profit margin as the primary metric

 Focusing solely on profit margin as the primary metric for business success can be misleading and detrimental to the overall health of an organization. While profit margin is undoubtedly important, it doesn't capture the complete picture, particularly when it comes to understanding cash flow and the flow of products through the system.

Here's why fixating on profit margin can be misleading:

• Profit margin doesn't account for the velocity of money. A business can have a high profit margin on a product, but if it takes a long time to sell, the cash flow can be sluggish. In a cash-constrained situation, prioritizing products with high cash velocity, even if they have a lower profit margin, can be more beneficial for the company's survival.
• Overemphasis on profit margin can lead to inventory build-up. If the focus is solely on maximizing profit margin, a company might be tempted to produce large batches of products to reduce unit costs. This can lead to an excess of inventory, tying up cash and potentially leading to obsolescence and storage costs.
• Ignoring the constraint can lead to suboptimal decisions. The Theory of Constraints (TOC) emphasizes that the overall performance of a system is determined by its weakest link, the constraint. Focusing solely on profit margin without considering the impact on the constraint can lead to decisions that maximize local profits but hinder the overall throughput of the system.
• Short-term profit maximization can hurt long-term growth. A relentless pursuit of maximizing profit margin in the short term can lead to neglecting investments in areas like research and development, marketing, and employee training. These investments may impact short-term profits but are essential for the long-term sustainability and growth of the business.

Here's a simplified example:

Let's say a company manufactures widgets with a production capacity of 10,000 units per month. The actual market demand for widgets is 8,000 units per month.

●

Scenario 1: Matching Production to Demand

○

The company produces 8,000 widgets, incurring a fixed overhead cost of £80,000 (equivalent to £10 per widget).

○

All 8,000 units are sold.

○

The income statement reflects the actual profit generated from the sale of 8,000 units.

●

Scenario 2: Overproducing to Inflate Inventory

○

The company produces 10,000 widgets, incurring the same fixed overhead cost of £80,000.

○

Only 8,000 units are sold.

○

The remaining 2,000 units are added to the finished goods inventory.

○

Instead of expensing the full £80,000 overhead cost, the company allocates a portion of it (e.g., £20,000) to the 2,000 units held in inventory.

○

This reduces the overhead cost reported on the income statement, artificially inflating the profit for the current period.

The balance sheet would also reflect this inflated inventory value, creating a more favorable picture of the company's assets. However, this profit and asset increase is deceptive:

●

The unsold inventory doesn't represent actual cash flow. The company has tied up resources in producing goods that haven't yet generated revenue.

●

The allocated overhead cost will eventually have to be recognized. When the excess inventory is sold (possibly at a discount), or written off as obsolete, the previously deferred overhead cost will hit the income statement, eroding the initially inflated profit.

This practice is unsustainable. Eventually, the buildup of unsold inventory and the delayed recognition of costs will reveal the company's true financial position. This tactic might temporarily boost the company's stock price or secure a favorable loan, but it will eventually harm the business, leading to:

●

Distrust from investors and creditors when the true financial picture is revealed

●

Potential cash flow problems due to excessive inventory holding costs

●

Difficulty in accurately assessing the company's profitability and making sound strategic decisions

A more holistic approach that considers both cash flow and the flow of products through the system is essential for sustained business success.

Here's what a more comprehensive approach looks like:

• Focus on Throughput. TOC advocates for maximizing Throughput, which is defined as the rate at which the system generates "goal units" or, in simpler terms, the rate at which the company generates money through sales. This means prioritizing products or services that contribute the most to the overall cash flow, even if they don't have the highest individual profit margins.
• Manage the constraint effectively. Identify the constraint in the system and make decisions that maximize its utilization. This might involve prioritizing certain products over others, adjusting batch sizes, or investing in capacity improvements.
• Maintain a healthy cash flow. Ensure that the company has sufficient cash on hand to meet its short-term obligations and invest in future growth. This might involve shortening customer payment terms, negotiating favorable supplier terms, and carefully managing inventory levels.
• Balance short-term and long-term goals. Don't sacrifice long-term growth for short-term profit gains. Invest in areas that will ensure the company's future competitiveness and sustainability, such as developing new products, expanding into new markets, and building a strong brand reputation.

By shifting the focus from solely profit margin to a more holistic approach that emphasizes Throughput, constraint management, and cash flow, businesses can achieve greater long-term success and avoid the pitfalls of short-sighted decision-making.