The Standard

Maximise Profit
We are all taught by practically every advisor or other source
of advice that we should focus on the profitability of our

Profit =Sales – Op
business and that the number we should focus on is the level
of profit it generates.

Profit is important but to focus on it and use it as the

fundamental (financial) guide on how we run the business is
not only bad but fundamentally dangerous.

This is not a marketing concept, an ethical concept or even a

psychological idea. It is simply, and as you will see
mathematically flawed. And when you understand the
demonstration and grasp its implications for business as a
whole it will change your approaches to business.

The demonstration is based on a manufacturing environment

because it is the easiest way to demonstrate it but the logic is
equally applicable in any other business environment, be it
project management (construction or computer programming
for example) or service (e.g. solicitors or shops)

It may take a little time to follow and perhaps seem a little

complicated but bear with me – at the end when you have
reflected upon it you will – like almost everyone else say:

“Obvious really, just common sense!”

 The Investors De
The standard approach misses out the one thing that any
How much interest will it pa
Investor thinks about, the interest rate that their investment
will enjoy.

If you had a choice between two equally secure building

societies but one offered you a 10% interest rate and the
other only 5% you would not have too much difficulty deciding
Building Society A
which one to place your money with.
10
When we are considering the investment in an aspect of a
business we call the interest rate Return On Capital Employed
or ROCE for short

Building Society B 5

Where should I put my mon

 Return On Capit
This appears similar to the sum one would do to calculate the
interest rate on an investment in a building society. Actually
it is exactly the same!

Prof
The profit is the amount of money you retain after your
running expenses and the capital employed is the amount of

ROCE =
money tied up in the operation.

Capital E
If I make £200 profit and I have to invest £10,000 to do so I
will have made a 2% ROCE.

If I only make £100 profit but only need to tie up £500 I will
have made 20% ROCE.

Clearly I would be sensible to invest my money in the second

of these propositions and find somewhere else to invest my
remaining funds.

Obvious really, just common sense!

It is curious therefore that most businesses tend to adopt the

first investment simply because it makes the higher profit.
And there is one particular area of business that has spawned
thousands of articles analysing the best approach to the first
investment and entirely missing the implication.
 Economic Batch
Set up cost (for a printer)
Getting the Economic Batch Quantity right is regarded as
Half
critical for any manufacturing anthathour
company producestoits produce p
products in batches.

Putthethem
Before a batch can be produced machinery on the
has to press
be set
up. This takes time and therefore there is a cost before

Add the ink and paper

anything has actually been produced.

Once you begin producing the goods you have to pay for the

Running costs
materials being consumed by the process, the electricity
being used and the time of those people operating the
machinery.

Labour for each hour

Paper
Ink
Power
 Production Cost
Uni
300only produce one item it has to bear all
This means that if you
the costs of setting up the machinery as well as the costs
immediately associated with it.
250 then they share the set up costs and
If you produce two items
therefore half the amount each is bearing and then have to
carry their own immediate costs.
200
If you produce three then the costs are similarly reduced.

This results in a Cost curve similar to the one shown above.

150

100

50

0
1 2 3 4 5 6 7 8 9 10 11 12 13
 Holding Cost
Holdi
Unfortunately there140
is a further aspect to consider.

As I produce more I have additional costs simply to hold the

volume I produce. 1I20
have to store the goods which means I
have warehousing costs – space, heat and light, I have money
tied up in the materials required to produce the goods on
which I am either paying
100 interest or foregoing interest. I have
expended money on the labour used to produce them. I will
have to pay insurance, I may lose some or get them damaged
or I may find the market
80 for them declines.

As a consequence I have a holding cost that rises – this time

in a straight line – as shown above.
60

40

20

0
1 2 3 4 5 6 7 8 9 10 11 12 13 1
 Total Unit Cost
300

This means I have to add the two costs (production and

holding) to find the250
Total Unit Cost.

This produces a graph that looks similar to the one above.

The lowest total cost will be at the point where the two lines
cross. 200

150

100

50

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14
 Profit
300

We can also add to this graph a horizontal line that show the
price at which we sell the goods.
250
It is not difficult to see that the profit can be derived by
measuring the difference between the Price line and the Total
Unit Cost line. It also shows that the point of maximum profit
falls at the point where the 200two cost lines cross.

We can see that profit starts low, the rises rapidly to the point
where the two cost lines cross and then gradually declines.
150

100

50

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14
 Profit
Pr
Following this fairly 1basic
00
logic we can draw the profit graph
as shown above. It is simply the Total Unit Cost Line inverted
(turned upside down).

50

0
1 2 3 4 5 6 7 8 9 10 11 12 1

-50

-100

-150
 Maximum Profit
Pr
And we can see the100
point of maximum profit!

50

0
1 2 3 4 5 6 7 8 9 10 11 12 1

-50

-100

-150
 Return on Capit
Stock

Pr
100
Now reflect on the fact that the X axis is a quantity of stock.
This has a value (the quantity multiplied by the Unit Cost) and
we have money tied up in it – Capital Employed.

So the more we produce in each batch the more money we

50
have tied up –

or the more capital employed!

And because, as we approach the point of maximum profit the

0 not change much it means that if we
slope of the graph does
reduce the quantity we produce
1 2 we 3 make
4 5very6 little
7 difference
8 9 10 11 12 1
to the profit.

Typically we can almost half the batch quantity and only

sacrifice about 10%-50
of our profit.

So – produce at maximum profit and ROCE equals (say)

100/1000 = 10%
-100
Or

90/500= 18%

Which do you want?

-150
And bear in mind this is not 8% more ROCE it is 80% more.

And you still have 50% of your capital to invest in something

else!
 ROCE
100

And as you will see from the graph above the maximum
return on your capital is always at a point well below the
maximum profit level.50 And incidentally if you drift just a little
to the right of the maximum profit level your Return continues
to drop dramatically.

The point about this explanation has not been to teach you
about Economic Batch Quantities nor just to show that the
0
focus on profit is wrong.
1 2 3 4 5 6 7 8 9 10 11 12 13
It is wrong and, if you follow the implications through, it will
change the foundations of the way you approach your
business. It obviously affects decisions on production
quantities but changing
-50 the focus will also affect investment
decisions on plant, on relations with suppliers, on staffing
levels, on your sales propositions to your customers to name
but a few.

Even More Important

-100
May I suggest that if the advice you have been receiving from
your accountants, bank managers and from the mass of
business books is so fundamentally flawed and potentially
dangerous there might just be other basic concepts that have
equally shaky foundations?
-150

I promise you there are, and when you see them your reaction
will be:

“Obvious really, just common sense!”

 Visit us at www.obviousreally.com

And find out more about using this type of knowledge

to make your business fly!