Sunday, October 12, 2014

Focua and Leverage Part 380

In today's posting I want to lay out the framework for a new way of looking at accounting known as Throughput Accounting (TA).   As I said in previous postings, most companies use traditional Cost Accounting (CA) and they do so to satisfy GAAP rules for financial decision making.  I have pointed out that the primary issues with this form of accounting is that it is based upon cost-centric rules and performance metrics.  These rules and measures worked in yesterday's production world, but things have changed.  Today's world is much more complex than yesterday's world, but unfortunately the rules and metrics haven't changed.  In today's complex world, we must move to a flow-centric way of managing and running our businesses.

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.
  1. 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.
  2. Investment/Inventory is the money an organization spends on items it intends to sell.
  3. 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.
With TA it is important to remember that TA does not use allocations to specific products.  Instead, TA is focused on cash without the need for allocation to products and this is a big difference between the two accounting methods.  In the calculation for Totally Variable Costs (TVC), TA believes that TVC is only the cost associated with the sale of a single unit of product.  This would include things like the cost of raw materials, sales commissions, shipping charges, etc.  In TA, labor is not considered variable, it is a fixed cost in today's world.  The following definitions apply to Throughput Accounting:
  1. Throughput (T) = Revenue - Totally Variable Costs or T = R - TVC
  2. Net Profit (NP) = Throughput (T) - Operating Expense (OE) or NP=T - OE
  3. Return on Investment (ROI) = Net Profit / Operating Expenses or ROI = NP/I
  4. Productivity (P) = Throughput (T) / Operating Expenses (OE) 0r P = T/OE
The basic concept of TA is actually very simple.  If you have to pay someone else, it's either and Investment or an Operating expense.  On the other hand, if someone has written a check to you, then it's Throughput.

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:
  1. Throughput (T) to increase
  2. Investment.Inventory ( I ) to decrease or stay the same
  3. Operating Expenses (OE) to decrease or remain the same
The long and short of these two accounting methods comes down to a comparison between two facts:
  1. Traditional Cost Accounting is all about the actions you take to attempt to save money
  2. Throughput Accounting is all about the actions you take to attempt to make money
In CA, once you've made your cost reductions and you need more, what do you do?  Cut more and damage the organization's ability to produce and sell your product?  Making money, on the other hand, is potentially infinite.  Think about it....doesn't making money make more sense than saving money in terms of your company's profitability?

In the figure above we see a head-to-head comparison between the CA and TA models.  In this example, suppose the product we are making is exactly the same for both models.  In the CA model you can see the various layers of allocated costs that are applied to each product, usually reported as some percentage of the cost, or allocated rate.  The sum of all of these costs are what CA believes is the cost to manufacture the product.

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?

Bob Sproull



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