Monday, September 22, 2014

Focus and Leverage Part 374

I finished my last posting by telling you that in today's accounting world there are essentially two very different pathways to profitability.  There is the cost world belief (i.e. Cost Accounting (CA)) that profitability is achieved based upon how much money you can save through cost cutting.  On the other hand, there is the Theory of Constraints version of accounting known as Throughput Accounting TA) which tells us that the pathway to profitability is through how much money you can make.  In todays posting we're going to briefly look at both of these methods and compare some of the stark differences between the two methods.  Let's start with a head-to-head comparison of the relative priority each method places on Throughput ( T ), Inventory or Investment ( I ) and Operating Expense (OE).

Cost Accounting
Throughput Accounting
Operating Expense
Operating Expense

While Cost Accounting places Operating Expense as its number one priority, Throughput Accounting believes that Throughput is the most important while Operating Expense is the least important in terms of profitability and herein lies one of the major differences.  This difference is even more profound when you consider the two distinctly different definitions of Throughput.  In the CA world, T is all product produced through processes to be sold while in the TA world, T is actually money received from the customer after the product is produced and shipped to the customer.  In the CA world product produced is considered an asset, even though there is a carrying cost associated with it.  TA believes it is not an asset if it is placed into inventory, but rather it is a liability until it is sold.

The core principle behind the Theory of Constraints (TOC) is that every system has at least one constraint and that the constraint controls the throughput of the system.  From this perspective, the constraint must be managed so that the system will produce its optimum amount.  One of the biggest problems in managing the constraint is CA's belief that maximizing throughput on every resource (i.e. increasing efficiency) will decrease costs and improve profits for the  entire system.  The reality is that the CA belief that attempting to maximize productivity and efficiency of every resource will actually increase costs across the board.

For me one of the major differences between CA and TA is how TA accounts for labor expenses compared to CA.  TA includes all labor in Operating Expenses while TA allocates labor across products being produced and becomes part of the cost calculation.  So one of the natural consequences of cost allocation is that by reducing labor (i.e. layoffs) CA somehow believes that the cost of the product decreases as a result of reducing labor and that profitability improves.  TA, on the other hand, believes that as throughput increases, revenue increases and profitability improves at a much faster rate than reducing costs.  Remember, with TA, throughput is not considered throughput until money is received from the sale of the product.

There are other differences that exist between these two methods that we will explore in future posts, but remember that the most glaring difference is how the two methods view their pathway to profitability.  CA advocates saving money through cost cutting while TA advocates making money through increasing throughput.

Bob Sproull

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