Wednesday, September 25, 2013

Focus and Leverage Part 251

In this posting we will continue our series on Cost Accounting and Throughput Accounting and look into them in a bit more detail.

Throughput Accounting is not necessarily a frontal attack on Cost Accounting, however, it is a different way to view accounting measures, solve issues and manage the company at a much higher success and profitability level—an update of the accounting rules, if you will, that is much more in line with current business reality.
Throughput Accounting uses primarily three performance metrics—Throughput (T), Investment/Inventory (I) and Operating Expense (OE).   These metrics are a simplified methodology that removes all of the mystery of accounting and rolls it into three simple measures.

1.  Throughput is the rate at which inventory is converted into sales.  If you make lots of products and put them in a warehouse, that is not throughput—it’s inventory.  The products or services only count as throughput if they are sold to the customer and fresh money comes back into the business system.

2.  Investment/Inventory is the money an organization invests in items that it intends to sell.  This category would include inventory, both raw materials and finished goods, but also includes buildings, machines and other equipment used to make products for sale, knowing that any or all of these investments could at some point in time, be sold for cash.

3.  Operating Expense is all of the money spent generating the Throughput.  This includes, rent, electrical, phone, benefits and all wages.  It is any money spent that does not fit within one of the first two TA categories.  When you read and understand these definitions it seems likely that all the money within your company can be categorized to fit within one of these three measures.

In thinking about TA it is important to consider the following thoughts:  TA is neither costing nor Cost Accounting.  Instead, TA is focused on cash without the need for allocation to a specific product.  This concept includes the variable and fixed expenses for a product.  The only slight variation would be the calculation for Total Variable Cost (TVC).  In this case the TVC is a cost that is truly variable to a product or service, such as raw materials, paying a sales commission or shipping charges. The sum total of these costs becomes the product TVC.  TVC is only the cost associated with each product.  Some would argue that labor should also be added as a variable cost per product.  Not true!  Labor is no longer a variable cost, it’s a fixed cost.  With the  hourly labor measures, you pay employees for vacation, holidays and sick leave.  You pay them while they are making nothing!  The employees cost you exactly the same amount of money whether they are at work or not.  Using this example, labor is an operating expense and not a variable cost associated with products.

The following definitions apply to TA:

1.  Throughput (T) = Product Selling Price (SP) – the Total Variable Cost (TVC).  Or T = SP – TVC.

2.  Net Profit (NP) = Throughput (T) minus Operational Expense (OE).  Or NP = T – OE

3.  Return on Investment (ROI) = Net Profit (NP) divided by Inventory (I).  Or ROI = NP/I

4.  Productivity (P) = Throughput (T) divided by Operating Expense (OE).  Or P = T/OE

5.  Inventory Turns (IT) = Throughput (T) divided by Inventory Value (IV). Or IT = T/I

Some would argue that TA falls short because it is not able to pigeon hole all of the categories of CA into TA categories.  Things like interest payments on loans, or payment of stock holder dividends or depreciation of machines or facilities. However, this argument appears to be invalid.  Which one of those specific categories can’t be placed into one of the TA categories?  The baseline TA concept is really very simple.  It you have to write a check to somebody else, it’s either an Investment (I) or an Operating Expense (OE).  It’s an investment if it is something you can sell for money at some point in time.  It’s an operating expense if you can’t.  Put this debt in the category that makes the most sense. On the other hand, if somebody is writing a check to you, and you get to make a deposit, then it’s probably Throughput (T).  Cost accounting rules have made it much more complicated and difficult than it needs to be.  When you make it that complex and difficult and intently argue about the semantics, the stranglehold that CA has on your thinking becomes even more obvious.

TA is really focused on providing the necessary information that allows decision makers to make better decisions.  If the goal of the company is truly to make money, then any decisions being considered should get the company closer to the goal and not further away.  Effective decision-making is well suited to an effective T, I & OE analysis.  This analysis can show the impact of any local decisions on the bottom line of the company.  Ideally good business decisions will cause:

1.  Throughput (T) to increase.

2.  Investment/Inventory to decrease or stay the same.  It is also possible that investment can go up as long as the effect on T is exponential.  In others words, sometime a very well placed investment can cause the T to skyrocket.

3.  Operating expenses decrease or stay the same.  It is not always necessary to decrease OE to have a dramatic effect.  Consider the situation where the T actually doubles and you didn’t have to hire anyone new to do it, nor did you have to lay anyone off.

In my next posting we’ll complete our series on Cost Accounting and Throughput Accounting from Bruce Nelson’s appendix in our book Epiphanized.

Bob Sproull


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