Sunday, April 26, 2015

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


rasmus hammer said...

Did you choose to stop/take down the series on demand driven MRP?

Bob Sproull said...

Hi Rasmus. No, it's still there. What I'm doing is changing from a basic numbering of the posts to labeling them according to content. I was advised to do this so that search engines could locate the subjects within my blog.