Comparison of Cost Accounting and Throughput Accounting

Before I begin today's posting, I want to point out a change I have made in naming my posts.  Whereas in the past I have just simply numbered them, I have been advised to label them according to the subject matter being presented.  The reason for this is to improve the search capabilities of future readers.  Now onto today's post.

In response to my last posting comparing Throughput Accounting and Cost Accounting, I've received some very interesting emails from senders who said they want to hear more.  One email in particular was interested in knowing more about the differences between these two distinctly different forms of accounting.  So today I will honor these questions and point out these differences.  But in order to do so, I've got to back up a bit and provide a bit more information about TOC in general.  And please remember that I am not advocating the abandonment of traditional Cost Accounting because it is required by law to use it to satisfy GAAP requirements.  TA, and more specifically, Throughput (T), Inventory ( I ) and Operating Expense (OE), was always intended to be used to make operational decisions in real time.

T, I and OE provide the links between operational and financial measurements which help companies understand their profitability status.  But what really makes TA unique is that it provides the financial information required to make real time decisions at the operational level and for me, this is the most important element of TA.  The problem with traditional Cost Accounting (CA) and its performance measures is the emphasis it places on direct labor efficiency and unit costs.  TA, on the other hand, places its emphasis on increasing throughput while decreasing or maintaining inventory and operating expense.  Whereas CA believes that in order to be profitable a company must manufacture its products efficiently at every step in the process, TA teaches us that profitability is achieved by how efficiently the entire organization must manufacture its products.  In other words, TA focuses on optimizing the system while CA focuses on optimizing each step in the process and this difference is a critical element in a company's quest for improved profitability.  The bottom line is that a company using a standard cost system where increasing the efficiency of every work station can actually inhibit throughput and therefore decrease revenues.

Traditional Cost Accounting uses manpower efficiency (productivity) as one of its primary metrics with the basic calculation typically being actual time to produce product divided into a time standard.  The higher the efficiency becomes, the more work-in-process inventory is generated which in my world extends the overall cycle time, decreases throughput and consequently the level of on-time delivery deteriorates.  In addition, companies using CA are typically heavy into the cost world thinking which many times results in layoffs and general manpower reductions.  CA believes that the key to profitability is through saving money whereas TA believes it is through making money.  You may be thinking that these are the same, but in reality these two approaches are remarkably different.
TA uses a drastically different way to measure productivity, namely Productivity equals throughput divided by Operating Expense or P = T/OE.  OK, so let's move on to some important differences between these two forms of accounting.

One of the major differences between CA and TA is how the two of them view sales.  CA books the sale as earnings whereas TA does not count the new revenue until it has actually been received from the customer.  This may not seem like a "big" difference, but in reality it is.  TOC/TA does not consider revenue earned until cash is received.  Keep in mind that CA views finished goods as assets while TA believes that excess finished goods inventory costs the company money, especially if it is stored in an external warehouse....they aren't free.  In other words, TA does not include the value added to the system in its inventory value calculation.  Inventory in TA only includes the purchased costs of materials and components that will eventually become throughput.  In fact, in the TOC world, excess inventory of any kind (i.e. raw material, WIP and finished goods) are considered liabilities.  They may turn into throughput later on, but until they do, they are simply costs to the organization.

In TOC/TA, process improvements are mostly focused on improving the throughput of the process.  Because of this, the focal point for improvement is the system constraint.  This is TA's leverage point.  Improvement according to CA is focused on cutting costs and the elimination of non-value-added work and costs anywhere in the process. TA believes that the true leverage point in any process or system is the operation that is getting in the way of producing more throughput.  Think about it for a minute.  If you were to simply maintain your current levels of operating expense and inventory, but you increased your throughput by twenty percent, how much of the new revenue would fall to the bottom line?  The only reduction would be, the costs of the raw materials.  (Remember, throughput is revenue minus totally variable costs and net profit is throughput minus operating expense (NP = T - OE).  Also remember also that return on investment is net profit divided by inventory (ROI = (T - OE)/I)).

