Recently I had the opportunity to meet with
an executive of a very large and diversified company. The meeting was a follow-up to a meeting I
had several months ago with the same executive.
This particular company has been very successful and profitable in the
past, but their most recent financials indicated that their profitability was
moving downward. Since for-profit
companies are in business to make money, the Board of Directors was not very
happy with the company’s current direction and wanted something done to stop
the bleeding. This company had been
working on a plan to improve profitability, but it wasn’t working as well as
they had hoped it would.
I asked this executive to share the essence
of their profit improvement plan with me.
He explained that they were cutting all unnecessary overhead and scrutinizing
all purchases wherever they could. In
addition, they were looking at possibly unloading parts of the company that
were driving profitability lower. For
me, it wasn’t much of a plan or should I say an effective plan. When I asked him how this plan was working
for them, he just smiled and said, “Well Bob, if it was working well, do you
think we would be having this meeting?”
I smiled back and said, “I guess not.”
He told me that he wanted my thoughts on what they should do.
I explained to him that there are two
distinctly different approaches to achieving profitability. On one hand, many companies like his company,
believe that the path to profitability is through saving money. He immediately responded by saying, “What’s
wrong with that approach?” “Isn’t that
what most companies do?” I shook my head
affirmatively and agreed that this was the most common approach, but it simply
doesn’t work in the long run. I further
explained that I have seen many companies using this approach that have failed
to improve their bottom line. He
replied, “You mentioned that there were two distinctly different approaches…..so
what’s the other one?” I explained that
the other approach focuses on “making money” rather than saving money. He asked me what the difference was because
in his mind, by saving money, you automatically make money. The following is how I explained the
difference between the two approaches.
I first asked this executive if the goal of
his company was to make money now and in the future and he confirmed that it
was. I then said, since the goal of his
company was to make money, doesn’t it make sense that the primary measurements
of how well the company is doing should be expressed in some form of money
unit? He agreed that the measurements
should be reflected by money in some form.
I then explained that with traditional cost accounting the focus is on
measurement like Net Profit, ROI and Cash Flow.
And while these metrics are good for financial reporting, they don’t
answer questions in real time because they are based on what happened yesterday
and not today. Typical financial reports
being used today tell us what happened last month, but what we need is some way
of being able to judge the impact of decisions now and in the future.
Throughput Accounting (TA) is that way. TA uses
three easily understood measurements of Throughput (T), Investment/Inventory ( I
), and Operating Expense (OE) which are defined as follows:
- Throughput (T): The rate at which the system generates money through sales. The key word in this definition is sales because product produced, but not purchased by the consumer is simply inventory. Money must be received before actual throughput is calculated. The formula for Throughput is:
Revenue
(R) – Totally Variable Costs (TVC) or
T =
R – TVC
- Inventory/Investment ( I ): All of the money tied up in the system in things the organization intends to sell. Part of this measure is inventory (i.e. raw materials, WIP and Finished Goods) and part of it includes those things owned by the company which is intended to generate Throughput (e.g. buildings, equipment, etc.).
- Operating Expense (OE): All of the money spent by the organization in the conversion of investments and inventory into Throughput. Unlike traditional Cost Accounting (CA), OE includes labor expenses of all kinds. It also includes things like supplies or any cost needed to create Throughput for the company
The executive pushed back immediately by
telling me that his company doesn’t build consumer products, so these measures
don’t apply to them. I chuckled to
myself and then told him that all three measures actually did apply to his
company. His company is primarily a construction
company, so I explained that Throughput for him was completed projects and that
if they could reduce the cycle times on his projects, his profits would
skyrocket. He then asked, “How does
Throughput Accounting calculate Net Profit and ROI?
I explained to him that the three basic TA
measures, T, I and OE are combined in different ways to provide the fundamental
performance measures. For example, Net
Profit is simply Throughput minus Operating Expense or NP = T – OE. Return on Sales (ROS) is TA’s measure of the
effectiveness of the bottom line to the top line performance measures of the
company. ROS is simply the ratio of net
profit and sales or ROS = NP ÷ Sales Revenue.
At this point the executive was becoming more and more interested in
what I was saying and said, “Bob, these formulas are so much easier than
typical Cost Accounting formulas.” I
then told him to understand that TA is not a replacement for CA because you
still have to use Generally Accepted Accounting Principles (GAAP) when you
report to the government. But what TA
does do is to provide an easy and effective way for your management team to
make financial decisions in real time.
He liked the explanation.
Our meeting time ended with a promise from me
to visit again so I could explain more about the Theory of Constraints. I am in the process of writing a brief white
paper for him to that end. It will
include how his team can use TOC’s Thinking Processes (TP) to identify their
one or two core problems that were causing the negative symptoms he was
seeing. I’ll also explain how he can use
the Goal Tree to develop a strategic improvement plan to turn his company in
the right direction. It should be a fun
next meeting…..at least for me.
Bob Sproull
No comments:
Post a Comment