Focus and Leverage Part 158

In this posting I want to talk in more general terms about both Cost Accounting and Throughput Accounting.  But before I do, I want to make sure everyone understands that I’m not advocating abandoning cost accounting….far from it.  It is required for GAAP reporting.  What I am saying is that it’s a mistake to use cost accounting to make routine operational and management decisions.  Keep in mind that Cost Accountants are not stupid, so if you accept that they aren’t, then why can’t they seem to understand that using cost accounting techniques for operational decision making isn’t very smart? In this blog posting I want to share an example from a wonderful book by Debra Smith, The Measurement Nightmare – How the Theory of Constraints Can Resolve Conflicting Strategies, Policies and Measures.  If you don’t have a copy of this book, I suggest that you get one.

It seems that Debra was involved with a venture capital group who had purchased a regional, building products manufacturing company that had achieved an annual growth trend of 25% in a national market growing at less than 2%.  The company produced tubing and the board of directors had approved the purchase of an automated case packing machine which was tied directly to a filling line.  The machine cost $250,000 and had replaced two packers that cost the company about $40,000 in direct labor costs.  It seems that the automatic case packer was about 20% faster than the two hand packers and because they could sell everything they produce, the filling line was expected to increase revenue from $3,750 per machine hour to about $4,500 per machine hour.  So the $40,000 annual reduction in labor plus the $1,560,000 in increased throughput were used to justify the $250,000 expenditure.  Plus, it was expected to increase efficiencies in the plant.  Sounds like a great deal, right?

When Debra arrived at the plant, the case packer was down and because it was down, the filling line had to be shut down as well because there was no place to put the product being produced.  The president of the company explained to Debra that everyone in the plant understood that the filling was the bottleneck and maintenance understood the importance of getting the packer back on-line as quickly as possible.  Debra asked the maintenance man working on the automated packer how often the line went down and he explained that on average it was about 10 hours per week.  Keep in mind that the maintenance worker’s base pay was twice the cost of the labor replaced by the automatic case packer.  He also explained that his personal overtime had increased significantly because of the case packer down time.

As it turns out, the loss of throughput due to downtime on the case packer was at least 10% more than the gain in throughput from running the filling line faster which amounted to about $15,000 weekly loss in throughput.  The increased cost of overtime for maintenance was equal to 20% of the $40,000 labor savings used to justify the automated equipment purchase and routinely stretched maintenance’s ability to keep up with routine work in the shop.  Of course because of cost accounting, the maintenance cost did not have an impact on direct labor efficiencies because maintenance is considered an indirect labor cost.  On the surface, the measures told the president the company was in better shape; however, the growing production backlog and bottom line told him otherwise.

 

Debra continues to explain that it took a pencil and paper to convince the president that the automatic case packer had actually reduced his throughput, but that the solution was simple.  In order to exploit the constraining resource, product must be packed as it comes off the filling line.  She recommended the installation of a diverter to move the product to a packing table where two people could be hired to pack product.  She explained that if, on average, the case packer was down for 10 hours per week and hand packing could keep the filling line operating at a rate of $3,750 of throughput per hour, then the company could receive $37,500 more every week by hiring two people for $800 per week.  The number one stumbling block to Debra’s recommendation was the idea of increasing headcount and the corresponding decline in labor efficiencies.  The president also had a problem of what to do with the two people when the automated case packer was operating.  Debra’s answer: Gardening, cleaning, painting, free car washing for employees!  She explained that anything was worth their availability to deliver the $1,910,000 ($3,750 hourly throughput x 10 hours x 52 weeks - $40,000 additional labor cost) of throughput annually.

 

Debra explains that one of the basic lessons she learned from the automatic case packer was the predictable effect of coupling a process to the constrained resource.  If a resource is coupled, either before or after, and it cannot be decoupled from the constraining resource, any downtime at the constrained resource will increase.  She further explains that coupling at the front of the process destroys the ability to buffer the constrained resource.  The majority of automation projects are justified by a reduction of labor costs or raw material costs or the elimination of process time before or after the constraint, without regard for the throughput of the constraint.  The bottom line is that any justification of a process improvement must address the impact on the throughput rate of the constraint.

 

A year later, this building-products company had become so successful that they were purchased by one of the giants of the industry.  What happened to this successful company after the acquisition?  That will be the subject of my next posting and in it you’ll see another example of just how devastating cost accounting can be.

Bob Sproull