On other difference between CA and TA is how TA treats labor.  CA develops a full product cost by calculating the sum total of the cost of raw materials, direct labor and a share of manufacturing overhead and then allocates it across the full spectrum of products produced.  One of the problems with this approach is that managers who see the benefit of reducing inventories, get penalized.  When inventory is reduced in a TA world, throughput, NP and ROI all increase.  TA includes all labor in the calculation of operating expense which again, is a significant difference between these two forms of accounting.

There are several things I really like about Throughput Accounting.  In the first place, the formulas used make it much easier for operation's people to understand and if they understand it, there is a much higher probability that they will use it to make real time financial decisions.  TOC, or more specifically Throughput Accounting, brings an entirely new dimension to management decision making.  Whereas for years companies have focused on improving profitability through saving money, TOC's focus is on making money by driving throughput to higher levels.  If your organization hasn't ever used Throughput Accounting, you need to try it.  I think the level of financial decisions being made in your organization will improve dramatically.

Bob Sproull

Throughput Accounting vs. Cost Accounting

I've gotten a lot of questions lately about how Throughput Accounting (TA) compares to traditional Cost Accounting (CA), so today I decided to write about this subject.  As many of you know, Throughput Accounting has its roots in the Theory of Constraints (TOC) which was developed by Eliyahu M. Goldratt back in the early 1980's.  The fundamental basis for TOC is that constraints establish the limits of performance for any system.  It doesn't matter whether it's a manufacturing company or a company that delivers a service....the performance of the system is dictated by that operation that is constraining throughput.

When it was first used, many people believed that it was simply a production scheduling system, but TOC has a much more broad and diverse range of usage.  In fact, TOC challenges leaders to think differently about many of their lifelong assumptions and beliefs and one of those assumptions is how to improve profitability.  Instead of cutting costs and saving your way to profitability, like so many leaders have been taught, TOC demonstrates that the key to improving profitability is through making money.  And saving money is not the same as making money.

There are some key principles that underlie TOC's way of doing business that challenge many of the ways leaders have been doing business most of their careers.  TOC views processes and organizations as chains and once the weakest link in the chain is identified, it must be strengthened to radically improve flow and revenue.  Another of these key principles is the belief that the sum of all local improvements somehow equals improvements to the system.  It's simply not true that an organization that maximizes the output of each and every machine will perform as well as one that focuses on and optimizes the output of the weakest link in their chain (i.e. the constraint).  One last principle that must be realized by organizations is the fact that all systems operate through a series of cause and effect, meaning that one event causes another.  In fact, most of the negative symptoms we see in an organization are usually caused by a single core problem and if you eliminate the core problem, many of the negative symptoms we experience will disappear.

Throughput Accounting (TA) uses three basic measurements - throughput, inventory and operating expense with the definition of each as follows:

• Throughput (T) is the rate at which the system generates money through the sale of its products and/or services minus totally variable costs (TVC) or T = Revenue - TVC where TVC includes any cost that varies with the sale of each unit of product (or service).  This includes things like raw material costs, sales commissions, shipping costs, etc. 
• Investment/Inventory ( I ) is all of the money spent on things the organization intends to sell such as work-in-process inventory, finished goods inventory and the cost of components purchased from outside that are used to produce the finished product.  It can even include things like tools, buildings and capital equipment.
• Operating Expense (OE) represents all of the money spent turning inventory into throughput.  In a major departure from Cost Accounting, OE includes all labor costs (i.e. direct and indirect labor) because the employees of the business turn inventory into throughput.  OE also includes depreciation.

It's important to understand that TA is not a replacement for traditional CA because publically held companies are required by law to report earnings according to GAAP rules.  TA is used to make financial decisions at the operational level.  What about net profit (NP) and return on investment (ROI)?  How does TA calculate these?  Simplicity is one of the reasons why managers like TA.  That is, all of the calculations are derivatives of T, I and OE.

