One thing that I think we can all agree upon is that the most important metric for businesses to know how they are doing is Return on Investment (ROI). ROI is simply defined as Net Profit divided by Investment (i.e. NP/I). Cost centric efficiency rules are based upon GAAP while flow-centric rules are based on economics/management accounting rules. So what is the difference? In order to answer this question, we must understand the performance metrics of each set of rules.
When a company is focused on a cost-centric efficiency strategy, most of the measures used emphasize local efficiency and cost-reduction. What's wrong with that you may be asking? The problem is, that the cost-centric view is based upon the belief that the system is broken down into its component parts and that the sum of these localized improvements translates directly into the system improvement. In a nutshell, I believe that this thinking is fundamentally flawed. That is, the sum of all local improvements, does not translate into improvements to the system.
In today's cost-centric world, everyone agrees that while flow is important, the real belief is that by driving individual efficiencies higher, individual unit product costs will be lower and more profits will naturally follow. This belief has been "the way" of running businesses since Cost Accounting came into existence. In fact, this belief is so widely accepted, that any other belief is blocked by most managers, In other words, while everyone believes that flow is important, in a cost-centric world, cost simply trumps everything else.
Cost centric methods are focused on planning and executing rules that drive local efficiencies higher and higher. Flow-centric methods, on the other hand, are focused on synchronizing and aligning all resource priorities to the market demand and increasing the flow of products through the entire system. These two differences are huge! Let's now take a look at the basic calculations of Throughput Accounting which should shed some light on why these basic beliefs are so important to understand.
Throughput Accounting (TA) uses three basic performance metrics - Throughput (T), Investment or Inventory ( I ) and Operating Expense (OE). These three metrics are simple to understand and quite frankly, removes the mystery of Cost Accounting so that decisions can be made in real time.
- Throughput is the rate at which inventory is converted into sales. Throughput is only throughput when a sales is made and money is received by the customer. Product produced and stored in a warehouse is not throughput, it is inventory.
- Investment/Inventory is the money an organization spends on items it intends to sell.
- Operating Expense is all of the money spent by an organization to generate throughput and as such includes things like rent, power costs, wages and benefits. The key difference here is that, unlike traditional Cost Accounting, TA includes all wages in the definition of OE.
- Throughput (T) = Revenue - Totally Variable Costs or T = R - TVC
- Net Profit (NP) = Throughput (T) - Operating Expense (OE) or NP=T - OE
- Return on Investment (ROI) = Net Profit / Operating Expenses or ROI = NP/I
- Productivity (P) = Throughput (T) / Operating Expenses (OE) 0r P = T/OE
TA is all about making better and faster financial decisions. If the goal of your company is to make money, then any decisions being made that take your company closer to that goal. Ideally good financial decisions will cause:
- Throughput (T) to increase
- Investment.Inventory ( I ) to decrease or stay the same
- Operating Expenses (OE) to decrease or remain the same
- Traditional Cost Accounting is all about the actions you take to attempt to save money
- Throughput Accounting is all about the actions you take to attempt to make money
The Throughput Accounting model, on the other hand, considers only Totally Variable Costs (TVC) and Throughput (T). Throughput is equal to the remaining money after subtracting the TVC. Nothing is allocated, it's just a simple cash transaction from the sale of products. You tell me which one is easier to make financial decisions from?