In my last blog I finished by saying that going after cost reductions is not the best way to make more money for your company. So if cost reduction isn’t the best way to make more money, then what is? In order to demonstrate this to you, I need to introduce you to a different brand of accounting called Throughput Accounting (TA). TA was developed by Dr Eli Goldratt, the creator of the Theory of Constraints, to simplify financial decisions. I know this will seem like a lot of new terms, but as you will see, they really are simple….. at least much simpler than a traditional cost accounting report. If you can learn these simple terms now, and apply them in your company, you will be well on your way to making more money for your company than you ever dreamed possible.
In order to judge whether an organization is moving toward its goal of making more money, three basic questions need to be answered:
1. How much money is generated by your company?
2. How much money is invested by your company?
3. How much money do you have to spend to operate your company?
Traditional cost accounting, as many of you have experienced, is not only difficult to understand, but it’s all about what you did last month. Goldratt recognized the need to have real-time financial data and created his own version of accounting. He developed the following three financial measurements:
Throughput (TP): The rate at which the system generates “new” money primarily through sales of its products. TP represents all money coming into a company minus what it pays to suppliers and vendors. The actual equation for TP is, TP = P – TVC where P is the price/unit of product and TVC is the totally variable costs associated with the sale of the product. TVC is typically the cost of raw materials, but could also include things like sales commissions, etc. things that vary for each unit of product sold.
Investment or Inventory (I): The money the system invests in items it plans to sell. This includes both work-in-process and finished goods inventory.
Operating Expense (OE): The money spent on turning investment (inventory) into TP, including labor costs, supplies, overhead, etc. basically any expense that is not in the TVC category.
The important point here is that TP is not considered TP until new money enters the company by producing and shipping product to its customers. Anything produced that is not shipped is simply inventory, which costs the company money and ties up needed cash. Accordingly Goldratt defined Net Profit (NP) and Return on Investment (ROI) as follows:
NP = TP – OE and ROI = (TP – OE) ÷ I
So with these three simple measurements, TP, I, and OE, Goldratt reasoned that organizations are able to determine the impact of their actions and decisions on the company’s bottom line NP and ROI in real time.
Ok, so why do I say that focusing on TP is so important? If you consider inventory reduction, it is a one-time improvement that frees up cash, but after the initial reduction, there’s really nothing left to harvest. OE has a functional or practical lower limit and once it is reached, nothing more can be harvested without having a negative impact on the organization. That is, companies that typically focus on OE many times engage in layoffs which if cut too deep will negatively impact the performance of the company. What about TP? Theoretically it has no upper limit! As long as you have the sales and you can reduce the cycle time of the constraint, TP continues to increase. Yes, TP has a practical upper limit, but the potential is there to continue growing profits.
The figure below represents a graphic of what I just explained. Look at the potential of all three profit components. OE, the target of most improvement projects, is actually the smallest component, followed by Inventory which is slightly higher, but is limited at zero. TP, on the other hand, is much larger than either I or OE. The point here is, if you want to drive profitability higher and higher, you must focus your improvement efforts on the process that is limiting your ability to do so….the constraint to drive throughput higher and higher. As we have seen, TA is much simpler to understand, allows for faster decisions (using real time data), and decisions that are linked directly to your company’s bottom line.
TA is used to make real time decisions. Is it obvious to you that the best decisions are those that result in increasing TP while decreasing OE and I? Keep in mind that I’m not suggesting that traditional cost accounting should be discarded, but if you’re trying to determine where to focus your improvement efforts, use TA. In my next blog, I’ll introduce TOC’s five focusing steps and how the Theory of Constraints process of on-going improvement (POOGI) actually works. This will set the stage for future discussions on why integrating TOC with Lean and Six Sigma is the best strategy of all for improvement.