Profit velocity analysis

Profit velocity is the profit generated per minute of production time for a product. The concept is used to decide which of several alternative products to manufacture.

The Need for Profit Velocity Analysis

When the sales department wants to know which products to push the hardest, the accounting manager prints a contribution margin report, and recommends whatever has the highest margin.  Contribution margin is sales minus all variable expenses.

Unfortunately, this approach ignores the amount of production time that a product requires in the manufacturing bottleneck operation. If a high-margin product requires an extensive amount of production time in the bottleneck, or its reject rate is so high that extra product must be manufactured, then the company would make more money producing higher volumes of a lower-margin product. You can highlight this issue with management by using a measurement called profit velocity.

Example of Profit Velocity

ABC Company has two products: Product High has a contribution margin of 40% and Product Low has a contribution margin of 25%. Product High requires four hours of production time, while Product Low needs only one hour of production time. Both products sell for $250. In a typical 8-hour work day, the profit velocity on Product High would be $200 (2 units x $250 price x 40% contribution margin), while the profit velocity on Product Low would be $500 (8 units x $250 price x 25% contribution margin). Consequently, it is more profitable in aggregate to sell the lower-margin product.

In this example, production time is the key profit driver, not the contribution margin.

The Derivation of Profit Velocity Information

How to create reports containing profit velocity? That is not simple, since the calculation combines financial information (the contribution margin) and operating information (production time), which are stored in different places. If a company is using an enterprise resource planning (ERP) system, then both types of information will be available somewhere in the ERP database, and will only require a report writer to combine onto a single report. Otherwise, combining the information using a data warehouse or electronic spreadsheet are the only remaining alternatives. In the latter case, it may be possible to reduce the workload by only deriving profit velocity information for the 20% of products that typically generate 80% of all profits. This concept is closely tied to the theory of constraints.

Related Courses

Constraint Management 
Financial Analysis 
Financial Forecasting and Modeling