September 18, 2018
FALLEN FINANCIAL IDOLS
Cost and Profitability
Like most managers, we took it for granted that the processes for a certain productmust be evaluated according to cost, and various products according to profitability. The deep-rooted belief, refuted by Professor Matejka at his training sessions, was definitively struck down by two variants for producing door hinges for automobiles.
Hinge price = 4
Variant A: Production of 2 parts plus assembly
Cost = 3,5, Profit = Price – Cost = 0,5, Profitability = Profit/Price = 0.125
Variant B: Only assembly; the parts are purchased as components
Cost = 3,8, Profit = Price – Cost = 0,2, Profitability = Profit/Price = 0.05
Everyone is under the illusion that variant A is more than twice as effective. However:
Variant A requires 5 times as much capital
The yield of capital, ROI in variant B is more than twice higher than in variant A.
Because we calculated this example ourselves it was a profound experience. I recommend this example for the first pages of management textbooks.
The second fallen idol of partial financial thinking is inventories, whose minimization is urged by all the world. Everyone who has encountered the issue oflean production surely knows the images of a smiling “one piece flow.” However, optimizing production lines for this ideal can be enormously demanding in terms of capital.
You gain small financial benefits from decreased inventories and you lose lots of money in little-used machines in lines that allow the longest different flows of individual pieces. Therefore, as the financial director I find it hard to understand the focus of financial audits on each cent in inventories and the absence of interest in the demands of processes on fixed capital.
(Radek Páleník, Chief Finance Officer, former: CMO, former: CIO, HŽP Prostejov, Czech Republic)
To be continued...