Throughput Price Setting
The use of throughput concepts can be used to arrive at product price points that allow for a sufficient amount of cash spinoff to fund the continuing growth of a business.
In essence, throughput focuses on the amount of profit that can be derived by altering the mix of products passing through a bottleneck operation. Typically, the bottleneck is located in the production area, and involves a machining operation that does not have sufficient capacity to handle the backlog of work associated with it. To maximize the overall profitability of a business, you should accept orders that have a combination of the smallest processing time at the bottleneck operation and the largest amount of throughput (revenues minus all direct costs).
As an example, a product generates throughput of $20 per unit sold, and requires five minutes of processing time at the bottleneck operation. This unit generates $4 of throughput per minute. By comparison, another product generates a much higher throughput of $90 per unit sold, but requires 30 minutes of processing time, which is $3 of throughput per minute. From a profitability perspective, the first product is superior, since it generates more throughput per minute.
Based on the throughput per minute concept, product price setting should be based on generating the highest possible throughput per minute.
If there is no bottleneck anywhere in a business that can interfere with the sale of goods, then the bottleneck is said to be in the marketplace. If so, the key pricing decision is whether a reduction in price will generate more sales, and whether the price reduction will still yield a net increase in throughput. An additional consideration is the cost (or even the availability) of additional working capital to support any additional sales. The seller may have to support larger amounts of accounts receivable and on-hand inventory balances if it chooses to reduce its prices, which may place a limitation on the amount of short-term growth that can be supported.
If working capital turns out to be the bottleneck that keeps a business from generating additional sales, then the focus on new sales should be on any transactions involving cash payments or short credit terms, while transactions involving longer credit terms are given a lower priority.
A discussion of throughput concepts is available on Episodes 43 through 47 of the Accounting Best Practices podcast.