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Most business models are fundamentaly flawed!

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Practically everyone involved in any batch processing environment knows how important it is to calculate the economic batch quantity and produce at the lowest possible cost.

Unfortunately they are wrong...

...and once you understand why you will realise why most business models in most other fields are also wrong.

The graph above shows how to caculate the EBQ to ensure that an organisation achieves the lowest cost and generate the higest profit for any given process. And there are many thosuands of articles written on the subject. It is a great shame that they do not make the next connection - if you do it will fundamentally change your thinking about business in general.

What is an Economic Batch Quantity (EBQ)?

If you already understand the EBQ concept then skip to the next step.

In any batch process there are two sources of cost; there is a set-up cost and a production cost. If you are running, say, a printing press, you have to put the plates on the press, add the right colour of ink, add the right paper etc. This time cost has to be shared by each piece produced, so the more you produce the less cost each has to bear which results in a cost that falls exponentially in a gentle curve, fast at the begining and more slowly as the quantity increases (grey line).

The prodcution cost is arithmetically related to quantity produced and rises in a straight line (orange line).

If you add the two costs together you will get the total unit cost - the blue line - which as you see falls fast to a low point and then starts to climbs gradually.

From this we can easily see the point of lowest cost, in this example, is at the point 4.

And if the price at which we sell is 140 we can also see the profit we will make per unit.

The Next Step

It is easy to invert the chart and see how the profit rises and then falls again and you can see that in this case the maximum profit is at 4 (where you actually make 62.5). Obviously the units could be anything - £s, $s, 10s, 1000s, etc.

EOQ2

This seems fine and obvious but...

Suppose you went to a building society and they told you that if you invested £100 they would pay you 5% interest but if you invested £50 they would pay you 10% and let you keep the other £50. Pretty crazy?

Well let's do some sums based on the graph above.

First you have to realise that the quantity of goods you have produced has a value. Assume each unit had a value of £100 and the profit figure on the vertical axix was in £s.

This would mean that producing 4 units would tie up £400 - this incidentatlly is known as Capital Employed.

So your return on that Capital Employed (ROCE) would be £62.5/£400.00 or 15.625%.

What happens if we accept a lower profit?

Cut production to 3 Units

  • £60.00/£300 = 20% ROCE

Cut to 2 Units

  • £45.00/£200 = 22.5% ROCE

Which is a 44% increase in the Return On Capital Employed. 

And if we could produce about 2.8 units we would find it was higher still.

What should you really take from this?

The point of this article was not to show that the EBQ calculation was wrong but help you (and the rest of the world) understand that Profit is not the standard on which to base business decisions or models.

That curious ratio, ROCE, that accountants occassionally mention is what you should be seeking to maximise.  This has many implications for both operations and the fundamental business model. It can change your evaluation of the key enabling resource, it will change your approaches to outsourcing and even affect your HR policies.

A note about ROCE

For the sake of clarity ROCE is simply Profit/Capital Employed but takes account of the time for which the money is tied up. Which contrasts with the frequently quoted ROI or Return On Investment.

If I buy something for £100 and sell it for £110 my ROI is £10.

If I sell it next in a year's time my ROCE is 10%, if I sell it next week ROCE is 520%. 

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Most business models are fundamentaly flawed! by David Willox is licensed under a Creative Commons Attribution-NoDerivatives 4.0 International License.

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