Lesson 1: Double the profit

Kestrel Electricals makes fans, lights, switches and wires in two plants and sells them through about 120 distributors to some 20,000 shops. It also has a small projects division that lights factories, offices and roads.

The board meeting is nearly over when the chairman turns to the managing director.

Chairman: “Anil, the plants are running better than ever. The operations people tell me we can make a third more without adding a shift. So I have one request for the next three years: double the profit.”

Anil: “Double?”

Chairman: “You heard me.”

That evening Anil calls Ruth Adler, the coach who helped Kestrel’s plants move to Drum-Buffer-Rope two years ago.

Ruth: “Give me your numbers in round figures. Pretend sales are 100.”

Anil: “Sales 100. Materials and other truly variable costs, 75. So throughput is 25. Salaries, rent, everything else, 17. Profit before tax: 8.”

Ruth: “And the chairman wants 16. Where will the extra 8 come from?”

Three doors

Profit is throughput minus operating expense. To double it, there are only three doors.

Door 1: cut variable cost. Variable cost is 75. To get 8 more profit from it, Kestrel would have to buy copper, steel and plastic about 11% cheaper, every year, while competitors buy from the same suppliers. Anil’s purchase team already squeezes suppliers every year; a point or two is possible. Eight points is not.

Door 2: cut operating expense. It is 17. Taking 8 out of it means cutting almost half the company. And the people who would go are the same people who make, sell and deliver.

Door 3: sell more. Throughput is 25% of sales. To earn 8 more throughput, Kestrel needs 32 more sales. And if it adds a few people to handle the growth, say 3 more in operating expense, it needs throughput of 35, which means sales of 140.

Anil: “Forty per cent more sales. Ruth, our market grows eight per cent a year.”

Ruth: “What share of it do you have?”

Anil: “In fans, about six per cent. In lights a little more.”

Ruth: “So ninety-four people out of a hundred buy someone else’s fan. Is the market really your constraint, or is your share of it?”

Where is the constraint?

Goldratt’s first step is always the same: identify the constraint, the one thing that limits how much the whole system can earn.

The plant? Not any more. After the operations project, it can make a third more.
The market? For a company with a small share, the market is rarely the limit. There are far more buyers than Kestrel serves.

So what limits Kestrel’s sales? Follow a fan from the plant to a home. It goes to a distributor, then to a shop, and there, one day, a person walks in to buy a fan. Only at that moment is a sale made. Everything before it is moving stock around.

Sales are limited by the number of end consumers who walk in to buy. And what each one will buy, where and when, is unknown. So the end consumer who walks in to buy is the constraint.

The more of those moments we turn into sales, the more we sell. That is step 2: exploit the constraint. Don’t waste a single consumer who walks in.

Pause and think: a woman walks into an electrical shop to buy a white 1200 mm ceiling fan. In how many ways can Kestrel lose her?

One: if the price is too high
Two: if the shopkeeper prefers another brand’s margin, or the fan is out of stock that week
Three: no Kestrel in the shop, Kestrel but not that model, or the model sold out

Three distinct losses, and each needs its own answer. Most sales teams see only the first one, because the other two never show up in any report: nobody records the customer who walked out.

Reach, range and availability

Each of the three losses has a name.

Reach: being on the shelf of as many shops as possible. New counters start keeping our products.
Range: in every shop we reach, offering the whole relevant range, all the products and price bands that shop’s customers ask for. Existing counters add the products they don’t keep yet.
Availability: for the range that fits each shop, the shop has it every time a customer asks. One hundred per cent.

The reasoning is simple. The opportunity is largest when we are in the most places, so we maximise reach. And wherever we reach, we want each visitor to spend more of their money with us, so we expose them to our widest range. Availability makes sure neither effort is wasted by an empty shelf.

If all three grow, sales for the company and its channel partners keep growing, and profits grow much faster, because the fixed costs don’t grow with them.

Exercise: which lever is this?

A hardware shop in a new suburb starts keeping Kestrel switches.
A shop that sells only Kestrel’s cheapest fans adds the premium range and the exhaust fans.
A customer asks for a model the shop always keeps, and it is there.
A shop that keeps Kestrel LED bulbs adds battens and panel lights.
Kestrel products appear in forty village shops that bought from the nearest town.

But why would a shop keep us?

Here Anil’s sales head, who has joined the call, has an answer ready.

Sales head: “Ruth, every company in the market wants the same shelf. Getting placed is an art. A few of my people can do it, because the shopkeepers trust them. The rest can’t.”

Ruth: “And how does the company help them? Can it always give the shopkeeper a decisive reason to keep you, without big investment, risk or money flowing out? Better products?”

Sales head: “Our products are good. So are the competitors’.”

Ruth: “Better quality? Higher margin to the shop?”

Sales head: “Higher margin we give all the time. It’s called a scheme. Everyone has one.”

Ruth: “Then let’s stop calling it an art. If the answer isn’t in our product, it must be in the shopkeeper’s business. Let’s go and see what a shopkeeper wants.”

Goldratt never accepted “it’s an art” as an explanation. An art is something we haven’t yet understood the cause and effect of. The next lesson looks for it in the shop.

Check your understanding

Answer all five. Get four right to complete the lesson.

1. Sales 100, variable cost 75, operating expense 17. To double profit, which door is most realistic?

Cut variable cost by about 11% every year by squeezing copper and steel suppliers harder
Grow sales: each extra sale adds throughput while expense barely moves
Cut operating expense in half
Raise prices by 10%

The other doors have a hard floor. Sales have no ceiling as long as the market isn’t the constraint.

2. For a company with a small market share, the market is usually…

The constraint, because the company can’t sell more than the market buys
Shrinking
Irrelevant
Not the constraint: its share of the market is

Most buyers buy from someone else. There is room to grow without the market growing.

3. In a consumer business sold through shops, the constraint is…

The end consumer who walks in to buy
The distributor
The plant
The advertising budget, which decides how many people know the brand

Only that moment turns stock into a sale, and when and where it will happen is unknown.

4. A shop keeps Kestrel fans but not the exhaust fans its customers ask for. Which lever is missing?

Reach
Availability
Range
Price

The counter is reached; the relevant range isn’t there.

5. Why does profit grow faster than sales when reach, range and availability grow?

Prices rise
Throughput grows with sales while fixed costs grow far more slowly
Variable cost falls
Schemes are no longer needed, so the company keeps more margin

Every extra sale adds its full throughput to profit once operating expense is covered.