Sunday, March 18, 2012

Focus and Leverage Part 98

In my last posting I was telling you about a recent discussion I was having with one of my clients and how he believed that the key to profitability was through saving money.  My counter-argument to him was that the key to profitability was through making money.  And while many people believe these two concepts are the same, in reality the strategies are grossly different.  One is firmly based in the traditional Cost Accounting (CA) mentality while the other is based on something called Throughput Accounting (TA).

Throughput Accounting is based upon three very simple metrics….Throughput (T), Investment or Inventory (I) and Operating Expense (OE).  Using these three simple metrics demystifies the concept of accounting.  So let’s look at each one more closely.
1.    Throughput is the rate at which inventory is converted into sales revenue.  That is, if you make product and store it on shelves or in a warehouse, this is not throughput…’s inventory.  Products are only considered throughput when a sale occurs and money is received from a customer.
2.    Inventory/Investment is the money a company invests in items it intends to sell.  This includes finished goods, buildings, equipment or anything that you could sell one day.
3.    Operating Expense (OE) is all of the money you spend to generate throughput and would include things like wages, utilities, etc. 
All of the money that resides within your company falls into one of these three categories.  One of the major differences between CA and TA is that TA is focused on cash without any need to allocate it to products like CA does.  In my last posting I told you that labor costs are no longer variable, but rather they are usually always fixed costs and this is an important difference when we’re discussing how to make money.
TA really is focused on providing the necessary information for decision makers to make much better decisions.  If the goal of the company is to make money, then any decision being considered should move the company closer to that goal.  So with these three simple financial metrics, T, I and OE, profitability decisions are much easier.  Quite simply good business decisions will:
1.    Cause Throughput to increase.
2.    Cause Inventory/Investment to decrease or remain the same.
3.    Cause Operating Expense to decrease or remain the same.
Any good decision should be based upon the global impacts to the company and not products or processes in isolation.
How many times each week do you hear about companies laying off employees in order to reduce costs become more efficient?  What these companies are in effect saying is that they’ve either forgotten or never learned how to make money.  They are so focused on saving money that they’ve ignored or forgotten how to make money.  Think about it….if the key to profitability is through saving money, then cost reductions through layoffs have a very distinct lower limit and if you go below that limit, you can actually debilitate the organization.
And what about inventory reduction?  Cost Accounting places a value on inventory while seemingly ignoring things like holding costs.  Inventory doesn’t have any value until it’s sold….or until it becomes throughput.  It’s really a liability until it’s sold.
What about Throughput?  Does throughput actually have an upper limit?  I mean theoretically you could produce an infinite amount of product with no upper limit and as long as it is sold the new revenue entering the company can continue to grow.  And if labor costs remained the same, this new revenue minus totally variable costs would flow directly to the bottom line.
So for me it’s easy, the key to profitability is through making money and not through saving money.  I hope you see the difference?

Bob Sproull

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