Another New Book Part 11

As I stated in Post 10, one of the most important entities within any organization is how they attempt to measure success.  This post is, once again, taken from my newest book, Theory of Constraints, Lean, and Six Sigma Improvement Methodology – Making the Case for Integration. Specifically, the material for this series is taken from Chapter 5 entitled, A Better Way to Measure a System’s Success. As I explained in my last post, readers that are totally familiar with the Theory of Constraints might find this series a bit basic, but I’m writing this series for those who are not totally familiar with the Theory of Constraints.  

As I explained in my last post, Throughput is maximized by selling goods or services with the largest difference between revenue and totally variable cost and by minimizing time between spending money to produce and receive money from sales.  It’s important to understand that TA does not use labor costs to allocate OE. Direct labor is not treated as a variable cost simply because businesses do not typically adjust their workforce every time demand for their product or service changes.  It’s also important to remember that Throughput is determined by both speed and magnitude.

From the three basic elements of Throughput Accounting, namely T, I and OE, we can calculate several other important metrics as follows:

•        Net Profit = Throughput – Operating Expense or NP = T – OE
•        Return on Investment = Net Profit ÷ Inventory or ROI = NP/I
•        Productivity = Throughput ÷ Operating Expense or P = T/OE
•       Inventory Turns = Throughput ÷ Inventory or i = T/I

[1] Ricketts explains that an ideal decision using TA would be one that increases T while decreasing or maintaining both I and OE.  A good decision increases NP, ROI, P, or i.  It’s important to remember that NP is net operating profit before interest and taxes.  Under TA there are no product costs, but instead there are constraint measures that should also be tracked as follows:

•   Throughput per Constraint Unit: T/CU = (revenue – totally variable cost)/units
•    Constraint Utilization: U = time spent producing/time available to produce

The best way to maximize Throughput (T) is to maximize these constraint measures.  Constraint utilization is important because every hour lost on the constraint is an hour lost for the entire business that can never be recovered.  On the other hand, utilization of non-constraints is not tracked because it encourages excess inventory.

Typical decisions based on the metric, T/CU include things like prioritizing use of the constraint (e.g. choosing the best product mix); deciding whether to increase the constraint’s capacity through investment; selecting products to introduce or discontinue and pricing products based on the opportunity cost of using the constraint.

[1] Ricketts eloquently explains that for normal product decisions, T/CU is used to determine the mix that best maximizes Throughput.  If producing less of one product in order to produce more of another product would increase Throughput, for example, then that is a good decision.  But for major decisions that might shift the constraint or forfeit some Throughput on current products, then TA uses the following decision-support measure:

•   Change in Net Profit: ΔNP = ΔT – ΔOE (Note: The Δ symbol stands for difference or change in (a comparison between alternatives).  Likewise, to show the impact of these investment decisions, the metric Payback: PB = ΔNP/ ΔI should be used.

·       To minimize unfavorable deviations from plans, TA advocates these control measures that should be minimized:

• Throughput Dollar Days: TDD = Selling price of late order x days late
•  Inventory Dollar Days: IDD = Selling price of excess inventory x days unsold

TDD measures something that should have been done but was not (e.g. ship orders on time) while IDD measures something that should not have been done but was (e.g. create unnecessary inventory).

In my next post, we will dive into product mixes and explain why using Throughput Accounting results in better decisions.

Bob Sproull

Another New Book Part 10

As I stated in Post 9, one of the most important entities within any organization is how they attempt to measure success.  This post is, once again, taken from my newest book, Theory of Constraints, Lean, and Six Sigma Improvement Methodology – Making the Case for Integration. Specifically, the material for this series is taken from Chapter 5 entitled, A Better Way to Measure a System’s Success. As I explained in my last post, readers that are totally familiar with the Theory of Constraints might find this series a bit basic, but I’m writing this series for those who are not totally familiar with the Theory of Constraints.

Throughput Accounting (TA) addresses all of the problems discussed in my last post with Cost Accounting (CA) by not using product costs, but rather by eliminating incentives for excess inventory and reversing typical management priorities.  It’s very important to understand that TA is not a substitute for conventional financial reporting simply because publicly traded companies are required by law to comply with Generally Accepted Accounting Principles (GAAP) requirements.  But having said this, TA does provide a way to make “real time” financial decisions.  Throughput Accounting will reveal which are the most profitable mix of products, and I promise you will be different than what traditional CA would give you. So let’s review the basics of Throughput Accounting.

