Tuesday, September 23, 2014

Focus and Leverage Part 375

In my last posting I laid out a few of the differences between traditional Cost Accounting (CA) and a Theory of Constraints based version of accounting known as Throughput Accounting (TA).  In this posting I want to take this discussion further and point out other differences that seem to be making CA obsolete or at the very least irrelevant.  CA is much too complicated for the average person to understand and as a result, incorrect decisions are made relative to, for example, which products are the most profitable for companies.  Let's look at some of these problems and others in a bit more detail.

Many managers and executives believe that the majority of reasons why companies are losing their competitiveness are things that lie outside the walls of the company.  Many people blame the government, the competition, or even their suppliers for their lack of profitability, but are these really justifiable reasons?  In other words, if we were to create a manufacturing utopia where taxes were low, competition wasn't a factor, suppliers always delivered materials on time, their processes were totally in control and even interest rates were low, would companies perform much better?  Maybe, but I think they would still fall short.  I think it's time for an example.  One of the best examples I have ever seen is from a book entitled Throughput Accounting by Thomas Corbett.  For those of you not familiar with Throughput Accounting, I highly recommend Thomas Corbett's book as it is one of the best books available on the subject of Throughput Accounting.  In fact, Throughput Accounting was the first book I read on this subject and to this day I continue going to it as a reference.  Let's take a look at Thomas Corbett's example.

Corbett tells us about a company that makes men's and women's shirts.  The process is a very simple one in that it has two machines.....one to cut the fabric and another one that sews the pieces together resulting in the two kinds of shirts.  The women's shirt requires 2 minutes on the cutting machine and 15 minutes on the sewing machine.  Conversely, it takes 10 minutes to cut the men's fabric and 10 minutes to sew it together.  The following is the full set of data for both shirts:

Women’s Shirts
Men’s Shirts
Weekly Demand
Raw Material Cost
Cutting Time (Minutes)
Sewing Time (Minutes)
Total Process Time (Minutes)

As you can see, both shirt types have the same demand (120 each), with both the selling price and raw material cost favoring the women's shirts.  So what differs is the process time, the raw material cost and the selling price, along with the individual machine's processing times.  Each machine has an operator who both work 5 days a week or 2,400 minutes a week.  The investment and cost for each resource are the same and the company's weekly operating expenses are $10,500 which includes rent, energy and wages.  What we now need to use our decision process (Cost Accounting) to define which product mix maximizes the company's profitability.

As Corbett points out, the first reaction is to try to calculate how much profit we would make if we sold all of the demand for both products.  Unfortunately the company does not have enough capacity to make and sell 120 shirts for men and women.  Why?  Because the sewing machine does not have enough capacity (see the following table).

Minutes for women’s shirt
Minutes for men’s shirt
Total Minutes Required
Necessary minutes/available minutes

As you can see in the last column to the right, we cannot produce and sell everything the market wants to buy, so we have to decide what we will produce and sell.  In other words, we need to determine which product is more profitable so that we can maximize it first and then make and sell what we can of the other based upon our available capacity.  We will use Cost Accounting methods to make this calculation.  To calculate the cost of a product we need to know its raw material costs and add up the cost to produce this product.  That is, how much time does each shirt take on each resource so that we would know how much of the indirect costs should be allocated to each type shirt.  Although we won't go into the details of this calculation, the important thing here is to realize that the cost of a product is the consequence of how much it uses each resource.  So to find out the profit per product, according to Cost Accounting, we need to subtract the individual product's cost from its selling price.  In the following table we see the results of this math.

Women’s Shirt
Men’s Shirt
Best Product
$ 105
$ 100
Raw Material
$ 45
$ 50
Process Time (Min’s)
17 minutes
20 minutes

So as you can see, using Cost Accounting the women's shirt is superior to the men's shirt in all of the characteristics.  Since we don't have enough capacity to make all of the demand for both shirt types, we must first make and sell all of the women's shirts.  Because the women's shirts will require 1,800 minutes to produce all 120 of them, this means we have only 600 minutes left to produce men's shirts.  Since the men's shirts require 10 minutes on the sewing machine, we will produce 60 men's shirts.  So based upon this product mix, let's now calculate the total profit.

Raw Material Cost
Gross Margin
Operating Expense
Net Profit
-$ 300

Breaking down the financials we see that the revenue for 120 women's shirts at $105 equals $12,600 while the revenue for 60 men's shirts at $100 each equals $6,000 for a total revenue gain of $18,000.  Likewise the total raw material costs equals $8,600.  The gross margin (i.e. Revenue - raw material costs) is $10,200, but it's weekly Operating Expenses are $10,500 which results in a  net profit loss of $300 for the week.  So based upon these results Corbett tells us that this company's only option is to close the factory.  That is, based upon Cost Accounting's method, but could it be providing the wrong information?

In my next posting we'll take a look at what would happen if we went against Cost Accounting's rules and sold all of the demand for the men's shirts and then used the remaining capacity to produce and sell the women's shirts.

Bob Sproull


Steve Schmidt said...


I've often faced this conflict many times in my career.

As a senior manufacturing manager, I've often had to accommodate both products, thereby maximizing profit. (You can imagine the moaning from the marketing and sales teams if the product demand of both products wasn't fulfilled.

By using the Socratic Method and your Interference Diagram, combined with the guidelines of TA, it is relatively simple.

As Dr. Goldratt stated, "Do not let inertia get in the way."
And, "Never say, I know."

Bob Sproull said...

Hi Steve, great to hear from you!! Yes, I can imagine the moaning from the marketing and sales team and probably from the accountants as well. The ID is such a simple tool to use and when used in conjunction with Goldratt's step 2, it can be awesome!! Bob