Focus and Leverage Part 169

One of the other key things I learned by reading The Goal was the whole idea of Throughput Accounting (TA).  I had never been introduced to TA so it was an eye-opening experience for me.  Actually, I had never been responsible for a company’s financials before and had difficulty understanding some of the “rules” of cost accounting.  I was being held accountable to traditional cost accounting and quite frankly some of the rules made no sense at all to me so I was questioning things.  For example, how could excess inventory be viewed as an asset?  Isn’t inventory tying up cash?  And as I explained in my last posting, running all process steps to the maximum capacity only served to drive Work-In-Process (WIP) inventory higher and since we had discovered that there was a direct correlation between having excess WIP and elongated cycle times, it made no sense to do so.  But those were the rules of engagement that I was being judged on.

When I read The Goal I had an epiphany of sorts.  Goldratt introduced the world to a new way of looking at profitability through a completely different spectrum.  While Cost Accounting preaches their sermon of profitability through saving money, Goldratt argued that rather than trying to save money, companies should be focused on trying to make money and as I would soon discover, the two approaches are drastically different!

One of the principle lessons within The Goal is that the goal of for-profit companies is to make money now and in the future.  He analogized that just like a chain having a weakest link, so too does a company and this weakest link controls how much money a company will make.  He also explained that attempts to strengthen any other part of the chain (or company) will do nothing to drive profitability higher.  From an organizational perspective, this simply means that every decision or action taken must be considered based upon its impact on the goal of making money.  If the action or decision doesn’t get you closer to the goal, then don’t take that action.  Goldratt further explained that if you want to know if you’re moving in the right direction in terms of profitability, you should ask yourself three simple questions:

• Does your action or decision result in more Throughput (T)?
• Does your action or decision result in more Inventory ( I )?
• Does your action or decision result in more Operating Expense (OE)?

If you answered yes to the first question, then it’s a good action or decision.  If you answered yes to either question two or three, then it might not be a good thing to do.  The optimum conditions for maximizing profitability are to have T increasing while I and OE are decreasing.  Notice I used the word “optimum” in terms of maximizing profitability.  It is certainly plausible to have OE increasing to drive T higher, it just won’t result in optimum profitability.  Let’s take a look at the definitions of these three components of profitability.

• Throughput (T): The rate that the organization generates new money primarily through sales.   Goldratt provided this formula for T:

Throughput = Revenue (R) $’s minus Totally Variable Costs (TVC) or,

T = R – TVC

TVC includes things that vary with the sale of a single unit of product such as the cost of raw materials, sales commissions, shipping costs, etc.

• Inventory ( I ): The money that an organization invests in items that it intends to sell. This category would include inventory of all kinds.
• Operating Expense (OE): The money an organization spends to turn ( I ) into (T)which includes ALL labor costs, office supplies, employee benefits, utility bills, etc.

Goldratt further expanded his TA definitions still further by defining net profit, return on investment, productivity and inventory turns and he based them all on the three simple measures T, I and OE.  So with these simple definitions, our team was able to not only take actions and make decisions, but we were sure they would positively impact our bottom line.  Here are Goldratt’s other definitions:

• Net Profit (NP) equals Throughput minus Operating Expense or NP – T – OE
• Return on Investment (ROI) equals T minus OE divided by I or ROI = T-OE/I
• Productivity (P) equals T divided by OE or T/OE
• Inventory Turns (IT) equals T divided by I or T/I

Our team went against the company culture when we decided to use Throughput Accounting, but believe me it worked.  And because of the simplicity of the definitions for each, we were able to teach our workforce how to use them as well.  Before you ask, yes, we had to continue using Cost Accounting to satisfy GAAP reporting requirements, but for daily decision-making, we found Throughput Accounting to be vastly superior to Cost Accounting.

In my next posting we’ll continue the saga of our plant in Kentucky and as I said in my last posting, some of our experiences were positive and some were very negative.  We celebrated our positives and learned from our negatives.