Tuesday, April 28, 2015

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


Tom G said...

Right on - I have used this method since 1995 as a mid level manager to steer my local decisions. It has served me well in that when you speak in these terms, it is real money being considered in your thinking and presentations. That just makes sense to everyone.

For those out there with accounting backgrounds, is is very similar to variable costing but leveraged an order of magnitude by other TOC principles.

Bob Sproull said...

Hi Tom. It amazes me that more accounting professionals aren't using throughput accounting. Not as a replacement for cost accounting, but rather to help teach managers how to make better financial decisions in real time.

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