Sunday, August 19, 2012

Focus and Leverage Part 137

As a continuation of my series on Throughput Accounting, I’ve asked Bruce Nelson, my co-author for Epiphanized – Integrating Theory of Constraints, Lean and Six Sigma, to write a posting on a subject he covered briefly in our book's Appendix 8, On-the-Line (OTL) Charting.  This is a very helpful tool to track the state of the business on a daily basis rather than waiting until the end of the month (or quarter) to find out.  I want to thank Bruce for writing this blog for me, especially when I only asked him to this morning.

Recently in his blog Bob Sproull has been writing several pieces about Throughput Accounting (TA).  As a supplement to those writings Bob has asked me to contribute a write-up about On-the-Line charting and how it applies to TA.

Most companies who use financial metrics live and die by the quarterly report.  Some companies are more inclined to look at it monthly as a decision tool and to get a “feel” for the financial numbers to date.  But, even when you track and monitor the financial numbers on a quarterly or monthly basis there are times when the interval of time seems inadequate.  It’s disheartening to review a quarterly report and realize you have been losing ground for the last two months and didn’t know.  Even the monthly interval can be too short to give the necessary “heads up” that a potential problem currently exists.  It is much more preferable to have reliable information available on a much shorter time interval.  However, compiling and presenting a useable profit and loss statement on a daily basis seems unrealistic.  But, what if there were a way to compile and analyze financial numbers on a daily basis to help with the decision making – would you be interested?  Without a doubt, I’m sure the answer is “YES!”  If you had information available that could tell you where you are TODAY based on business activities as of YESTERDAY then, that would be a valuable tool.  With this kind of information you could make the necessary and accurate daily decisions about where you are and where you need to be.  It’s always much nicer to know this information as quickly as you can, versus waiting until the end of the month, or worse the end of the quarter, before realizing a problem is present.

In order to view this information on a daily, enter the on-the-line chart (OTL).  The OTL is a simple concept that is based on the rules of TA to allow the user access to the lasted information available.  Setting up an OTL is very easy.  First, you need to have an estimate for the Operating Expense (OE) on a monthly basis.  In other words, how much does it cost you to keep your business running every month?  The beauty of the OTL is that it does not need to be accurate down to the dollar or the penny.  It is understood that there can be fluctuation in the monthly dollar amounts.  The OTL is strictly a compass to keep you heading in the right direction and notify you of potential issues when they happen.

There are a couple of ways to get these numbers.  You could take yearly expenses and divide by 12 to get an estimate of monthly cost, or you could take monthly OE and divide by the number of days in the month to get a daily cost.  What we want to end up with is an estimate for the daily OE being accumulated.  Once you have that number we can plot it on a graph using Excel.  Suppose, for an example we had a business that had a monthly OE of $30,000, and we want to plot this number for the month of June.  If we take the $30,000 and divided by 30 days then, the estimate is about $1,000 per day of OE.  We would plot this in Excel as a cumulative number, i.e., Day 1 equals $1,000.  Day 2 equals $2,000. Day 3 equals $3,000, and so on.  Figure 1 gives an example of what this chart might look like.

Figure 1 – The daily plot of Operating Expense for one month.

With the information plot this graph shows the daily cumulative totals for the entire month.  It is possible that the OE numbers could change in any month.  Some employees quit, and new employees are added.  If the variance is high then, adjust the numbers accordingly.  However, what we are really trying to establish here is the view of the OE from the ten-thousand foot level and not necessarily the day-to-day changes.  Think BIG picture and not finite detail.

With the OE line established, we now want to the collect the throughput data.  REMEMBER:  this only works if we are collecting and reporting throughput in accordance with TA rules.  As such throughput is calculated as product selling price – total variable costs (T=SP – TVC) while Net Profit equals Throughput minus Operating Expense (NP = T – OE).  As you probably already know but, let’s refresh anyway, TVC is any cost associated with the product.  This will include raw material, sales commission and shipping charges.  Remember labor charges ARE NOT added into this number.  Labor costs are part of the operating expense.  Suppose for our example the product we make has a selling price of $90.00 and a TVC of $25.00.  That means for each product sold we have a throughput value of $65.00 ($90.00 (SP) – $25.00 (TVC) = $65.00 (T)). With this information we now know that in order to break even on the OE we must make 15 or more product per day.  With 16, or more, product per day we start to make a profit.  It is interesting to note that the CA rules will tell you that you are making a profit with each product sold.  TA counters with the realization that profit does not and cannot begin until the 16th product is made.  It is a vastly different financial concept to think of products, product pricing and product margins using TA.

