In this posting, I want to focus on Constraints Management’s version of accounting known as Throughput Accounting. Although I’ve written about this subject on numerous postings, it is such an important aspect of Constraints Management, I think it’s worth writing about again.
Throughput Accounting (TA), or as some prefer to call it, Throughput-Based Decision Making, came into prominence in the early 1980’s when Dr. Eli Goldratt wrote his best selling business novel, The Goal. It's important to understand that TA was never intended to replace traditional Cost Accounting (CA), primarily because businesses are required by law to use Generally Accepted Accounting Principles (GAAP) when reporting to the government. Dr. Goldratt developed Throughput Accounting for several reasons, most notable of which was that traditional Cost Accounting motivates managers to make incorrect decisions. In addition, CA motivates the wrong behaviors within the general work force. Maybe even more important, Throughput Accounting makes it possible for managers to make decisions in real time rather than having to wait for financial reports that reflect what happened last month. Last month’s information does not reflect what is happening today and that is what managers need.
Unlike traditional Cost Accounting measures, Throughput Accounting’s measures are simple to learn and easy to apply. In fact, in my experiences, many people have told me that for the first time in their careers, they finally understand accounting. Throughput Accounting permits managers to see in real time the bottom line impact of their day-to-day decisions. It is simple and logical and requires much less data and calculations than conventional Cost Accounting does. It is also more tolerant of inaccurate or incomplete financial data.
Throughput Accounting, in its most basic form, 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 waiting to be sold. As such, inventory has no value until it is sold. Money must be received before actual Throughput is calculated. The formula for Throughput is:
Throughput = Revenue (R) – Totally Variable Costs (TVC) or
T = R – TVC
Totally Variable Costs are those costs that vary with the sale of a single unit of product and includes things like raw material costs, sales commissions, shipping costs, etc.
- 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.
At this point you might be tempted to push back and tell me that since your company isn’t in the business of building consumer products, that these measures don’t apply to your company. I would tell you that they actually do apply. For example, if your company is one that makes money primarily as a construction company, then Throughput for your company is completed projects. Imagine what would happen to your company's profits, if you could reduce the cycle time it takes to complete projects?
You might be wondering at this point about other measures like Net Profit, Return on Investment, etc. TA combines these three basic TA measures, T, I and OE in different ways to provide these fundamental performance measures. For example, Net Profit is simply Throughput minus Operating Expense or NP = T – OE. Return on Investment (ROI) is TA’s measure of the effectiveness of the bottom line to the top line performance measures of the company. The formula for ROI is Net Profit ÷ Investment, or (T–OE)/ I. Once again, 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.
In my next posting, we’ll take a look at how TOC treats another important facet ot your business, how your parts are probably ordered and replaced. If you’re like many companies, you probably have stock-outs, even though your inventory value is high. I’ll show you how you can reduce your inventory by over 30% and virtually eliminate stock-outs.