Throughput price setting
/How to Set Prices Based on Throughput
The use of throughput concepts can be used to arrive at product price points that allow for a sufficient amount of cash spinoff to fund the continuing growth of a business. In essence, throughput focuses on the amount of profit that can be derived by altering the mix of products passing through a bottleneck operation. Typically, the bottleneck is located in the production area, and involves a machining operation that does not have sufficient capacity to handle the backlog of work associated with it. To maximize the overall profitability of a business, a company should accept orders that have a combination of the smallest processing time at the bottleneck operation and the largest amount of throughput (revenue minus all variable expenses).
If there is no bottleneck anywhere in a business that can interfere with the sale of goods, the bottleneck is said to be in the marketplace. If so, the key pricing decision is whether a reduction in price will generate more sales, and whether the price reduction will still yield a net increase in throughput. An additional consideration is the cost (or even the availability) of additional working capital to support any additional sales. The seller may have to support larger amounts of accounts receivable and on-hand inventory balances if it chooses to reduce its prices, which may place a limitation on the amount of short-term growth that can be supported without accessing additional outside funding.
If working capital turns out to be the bottleneck that keeps a business from generating additional sales, the focus on new sales should be on any transactions involving cash payments or short credit terms, while transactions involving longer credit terms are given a lower priority.
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Example of Price Setting Based on Throughput
Armadillo Security Armor manufactures several types of body armor. Four items made from spun graphite must be cured in the company’s baking oven, which is the constrained resource. The baking time depends on the physical size of the parts inserted into it. Two other items are made from plate steel, and so use other machinery within the company that are not related to the sprint capacity situated upstream from the baking oven. The relevant information is:
Based on the throughput per minute information in the last column of the table, Armadillo should emphasize sales of its graphite torso plate, since this product generates the highest throughput per minute. Another option is to increase the price of the graphite chest plate, so that the product is no longer mired at the bottom (figuratively speaking) of the rankings.
Another consideration is whether these products are ever sold as bundles. If so, the torso plate should be combined with the mitts and leggings as a bundle, while the graphite chest plate should be excluded. In this case, the main point is that the throughput per minute for the graphite chest plate is significantly lower than for the torso plate.
Both of the steel products have no impact on the baking oven, so there is no constraint time analysis upon which to base a price.