Chris Lynn

How to Think About Digital Printer Investments

Use Goldratt’s Theory of Constraints, not job-costing

It’s almost 100 years since the essayist H.L. Mencken wrote: “There is always a well-known solution to every human problem—neat, plausible, and wrong”. Among the problems that printers face today is how to stay competitive with new capital investments, especially in digital equipment needed to enter new markets. I am going to suggest that the well-known spreadsheets frequently used to analyze the Return on Investment (ROI) of digital printing equipment are neat, plausible – and potentially misleading. (Elsewhere I have proposed a manufacturing simulator that shows an animated workflow, and allows some degree of statistical variation of orders and productivity to be built into an ROI analysis.) But in this article, I want to take a step back from detailed analysis and suggest a broad way of looking at productivity investments that is different from the standard approach.

The first problem to address is conventional job costing. Many printers rely on a software-based estimating system to generate quotes, and to provide the absorption-cost, Budgeted Hourly Rates (BHR) that go into an analysis of potential investments in new machinery. These estimating systems – while not necessarily wrong – can give a misleading view of how to price jobs and how to judge investments, because they allocate costs to jobs and press-hours. A cost accountant will argue that allocation of labor costs and overheads to cost-centers is a good thing, because it ensures that jobs can be priced to ensure that all the business’s costs are covered, and that it allows managers to be held accountable for metrics like departmental profitability, set-up times, and machine utilization.

Goldratt’s Theory of Constraints (TOC) teaches a different approach – one that takes a holistic view of the company’s ability to reach ‘The Goal’ – which is to increase ‘Throughput’. Goldratt holds that allocating costs within a business is potentially misleading and, like attempting to maximize the utilization of individual machines, results in sub-optimal decision-making. There are plenty of online resources describing TOC and its related ‘Throughput Accounting” methods so I will not describe them at length here, except to define the basic terms: Throughput (‘T’) is equal to Revenues (‘R’) minus Totally Variable Costs (‘TVC’) such as direct materials; Operating Expenses (‘OE’) captures the non-varying costs of creating Throughput – crucially, this includes direct labor since, in the short term, this does not vary with production volume; and Investment (‘I’), which includes inventories and other assets. The key equations of Throughput Accounting are:

Throughput (‘T’) = R-TVC
Net Profit (‘NP’) = T-OE, and
Return on Investment (‘ROI’) = NP/I

Using these definitions, let’s consider a simple situation of a business that uses a linear process to make products, graphing profit against production volume in a set time period. For a conventional printer, this could include cost-centers such as: pre-press, platemaking, printing, finishing and packing/shipping.

Here we can see that, with zero production, the business loses an amount equal to its Operating Expenses i.e. its fixed costs. As production volume grows, Throughput (R-TVC) increases until it passes the breakeven point (‘BE’) and continues upwards until the system cannot produce any more in the given time period and it hits a wall, producing the maximum profit of P.
How can we increase this profit?

• We can reduce our Operating Expenses, OE (moving the start of the line up the y-axis), or
• We can increase Throughput T by

o Increasing Revenues or
o Reducing TVC (e.g. direct materials or sales commissions) or
o Removing the constraint represented by the wall in Fig 1.

Let’s look at these in turn, starting with reducing OE:

It’s pretty obvious that, by moving the line up to OE’ and keeping the slope of the line the same, we will reduce the volume at which the company breaks even and we will increase the profit that we can get when we reach ‘the wall’. What else can we do? We can note that the slope of the line is equal to throughput per unit volume or, in conventional terms, the contribution margin on the product (excluding direct labor).

Increasing the revenue per job, or reducing its totally variable costs, has the effect of pivoting the line up more steeply – lowering the break-even point and increasing the maximum profit. Doing the opposite swings the line downward, making it harder to break even and reducing the maximum profit achievable. These effects are shown in Figure 3.

