Saturday, August 4, 2012

Focus and Leverage Part 135

I had an interesting conversation the other day with one of my clients about traditional Cost Accounting (CA) and the TOC based Throughput Accounting (TA) that might be interesting for everyone.  It seems that one of my client’s bosses at the company’s corporate office asked what they were going to do about reducing their overtime.  Seems like a reasonable request if the overtime is too high…right?  And if you look strictly at the numbers (i.e. $’s spent on OT), and if you’re deeply imbedded in traditional CA, you just might come up with the wrong question.  Now what do I mean by that?

At the direction of their corporate “brothers” and as part of the contract, this particular client had “staffed up” to what they consider “normal” workloads and as long as the workload remains within what they considered to be normal range of workload, then very little overtime was required.  But when the work load increased significantly, they used overtime so that they could meet the new demand?  Isn’t that when overtime is justified and should be used?  I mean it would make very little sense and would probably not be possible to rush off and hire additional workers to cover a sudden increase in workload.  Now, if there was a clear shift upward in workload that sustained itself for a definite period of time, then they might hire more people.  So knowing that the plan was to use overtime to cover sudden increases, why would the corporate experts ask them what they were doing about their increase in overtime?  The answer to this question and other ridiculous one lies in traditional CA’s belief that favors cost reduction above everything else.  Let’s explore some of the differences (maybe conflicts is a better word) that exist between traditional Cost Accounting and TOC based Throughput Accounting.

Throughput Accounting (TA) is really defined by a few simple definitions as follows:

·         Throughput (T): T = The rate of cash generation through sales or Sales Revenue – Totally Variable Costs  or T = SR - TVC

·         Inventory or Investment ( I ): I = All the money invested in things companies purchase that they intend  to sell.

·         Operating Expense (OE): OE = All the money a company spends to turn inventory into throughput

·         Net Profit (NP): NP = Throughput – Operating Expense or NP = T - OE

·         Return on Investment (ROI): ROI = Net Profit ÷ Investment or ROI = NP/I

So with these five simple formulas we can answer, in advance, the impact of the decision we are about to make.  Will the decision:

1.    Increase Throughput?

2.    Reduce Operating Expenses?

3.    Increase our Return on Investment?

It really is this simple.  With Throughput Accounting, good sound business decisions can be made if the actions we are considering increases throughput, decreases operating expenses or increases ROI.  But if you’re making decisions using Cost Accounting rules, your decisions will be much, much different.  Remember, above everything else, cost accounting looks first at cost reduction or "How do we save money?"  So is it any wonder that this guy’s corporate boss was asking him about overtime reduction?  Never mind that the overtime generated significantly more throughput because he’s only looking at how much money he could save by reducing overtime.

And so it goes, cost accounting stimulates the wrong behaviors in other ways.  Consider the belief by CA that embraces efficiencies as a performance metric.  What type of behavior results by using this metric?  If I am being measured by how high I can make my efficiencies, then one of the focal points would be to run my part of the process to the max.  But what happens when I do this?  If my part of the process has the shortest processing time, then the next process step will have a mountain of work in process (WIP) inventory sitting directly in front of it.  My people will appear busy for sure, but have they contributed to improved profitability?  If you ask a die-hard cost accountant, they’ll probably give you a thumbs up because they view inventory as an asset and because higher efficiencies are a good thing.  The fact is excess inventory ties up cash, increases operating expenses, impedes throughput, extends cycle times, hides quality problems and causes on time delivery metrics to deteriorate. The only place efficiency makes any sense at all is in the constraint!

Here’s my bottom line.  Using cost accounting to make daily management decisions is a serious mistake because this is not the intended purpose of cost accounting.  Cost accounting has only one purpose….to satisfy outside reporting requirements (i.e. GAAP).  Traditional cost accounting provides false incentives to build inventories because it views inventory as a positive asset.  Throughput Accounting views inventory as a negative liability because it is indicative of system-wide flow problems.

So back to the original discussion I had with a client the other day.  If the corporate office truly believed in or at least understood even the basics of TOC and TA, the correct question should have been, “What are your plans to increase throughput?”

Bob Sproull

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