Saturday, March 15, 2014

Focus and Leverage Part 322

In my preceding posts on Throughput Accounting I focused my attention on how Constraints Management works in manufacturing and service industries.  I now want to turn my attention on the Accounting Department.  Again, for those of you who are just joining this discussion, I am recommending that you purchase a wonderful book by Steven Braggs, Throughput Accounting – A Guide to Constraint Management.  In this posting I want to present, word-for-word how Bragg presents his message directly to the Accounting Department.

“In a traditional accounting environment, the accountant is trained to focus on product costs, usually in extraordinary detail, rather than on the ability of the company to generate profits.  Conversely, throughput accounting is least concerned with costs and more concerned with using the existing system (and the costs built into it) to generate the largest amount of profit.  Which concept is right?”

“Under the traditional cost accounting approach, if the accountant is solely reporting on the cost of operations, then it is reasonable for management’s attention to be skewed in the direction of cost management, since this is the only information they see.  However, nearly all costs fall into the Operating Expenses category of costs, and the primary purpose of that cost category is to support the ability of the company to produce throughput.  Thus, an excessive degree of attention to cost reduction will eventually impact a company’s ability to produce throughput, so that profits may decline even faster than any cost reductions that have been achieved.”

“The problem is especially difficult to perceive when the accountant identifies an excessive level of capacity in a nonconstraint area, and proposes that the company save money by eliminating some portion of the excess capacity.  What the accountant misses is how important that excess capacity might be.”

Bragg explains that the total capacity at each work center should be divided into three parts as follows:

  • Productive capacity which is that portion  of the work center capacity needed to process currently scheduled production or service.
  • Protective capacity which is the additional portion of capacity that must be held in reserve to ensure that a sufficient quantity of parts or patients can be manufactured or serviced to adequately feed the bottleneck operation.
  • Idle capacity which is the left over capacity other than productive or protective capacity.  Only the idle capacity can be eliminated from a work center.

Bragg goes on to explain that if the capacity to be eliminated is protective capacity and not idle capacity, then the constrained resource will not have any inventory on which to work, and must shut down until its inventory inflow can be replenished.  So while the reduction in capacity in order to cut costs may seem like a reasonable decision in the short term, in the long term if demand increases, it would be the wrong approach.

Bragg goes on to explain that Throughput Accounting takes the opposite approach to financial analysis, focusing instead on improving the utilization of the constrained resource in order to maximize profits through increases in throughput.  It is designed to answer three questions regarding management decisions, which are:

  1. What is the decision’s impact on throughput (top priority)?
  2. What is the decision’s impact on investment (second priority)?
  3. What is the decision’s impact on operating expenses (last priority)?

As you can see, the strongest emphasis is on increasing throughput while the least emphasis is on reducing operating expenses.  The primary reason that operating expenses are considered the least important is that a large portion of operating expenses are need to support the system’s capacity to create throughput.

In reality, both systems (CA and TA) focus on profit improvement, but throughput accounting takes the path of doing so by increasing throughput while costs accounting choses the path of cost reduction.  So even though both systems are attempting to achieve the same goal, it is my belief (and Bragg’s) that the more effective pathway is through enhancing throughput.  Why?  Simply because there is no theoretical upper limit to throughput, but there certainly is a lower limit to cost reduction.

In my nest posting we’ll continue to look at the stark differences between Throughput Accounting and Cost Accounting and why one is so much better than the other for real time financial decisions.

Bob Sproull

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