Continuing on with our discussion on throughput accounting, in this posting we will consider steps 4 and
5 of Goldratt’s 5 focusing steps and then turn our attention to the basic
measures of Throughput Accounting.
Step 4 of Goldratt’s 5 focusing steps is to
elevate the constraint if we still haven’t “broken” the system constraint. In other words, if the improvements we have
made to the constraint, using primarily Step 2, are still not enough to satisfy
the market demand, then we might have to spend some money to do so. If the constraint is a piece of equipment,
for example, then we may need to purchase another one to meet market
demand. Sometimes by adding additional
human resources, we can deliver enough throughput to meet demand. The good news is, most of the time we never
have to get to step 4 meaning that in step 2 there is usually enough “hidden”
capacity to get what we need to satisfy the market demand.
Assume we have broken the system constraint
and it is no longer the system constraint…..what then? This means that the constraint has moved to a
new location, so we move back to step 1, identify the system constraint. We then follow the 5 focusing steps as
presented above. Now that we have
discussed Goldratt’s 5 focusing steps, let’s now turn our attention to TOC’s
accounting methodology referred to as Throughput Accounting, the subject of
Steven Bragg’s book.
In order to explain the financial aspects of
the Theory of Constraints, we need to define the basics of Throughput
Accounting using three basic measurements.
The first term to define is Throughput
which is the contribution margin left after a product’s or services’ price is
reduced by the amount of its totally variable costs. Simply stated, Throughput is defined as Revenue minus Totally Variable Costs. Unlike
traditional cost accounting, there is no attempt to allocate overhead costs to
a product or service, nor to assign any semi-variable costs. As a result, the amount of throughput for
most products or services tends to be quite high. Totally variable costs is a cost that will
only be incurred if a product is created or a service is provided. For a manufactured product, this usually
includes things like raw material costs, sales commissions, customs duties, and
maybe shipping charges. The key
difference between Throughput Accounting (TA) and Cost Accounting (CA) is that
in TA direct labor is not treated as variable.
In TA the next item to define is referred to
as Operating Expense (OE) which is
the sum total of all company expenses excluding totally variable expenses. Steven Bragg explains that as a general rule,
all expenses incurred as a result of the passage of time (rather than through
the process) are operating expenses.
This would include things like all direct and indirect labor,
depreciation, supplies, interest expense, and overhead. The theory of constraints really doesn’t care
if a cost is semi-variable, fixed or allocated, so all costs that are not
totally variable are included in OE.
This is totally different than what happens with traditional cost
accounting.
The third definition is for Investment and is the same one would
find for standard accounting rules. But
having said that, there is a particular emphasis on a company’s investment in
working capital (especially inventory).
The value of a company’s investment in inventory only includes the
amount paid for components or materials purchased from outside suppliers and
used to manufacture inventory. As such,
in TA, inventory is not categorized as an asset like CA does and this is an
important distinction.
The last term to be defined in TA is Net Profit which is simply Throughput
minus Operating Expenses. The
differences between Throughput Accounting and Cost Accounting are amplified
when making decisions about how the business should be run. Unlike traditional Cost Accounting which
typically reports financial information from the previous month, Throughput
Accounting, because of its simplicity, permits decisions to be made in real
time. For me, the real difference
between TA and CA is the believed pathway to profitability. Cost Accounting focuses on saving money
through cost reduction, while Throughput Accounting focuses on making money
through throughput improvement. So in
summary, the simple TA formulas are:
- Throughput (T) = Revenue – TVC
- Net Profit = T – OE
- Return on Investment (ROI) = Net
Profit/Investment
When making decisions involving changes to
revenue, operating expenses or investment/inventory, these three formulas can
be used to arrive at the best decision which will yield the best possible
results assuming the following order of importance:
- Does the decision increase throughput?
- Does the decision improve return on investment?
- Does the decision reduce operating expenses?
Throughput increases are always the most
important decisions because improvements here lead to automatic profit
improvements assuming no change in operating expenses. Operating expenses are always the lowest
priority simply because a reduction in OE might limit the production capacity
of the system, which in turn may result in less throughput.
Bob Sproull
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