I read and took notes on chapter 2 of _The Choice (Revised Edition)_ by Goldratt.
> CHAPTER 2: Uncommon Sense
> A few weeks ago, I spent a morning with a group of more than twenty middle-level managers from a major brand in apparel. We will call the company BigBrand. My reason for writing this report is the annoying feeling that you think that there is a limit to how much a company can improve, that a quantum jump in performance is possible for only small and maybe medium-sized companies. But when it comes to very large companies (the billions-of-dollars companies), an improvement of the magnitude of, for example, bringing their yearly net profit to be equal to their current annual sales in just a few years, is really beyond a realistic possibility.
The quantum jump idea reminds me of BOI's jump to universality idea.
> There was a lot of debate in the room until the top gun—the director of finance—spoke up. His decisive answer was that in five years they would almost double their net profit to $1 billion per year. They are aware that it is quite an ambitious target, and they know it is not going to be easy. Nevertheless, as a company they are determined that yes, they can make it. That ended the debate.
That director of finance isn't really doing any reasoning or calculation besides saying that they'll increase profits 15% annually (which equates to 100% in 5 years). That basically equates to (at least by some valuation models) an increase in company valuation of 15% annually. When I was in college studying engineering economics, I recall the professor talking about how big companies like Caterpillar make finance decisions regarding new projects. He said that they look for a rate of return of like 15%, and they reject any projects less than 15% expected rate of return. So I took that to mean that 15% minimum expected annual rate of return is standard in the business world.
I think the existence of that standard pressures people (like the director of finance mentioned above) to never claim anything less than 15% expected annual rate of return.
> Rather than starting to explore how they are going to achieve this ambitious target, I preferred to ask if they think that in five years they can reach a $4 billion net profit per year. Not surprisingly, they didn't need any guidance answering this question. They made it clear this number is totally, utterly unrealistic.
A $4 billion net profit per year after 5 years (starting from $500 million), means 51% annual rate of return, or 800% in 5 years.
Earlier there was a data point mentioned that can be combined with these others to figure out how much of an increase in sales is required to make an increase in profit of $3.5 billion per year. (I'm guessing this gets discussed later in this chapter.)
I ran some numbers and found out the following. If we assume a gross profit margin of 65%, and an increase in sales of 108% over 5 years, then that translates to an annual net profit increase of $3.5 billion, taking the company to the proposed number of $4 billion annual net profit. This assumes that the current overhead cost would not need to be increased in order to handle the 108% increase in sales and production.
Instead if we assume a gross profit margin of 80%, the increase in sales needed to reach the same target is 88% over 5 years. Again this assumes that overhead cost would not need to be increased.
I don't think 88-108% increase in sales over 5 years is unrealistic. Like maybe you could buy up another company with equivalent sales numbers such that you can consolidate overhead expenses (like maybe you don't need any of the overhead expenses of the company you're buying). This would reach the $4 billion net profit target.
> To reveal the true potential for improvement I wanted them to examine the phenomenon of shortages—of missing items.
looking for missed opportunities. that could be a bottleneck.
> When many then speculated that lost sales might be as high as fifty percent, I added, "If we take as a base the existing sales, doesn't it mean that the amount you lose due to shortages is close to what you are actually selling?
holy crap. so if they greatly reduced lost sales due to shortages -- say by 90% -- they'd get a 90% increase in sales, which is near the 108% that I said was needed to get a $4 billion annual net profit. (90% increase in sales translates to $3.4 billion annual net profit (assuming 65% gross profit margin).
> We went over the following chain of logic. If an item was depleted in one month, they actually lost its sales during the next five months. The lost sales of that item are probably equal to five times the amount that was sold. (They agreed that, usually, demand for an item at the beginning of the season is not a peak but a reflection of genuine market demand.)
FUUUUCK! So for some items, 83% of their sales are lost!
> They didn't have numerical answers, but their impression was that the number of items depleted within the first three months of the season is very significant. They would not be surprised if it is typically equal to one-third of all SKUs.
so 33% of SKUs lose >50% of their sales due to shortage.
> As we said, items missing from a brand's warehouses are erased from the list of items that the shops should hold. Therefore, we should combine the impact of missing items in the shops with the impact of missing items in the warehouses. They agreed that we are dealing here with a phenomenon that is, most probably, equal to or higher than the total amount of realized sales.
But the "equal to" scenario was already decided earlier in the discussion. These new facts mean that its much more than "equal to".
> After some discussion, they reached the conclusion that if by some miracle the shops will not suffer from any shortages, BigBrand would need to increase only modestly its infrastructure to support the resulting increase in sales; the resulting increase in sales would not be associated with a meaningful increase in operating expenses. The only cost that would go up is the amount of money they will have to pay their suppliers for the additional goods. But since they purchase the goods for a price that is only one-fifth of their selling price, 80 percent of the money generated by the increase in sales resulting from the reduction in shortages goes directly to the bottom line.
Ok so now we learn that their cost of goods sold is 20%, in other words, the gross profit margin is 80% (which was my second theoretical assumption about it).
So a 100% increase in sales translates to $4.5 billion annual net profit. That's $500 million more than the original $4 billion idea.
> Yes, they can, provided that they will abandon the illusion created by the forecast—the illusion that the future demand is known. How should they operate if their starting assumption is that they do not know the future demand per SKU?
I'm guessing he's going to explore the idea of reducing batch size (similar to what was done in the manufacturing company in the book _The Goal_ by Goldratt).
> Will ordering much smaller quantities, more frequently, raise the price?
> Not as long as the total amount ordered per season is roughly the same or larger," was their answer.
HAHA! So they can reduce batch size down a lot without increasing cost per item (though cost of shipping will go up, but that's far smaller than the current cost of lost sales).
> What would happen," I asked, "if BigBrand were to make this offer to their retailers: you will accept back any merchandise for a full refund?"
Ah. This would release the pressure on the retailer to buy less. So if retailers buy more, then there's less losses due to shortages at the retailer.
> The head of finance provided a perfect ending when he summarized: "Reaching four billion dollars net profit per year is starting to look conservative."
this made me laugh out loud. :)
# Process
Started 8am
Ended 9:25am
I did not take notes in Apple Books app. Instead I wrote full comments about each quote that I wanted to comment on. I'm not sure which method is better, the one I did in last chapter or this one.
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