If you track the daily throughput from the system and, calculate throughput correctly, you should have a pretty good idea where your company stands right now.  Figure 2 shows the impact of throughput to OE after 17 days of tracking.

Figure 2 – This figure shows Throughput track to the OE line.

Using throughput accounting and looking at this chart on a daily basis can give a General Manager or department manager accurate and useful information.  The analysis is simple.  If throughput is tracking below the OE line then, you aren’t making enough money to cover the OE expense.  The management team can determine the issues causing the lower than necessary throughput and initiate corrective actions to bring the throughput line up.  If the throughput line is tracking above the OE line then you are making a profit and possibly no actions are required.

The OTL is a great tool to track and monitor the OE and T on a daily basis.  It gives you a good “Kentucky wind age” analysis to determine where you company is today – right now.  No need to wait for the month end, or quarterly reports to figure out what happened – good or bad.  Using the OTL you can have a pretty good estimate of how the company is doing, and make corrections, as necessary, to get back on track for revenue and on-time-delivery.

I hope this has been a helpful explanation of the On-the-Line chart and how it can be used for a daily assessment of where your company is.

Bruce H. Nelson

Thanks again Bruce for your excellent posting.
Bob Sproull


Anonymous said...

this article is just what I was looking for to bring the OE and TH concepts together to sell the TH concept to management

Anonymous said...

the last comment was from Alex Fedotowsky about bringing the OE and TH together....etc.

Anonymous said...

Loosely to this article: Don Wheeler writes about numerical naivete and how decisions are based on falsely monthly reports. Changes are shown in percents and no-one knows monthly variation. Is this just normal noise or is there a signal telling true change in system? If you ground your decisions on noise you are totally wasting time.

Bob Sproull said...

To Vellu: I received the following comment from Bruce Nelson in response to your posted comment on 8/21/2012.

"I agree that data that is not accurate leads to useless decisions and wastes time. However, I think we stressed the need for accurate data input! Any system(s) that collects data to be used in reporting MUST maintain accuracy, or at least high ethics to input data correctly. The old adage is true - "Garbage in - Garbage out!" This is not to say that data must be pristine to be useful, but rather close enough to make solid and accurate decisions. Data collection is usually dynamic and not static to any system. Most companies that use data pick a point in time and measure on that day or that time, or whatever the rule is. Not unlike banks and other institutions who track checking account and other things. After they run a statement the data can and does change with additional checks written, or deposits made - it is dynamic in nature, but they pick a point in time and take a snap-shot at that point. It can go up or down from that point based on the action taken (withdrawal or deposit)."

Anonymous said...

Maybe I wrote little badly, sorry I'm from Finland and english is not my native.

My point was that collected data can be absolutely accurate but there's always natural variation in any system. And you must know that. If you make decisions based on last month without knowing the variation you could just waste your time. So if next month looks different was it just variation or action taken?

Put the data in process behavioral chart (like XmR) and then base you decisions on that what the chart tells you about the system.

Bob Sproull said...


Here is Bruce's response to your comments. "Any system will exhibit variation and that should be seen with the collected data. I believe what we were talking about was the distribution and resupply model ?? The variation is based on usage and can certainly vary by the day, week, or month. The distribution is a system to react daily to changes. X-MR (to me) is more to predict stability (X) and predicatability (MR). If 10 are used then, put 10 back in the system. I don't see this as a predicitve tool but, rather a replenish tool. We aren't trying to make decisions about future buys but, rather if we replaced what was used. From an X-MR stand point I'm not sure it would apply?? The X (stability) comes from the replenish. The MR (Pedictability) come from the distribution (usage). I think X-MR would add complexity, while Distribution and Replenish creates simplicity."


Anonymous said...

I was writing more general about metrics, how managers are numerical naive and "go panic" based on one bad month. Not directly to this article. Sorry if I was confusing...

The OTL tool is great, simple and works well as "eye-opener".