The analysis so far might strike you as what a colleague of mine used to call “a blinding flash of the bleeding obvious”. But bear with me as we consider an investment: the sales rep from your favorite digital printer vendor has just proposed an upgrade to your old machine that will allow it to run 50% faster than your current unit. The (totally variable) ink and paper costs per unit, and your direct labor costs (which, remember, we are considering to be part of OE) won’t change; in fact, your lease payments and maintenance contract will be higher than they are now, so OE will increase. But the printer itself will be faster – as fast (as the rep was not slow to tell you…) as the unit he has just sold to your competitor down the road. Let’s graph the effect:

Several points are immediately obvious: the line has moved downward, starting now at OE’, because of the increase in fixed costs. So the break-even point (BE’) has moved out to the right, which increases your business risk. Because the revenue and variable cost per unit haven’t changed, the slope of the line remains the same. The only good news is that the higher productivity of the new printer has moved ‘the wall’ to the right, allowing you – potentially – to make more profit.

But here’s the key point – this is only true if your old printer was the constraint (or bottleneck) in the system. The ‘system’ is defined as everything that converts raw materials into cash. If the true constraint is your prepress or finishing department, or your inefficient order processing, or the market itself, all your new investment will do is to make it less likely that you can be profitable. You will have spent money without increasing Throughput because ‘the wall’ is not where you thought it was. This is why the TOC ‘five focusing steps’ start with identifying the system constraint and then exploiting it to the fullest extent.

Let us take a less gloomy view of the potential investment, and assume it is indeed going to address a production constraint. Furthermore, perhaps it will allow you to retire some old analog equipment, or reduce the space needed for production or inventory, or save labor or overtime – possibly resulting in a net reduction in OE. More significantly, it might allow you to enter a new market, or address the needs of a less price-sensitive group of customers. How does this change the picture?

The investment is unlikely to reduce direct materials costs (unless you have a problem with waste that it will address), but the new market might allow you to charge higher prices. This means more Throughput, so the productivity line gets steeper – good! As Figure 5 illustrates, the combination of a small reduction in OE, a steeper slope to the Throughput line, and a higher maximum achievable volume has resulted in a lower break-even point and much greater profit potential. On this basis, the new investment looks easily justifiable.

The real world, unfortunately, is more complicated than this idealized picture. Printers are not producing identical widgets at constant prices; they are taking jobs at different prices, with different run-lengths, and printing them on machines of differing set-up times and run-speeds. But this does not mean that TOC thinking has no value. It leads to the realization that, as long as you have production capacity available, taking any work for which Throughput is positive (R>TVC) is valuable – even though, on an allocated cost basis, it may look unprofitable. (In his books, Goldratt calls this “making a mafia offer” – one that the customer cannot refuse, because the price or delivery terms are so attractive. He points out that this tactic needs to be used with care to ensure that it does not set a new low price point in a core market.)

The key point is that any positive Throughput contributes to fixed costs. For example, you may find that, given a short-run job opportunity but with a digital printer that is already fully-loaded, making plates and setting up an offset press might make sense – even though the estimating software that uses your ‘standard cost’ model is telling you the job is unprofitable on that machine.

Too many printers rely on a ‘cost-plus’ model using BHR to determine pricing. Throughput Accounting leads away from a ‘cost-plus’ model of pricing in favor of doing the hard work of finding out the true value to the customer of your service, and pricing accordingly. (Industry financial analysts New Direction Partners cite an even more pernicious result of using ‘cost-plus’ pricing: inadvertently giving away the benefits of your investment in new technology by basing prices on the newly-lowered costs that result from the investment!)

Many years ago, new to the pre-press and printing industry, I asked the owner of a small printing company what management metrics he used to keep track of his business. “Well I reckon that, if the overtime is up and the overdraft is down, I’m doing OK”, he said.

If your metrics for managing your printing business are the levels of your company’s overdraft and shop overtime, you are ‘driving by the rear-view mirror’ and probably not in control of your business. And if you rely on conventional cost accounting systems to tell you whether to take new work or enter new markets, maintaining competitiveness and profitability will be a struggle in today’s dynamic business climate. We need more sophisticated measures of the business, better methods for pricing by market segment, and better ways of evaluating potential investments. Relying on conventional cost accounting methods can be misleading – TOC and Throughput Accounting provide a different and valuable perspective.

This article first appeared in Printing Impressions.

