Image Source: Unsplash
 

Data centers and chip fabs are the hot parts of construction, as noted in a previous article, so producers of materials used in these projects are ramping up production. Many domestic companies are trying to increase production capacity as tariffs make American-made goods more economical. And consumer tastes have driven companies to ramp up production of low-alcohol and no-alcohol drinks as my fellow Forbes contributor Jess Cording has noted.

Demand for particular goods and services changes frequently, so companies need to be ready to ramp up—or down—their actual output. In many cases, the faster the better.

Supply elasticity is how quickly a business can ramp up production to meet surges in demand. A wide variety of tactics can be used, depending on the type of business. Before developing strategy to be ready to respond to demand increases, business leaders must assess just how important elasticity is to their particular business. For some companies, developing the ability to quickly ramp up production and delivery will be very profitable. For others, though, only the cheapest of steps will be justified by the additional profits. This article will walk through the issues that business leaders should consider before investing in supply elasticity improvements.

Note that your economics course used the phrase “supply elasticity” a little differently than this article. In economics, the phrase refers to the increase in quantity supplied as a result of a price change. Here the discussion will include any factor that affects demand, even if the price is not much changed. Industries that have very elastic supply will see only small changes in price when demand increases, but very large changes in quantity sold. (Determinants of demand elasticity were described in a previous article.)

A later article will describe methods to increase supply elasticity, which vary according to the type of business. This article will explain whether a particular business leader should read that future article. In some cases, the advice will be to not bother, while in other cases a thorough review will be profitable.
 

Experience With Demand Fluctuations

Company leadership can begin by reviewing their own history, assuming they have been in business for a number of years. Experienced people will have a gut feel for how variable sales have been, but it’s always good to look at actual numbers. If the company has made acquisitions or developed new products or markets, the resulting sales changes should be backed out.

Newer companies that lack their own sales history can look at their industry as a whole. Monthly data on sales and production are available from various government agencies as well as some private sources. Industry trade publications often mention the statistics, providing a lead for further research.

Whatever the source of data, first inspect for seasonal changes. An easy way is to simply determine how the average sales in January compare to other months; then February, etc. A sophisticated seasonal adjustment program is available for free, or use my “Poor Man’s Seasonal Adjustment” method.

Next compute percentage changes from month to month, graph the data, and look at the peaks. The data will probably understate the increase in underlying demand. That is, if you were unable to serve all customers at a point in time, then your sales could have been even higher than what you actually sold. If unsure how many unsatisfied customers to had, dig out data on delivery lead times and cancelled orders, and ask the old-timers in sales and shipping what their recollections are.
 

Importance Of Reliably Serving Customers

The next issue for company leaders to consider is how important reliable service to customers is for the business. Although every business serves customers, reliability varies in importance. A fruit stand on a road to the beach that sells to tourists can run low on watermelons without ruining its reputation. But the company that sells on-off switches to an appliance manufacturer has to meet that customer’s needs or risk losing its entire relationship.

Reliability may vary with product or customer segment. For example, consider a company that makes gaskets for hydraulic assemblies. They would sell to both original equipment manufacturers and repair shops. If shipments are delayed to an OEM, a large factory might have to slow down production, so reliability is tremendously important. But if replacement gaskets are delivered slowly to a repair shop, the mechanic will grouse but the financial consequences will be mild relative to the OEM segment.

Some sales are part of long-term customer relationships, while others are one-offs. Consider a customer cabinet maker that sells directly to homeowners doing their own remodel as well as to contractors who manage multiple remodels a year. That homeowner will probably never order cabinets again, whereas the contractor will provide regular sales for years to come—so long as the cabinet maker provides reliable delivery. Most businesses fall into one category or another, but a few can allocate their capacity to maintain their long-term relationships. (Note to those contemplating a remodel: Work with a contractor with good long-term relationships with the subcontractors.)

Finally, businesses should evaluate their competitors’ abilities to serve customers. In some cases, quoting a long lead time for delivery will cost the sale, as competitors can fill the order. In other situations, the customer will wait. An auto mechanic who needs a replacement component for a European car will tell the customer to wait for a shipment. But if the need is for an ordinary nut and bolt, multiple sources will be readily available.

Profits On Incremental Sales

With these issues understood by management, it’s time to look at numbers on profitability. This analysis should be at the margin rather than for average sales. If one additional unit can be sold, how much money would be taken in and what would the hard costs be? Forget allocations for overhead. Though that concept is useful in some analyses, it says little about the contribution to the bottom line of one additional unit sold.

Generally, companies with a large capital investment have low marginal costs; most of the costs are fixed. Less capital-intensive businesses usually benefit less from incremental sales. The fruit stand’s costs are probably mostly fruit plus labor. When the fruit is gone, the workers can punch out. Keeping an additional employee on the clock to sell that last peach won’t help the bottom line much. The gasket manufacturer, in contrast, probably has expensive equipment that can either be used or sit idle; running the equipment costs relatively little compared to the sales price of the gaskets being made.

The analysis of incremental costs comes naturally to those who studied economics, but is not used nearly enough in actual business practice. Average cost is much easy to calculate and usually very accurate. Marginal cost often requires some guesswork because data have not been collected in fine enough detail. But analysis should use the right concept, even if not perfect, rather than the wrong concept accurately measured.
 

Conclusion

Strategies to increase a company’s ability to ramp up production quickly will usually be costly. Some small gains will probably be cheap, and should be implemented, but the bigger improvements will usually be expensive. Before looking into large expenditures, business leaders should understand just how important this flexibility is in their business model.

More By This Author: