin of $10 that uses one minute of the bottleneck operation has a throughput/minute of $10, and is superior to another product with a throughput margin of $20 but which uses 4 minutes of the bottleneck operation, which results in a throughput/minute of $5. Consequently, price setting should be focused on wringing the highest possible throughput/minute from each product.
What if a company has more capacity than it can sell? Then the bottleneck is said to have shifted into the marketplace. When the potential exists to gain a sale, the only decision point is whether any additional operating expenses or investment required to obtain the order will be adequately offset by the increased throughput. However, there is a new constraint that now enters the picture, and which applies to the distribution firm which initiated this discussion -- working capital.
When a company resells products acquired elsewhere, it's primary limitation is likely to be the amount of cash available to support its working capital needs. If it sets prices too low, then its sales may skyrocket, but it won't have sufficient funding to support the receivables associated with the new sales. The solution is to focus intently on the working capital bottleneck. If a product sale has a combination of the shortest customer payment terms and the largest throughput margin, then it is using the minimum amount of the working capital constraint. Conversely, sales of low-margin products on long payment terms use the largest amount of the constraint, and are to be discouraged.
Podcast
A discussion of throughput concepts is available on Episodes 43 through 47 of the Accounting Best Practices podcast.
Related Topics
Burdened vs. throughput pricing
Opportunity cost of operations
Sales department bottleneck
Theory of constraints
Throughput analysis