• Net Profit (NP) is equal to Throughput minus Operating expense or NP = T - OE
• Return on Investment (ROI) is Net Profit divided by Investment/Inventory or ROI = NP/I

Throughput Accounting (TA) focuses management's attention on three critical decision objectives in this order:

• Will the decision increase throughput?
• Will the decision decrease or maintain inventory?
• Will the decision decrease or maintain operating expense?

The key leverage point in Throughput Accounting is through increasing throughput.  The fact is, if throughput grows while even maintaining both inventory and operating expense, the net falls directly to the bottom line.  Compare this approach to Cost Accounting's focus on cost reduction and you will see that profitability increases at a much faster rate than efforts to reduce costs.  The big difference here is that TA makes no attempt to allocate fixed costs to units of product (or service) and argues that these costs are not relevant at the operational level.  As I said earlier, TA is not a replacement for CA, it is simply a better way to make real time financial decisions at the operational level.

Bob Sproull

Help

I need to know if my regular followers are receiving my blog posts?  The last one I published was yesterday Focus and Leverage Part 413.  Please let me know via my email at ras8202@live.com

Bob

The Ultimate Improvement Cycle

I've gotten quite a few emails in the past several weeks asking why I've not written any new blog posts.  Today I want to share with you what's been keeping me busy and away from my blog.  As I’ve mentioned previously, Bruce Nelson and I have been working on the second edition of Epiphanized as well as the sequel.  We've submitted all of our materials, so I will have more time to write blog posts.

The other reason is that a wonderful company who produces business management software (i.e. ERP software) has hired me to help educate their customers and the industry on how to become more profitable.  I author a weekly educational post for them on the “Manufacturing Breakthrough Blog” and have been doing so since December.  Last year this company also hosted me so I could teach a classroom-based continuous improvement boot camp for their customers.  In late May and early June, this same company will sponsor me in Australia to hold four one-day workshops on continuous improvement.  I have just finished writing a whitepaper with this company on continuous improvement and I want to share a link to their website so you can download it.  You'll also be able to read my posts on the Manufacturing Breakthrough blog.

This company, ECi Software Solutions, is unlike any company I have ever been associated with.  While many companies care about their customers, ECi takes it a step further and revinvests their own money to help the customers they serve improve profitability.  ECi provides M1, an ERP specifically for growing manufacturers. If you are a manufacturer who needs to improve your on-time delivery and profits, I know they can help you.  I'll be writing more about them in the future, but until then, here's the link to download the whitepaper:

WHITEPAPER: The Ultimate Improvement Cycle

Bob Sproull

Focus and Leverage Part 412

One of Eli Goldratt's favorite expressions he used many times was, "Show me how you measure me and I'll show you how I'll behave."  One of the primary reasons he used this expression was to emphasize the importance of selecting the "right" performance metrics.  One of the metrics he wrote about was the predictable behaviors exhibited when manpower efficiency or equipment utilization were used to judge the performance of a manufacturing organization.  Whenever either of these performance metrics are used, the predicted outcome is excessive work-in-process (WIP) inventory that clogs processes which in turn causes extended processing times and late deliveries of products to customers.  The bottom line is that performance metrics do motivate behaviors.  But guess what...this same phenomena happens even in school systems.

In 2008, The Atlanta Journal-Constitution broke the first of what would be several stories highlighting suspect test scores in Atlanta Public Schools and other Georgia districts. From what I understand, the educators were responding to pressure from the school system's leadership administration to show improvement in test scores or face discipline, or less pay, or even termination.  Some even received bonuses for higher test scores.

So like many manufacturing companies, this school system used test scores as their performance metric, which by itself is not a bad thing.  But when you tie test score performance to a person's livelihood, you get the result we're seeing here in Atlanta.  That is, teachers and administrators actually changed answers on standardized tests to get better scores.  Once again, show me how you measure me and I'll show you how I'll behave.

Bob Sproull