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.