One of the basic business concepts is range of production. It means maximizing the capacity (range) of the assets in your operation. When the business operation goes beyond the maximum production range, costs associated with the marginal production generally exceed the revenue generated with the marginal increase. So to maximize profit in any business, operate within your range of production.
An extreme example of this concept is a poultry or egg production farm. In general a hen house is about 300 yards long and houses upwards of several hundred thousand chickens. So assume the hen house or warehouse can hold 250,000 animals and this is the maximum capacity. Well, what if you wanted or needed 250,001 chickens to meet the demand of your customer. Where do you put the next chicken? You would have to purchase a new hen house, add to this an upgraded waste production system, plus pay for the cost associated with a feeding/watering system and a cooling system. What do you think all of this will cost? $2? Try several hundred thousand or over a million dollars to add one more chicken to the production system. The chicken will earn you maybe $4 per quarter, at a cost of almost a million dollars. This is not a good business model and although an extreme example, you get the concept.
So how do you know the range of production for your company? Once you have identified the range, what is a good model to determine the best overall profitability? To step up to the next range of production, how much does it cost and what issues do you address to make this change? The following sections describe each one of these concepts in detail and uses examples to illustrate.
Determine the Range of Production
Every business operation has a range of production with its existing asset and labor pool. Determine which asset generates the real money for the company. If your business is service driven, then your production is limited by the knowledge (skill sets) and available hours of your staff. See Labor Availability for more information about this business concept.
For the equipment intensive or asset driven operation, use the old saying of ‘the chain is only as strong as the weakest link’. So look at your equipment, which particular asset drives the ability of the company to produce product? I’ll give you a great example.
This piece of equipment determines the range of the entire operation.
As the owner of your business, look at your assets and your staff and identify those one or two areas of concern. These issues will determine the maximum range of your production given the current situation. It is at this point that you need to evaluate some form of measurement to identify the number of units for maximum production. If labor intensive, it’s the number of available hours. If you are transportation driven, then it’s the number of miles in a given period of time that your fleet can produce. Other measurement units include square feet of construction if in the framing business, feet of pipe laid if involved in underground utilities, or number of widgets per hour/day/week if in a manufacturing environment. Identify the best measurement unit to evaluate the range of production.
Once the unit of measurement is identified, determine the maximum number of units in given period of time, a good profit point, and the various break even points (yes there are several). With this knowledge you can move forward with efficient operations.
Model of Profitability
Now that your range of production is identified, determine the optimum point of production. What this means is that it isn’t always a good idea to operate at 100% of the maximum point in the range. Whether human driven or equipment driven, every production device has an optimum operating (efficiency) point to maximize its production. A good example is a vehicle, many vehicles can operate the most miles without a major breakdown (engine replacement) if those miles are driven at 45 miles an hour on a relatively flat highway environment. To add value to this concept, the fuel mileage is best in the 35 to 40 range (optimum energy transfer via the proper gear usage in the transmission).
By evaluating and determining this optimum point, the business owner should allow for increased need in production (overtime, more units within a given period of time, etc.) to address customer needs. If you operate at the extreme point of production and have no leeway for additional production, then you are setting yourself up for the hen house issue illustrated above. Naturally, going to the maximum point does maximize profitability because you are spreading overhead, marketing costs over greater gross margin. But remember the long term goal; it’s about the lasting (mentally and physically) and enjoying owning the business. Don’t go through burn out just to make a few marginal dollars.
Stepping up to the Next Level
Every business is different in nature; there are costs to get in, costs to continue, and costs to increase production. The hen house above is one example. In the fishing industry, you add another vessel and the associated gear and more. The service industry has one distinct advantage in adding more staff. However, they do cost money for training, arranging office space (you could be maxed out for office space), and technology issues. So can one more staff member with a unique skill or knowledge increase your revenue enough to offset the additional costs involved?
In some situations, stepping up to the next level requires an entire corporate change, moving the location of production. An example would be an auto repair facility. One more bay may require relocating the entire business to a new site because of the land limitations or code restrictions. If you do decide to go to the next level and this requires a significant facilities or culture change, you will need to address having enough sales to cover these additional costs. Many novice business owners think that the next level is a linear line against revenue. The reality is it closer to a stair stepping graph than a linear line. So look at the costs and the change in sales to take the next step up.
As an owner of a small business, make sure you understand the operating range of production in your company. Identify the unit of measurement, determine the best optimum point of production and finally, evaluate what it will really take to step up to the next level. Remember, operate within your range of production. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.