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.