Posted by Chris Lynn in Blog Posts, Printing & Packaging, Strategy

Label plant simulation

This simulation compares the productivity and profitability of conventional flexo printing with a stand-alone digital printer (which requires a separate die-cutting operation), and a ‘hybrid’ flexo+digital solution in which the digital printer is mounted in-line with the flexo press. In the hybrid case, the flexo print units can be used for priming and varnish-coating, and the finishing is done inline, with no loss of productivity.

Posted by Chris Lynn in Blog Posts, Simulation

Goosing Sales in Industrial Component Marketing

The scenario is familiar: it’s getting near the end of a critical quarter or year, and sales are below where they need to be, so the CEO tells the head(s) of sales & marketing to “do something – or else!” If the company sells consumer products, B2B consumables, services or low-cost equipment, there are many options for promotional initiatives that can influence short-run orders: special pricing, ad & email campaigns, sales incentives, coupons, and so on. But if your business is selling a specialist (non-commodity) component of a much higher-value product, many of the classic sales promotion techniques are likely to be ineffectual or counter-productive.

To examine this, let’s look at some of the key differences between a capital good supplier and the vendor of a key component of these goods:

components table1

The key difference that can be summarized from this table is that, for the specialist component supplier, it’s all about ‘design wins’. As the vendor, your task is to get the capital goods manufacturer (or OEM – Original Equipment Manufacturer) to design the component into their next generation of product(s). And since the timescale over which the products are developed is typically long, there is nothing you can do to influence this quarter’s sales to new accounts. Other marketing initiatives – lead generation campaigns, improved product specs, new branding, better sales training or whatever – may be perfectly rational for growing the business, but simply cannot help the CEO make this quarter’s numbers.

So, if new account acquisition is not going to help revenues in the near-term, what can you as the component vendor do to increase sales to existing customers? Hiking the price is a possibility, but likely to be difficult in the event that the existing customer is probably buying under a supply contract or ‘blanket order’ (a long-term order with many regular shipments). It may also prompt the customer to look more closely at competitors’ products when it comes to the design of their next-generation of equipment.

The temptation is to go the other way: to lower the price on certain products for a limited period – “This month’s special offer!” This might succeed in driving sales in the short run, but it is likely to be disastrous in the not-much-longer term. Every buyer knows that the best time to buy a new car is at the end of the current model year or the dealership’s financial reporting period. Do you really want to educate them into believing the same is true for your business? Not only is this damaging to your brand, but worse, you are “stuffing the channel”. In other words, unless the OEM has enough additional sales to use up the extra components he has bought on special offer, your products will sit in his inventory instead of yours, and therefore reduce your sales in the next one or more periods until they are used up.

Is there therefore nothing you can do to influence short-term component sales without damaging future prospects? There is, and it takes the form of two related initiatives: a Marketing Development Fund (MDF) and Ingredient Branding. The MDF effectively provides money to the OEM to help them sell more of their products. You might allocate 1-2% of the value of your sales to the OEM (in cash or in kind) to support their advertising, trade shows, sales seminars, and so on that will drive short-term demand for their – and therefore, your – products. In some cases, the component vendor might even collaborate with the OEM to provide sales prizes and other direct incentives to the OEM’s salesforce.

So that you get maximum future value from this discount, you might require that the OEM puts your logo on their promotional materials, and you might tie this in with your own Ingredient Branding campaign. There is no room to explore Ingredient Branding in depth here, but the classic ‘Intel(TM) Inside’ campaign gives the general idea. Intel’s CPUs were a crucial but invisible component of PCs made by a variety of OEMs, but Intel successfully promoted its technology directly to consumers, and through joint marketing with its OEM customers, to make its products not only visible but apparently essential for discerning buyers. GoreTex(TM) is another example of similar Ingredient Branding.

This table summarizes the various factors that can influence sales in the short, medium- and long-term:

components table2

To summarize: the assumption here is that a new product takes 12-18 months to come to market, so the component vendor sees no sales benefit from a ‘design win’ for that period. Discounting is likely to be counter-productive in the longer term, whereas ‘pull-through’ marketing that drives sales of an existing customer’s products can drive sales in a much shorter timescale. Marketing Development Funds stimulate this pull-through, and Ingredient Branding can add a strategic element of value.

Posted by Chris Lynn in Blog Posts, Marketing