Throughput Accounting uses three basic financial measures, namely Throughput (T), Inventory or Investment ( I ), and Operating Expense (OE).  So, let’s look at each of these measures in more detail.

·       Throughput (T) – the rate at which the system generates money through sales of products or services, or interest generated. If you produce something, but don’t sell it, it’s not throughput, it’s just inventory. Throughput is obtained after subtracting the totally variable costs (i.e. cost of raw materials, or those things that vary with the sale of a single unit of product or service) from revenue.

·       Inventory or Investment ( I ) – all the money that the business has invested in things it intends to sell.  Inventory ( I ) primarily includes the dollars (or whatever currency you use) tied up in WIP and Finished Product Inventory.

·       Operating Expense (OE) - all the money the system spends in order to turn inventory into Throughput including all labor costs. It also includes rent, plus selling, general and administrative (SG & A) costs.  Including all labor costs is a huge departure from traditional Cost Accounting.

Throughput is maximized by selling goods or services with the largest difference between revenue and totally variable cost and by minimizing time between spending money to produce and receive money from sales.  It’s important to understand that TA does not use labor costs to allocate OE. Direct labor is not treated as a variable cost simply because businesses do not typically adjust their workforce every time demand for their product or service changes.  It’s also important to remember that Throughput is determined by both speed and magnitude. In my next post, I will introduce several other metrics that can be calculated from Throughput Accounting.

Bob Sproull

Another New Book Part 9

One of the most important entities within any organization is how they attempt to measure success.  In other words, exactly what type of performance metrics are they using to measure if what they are doing is successful or not.  This series of posts is, once again, taken from my newest book, Theory of Constraints, Lean, and Six Sigma Improvement Methodology - Making the Case for Integration.  Specifically, the material for this series is taken from Chapter 5 entitled, A Better Way to Measure a System's Success.  While those readers who are totally familiar with the Theory of Constraints might find this series a bit basic, I'm actually writing this series for those who are not familiar with the Theory of Constraints.

A system’s constraint was defined by [1] Goldratt and Cox as anything that limits the system from achieving higher performance versus its goal.  So how should we measure and judge our performance?  Since the most common goal of organizations is to make money now, and in the future, doesn’t it make perfect sense that at least some of the performance measurements we choose should be monetary metrics?  For example, two metrics that we could use are net profit (NP) and return on investment (ROI).  Goldratt explained that in order to judge whether an organization is moving toward its goal, three questions must be answered. 

1. “How much money is generated by our organization?”
2. “How much money is invested by our company?”
3. “How much money do we have to spend to operate it?”

In any improvement initiative, the person responsible for the financial well-being of your business should play a crucial role in assuring that the initiative stays focused on the primary goal of most companies—to make money now and in the future. Within the confines of our improvement methodology known as the Theory of Constraints (TOC), in this chapter I will present the details of an alternate form of accounting, known as Throughput Accounting (TA). Throughput Accounting is intended to be used for real-time financial decisions rather than basing decisions on what happened in the past like traditional Cost Accounting does. Many businesses will emphatically state that the primary goal of their business is to make money and yet they spend the largest portion of their time trying to save money.

The key to profitability is by identifying and focusing on that part of the system that controls and drives revenue higher and higher, rather than through cost-cutting efforts. It matters not if you are a service provider, a small business owner, a distributor or a manufacturer. What you need is a way to sell more product which increases revenue and, ultimately, profitability. In this chapter I will systematically compare two accounting methods and demonstrate the superiority of Throughput Accounting in terms of profitability improvement.

Because traditional Cost Accounting is so complicated, in this discussion, I won’t go into great detail, but I will cover the highlights of it so that a comparison to Throughput Accounting can be made.  The figure below illustrates selected elements of Cost Accounting (CA) which is taken from a brilliant book by [1] John Ricketts entitled, Reaching the Goal, as is much of what is to follow in this series.

In his book, Reaching the Goal, John Ricketts explains that when Cost Accounting began being used in the early 1900’s, labor costs were clearly dominated the scene in manufacturing and workers were typically paid by the piece.  That is, they were paid based upon how much they produced.  Back then, it made perfect sense to allocate overhead expenses to products on the basis of direct labor costs when preparing financial statements.  But since then, automation now dominates manufacturing, and workers are normally paid by the hour, allocation of large overhead expenses, on the basis of small labor costs, has created some very distinct distortions in accounting.

When observed at the enterprise level, product cost distortions do not affect financial statements much at all.  Yet if prices are computed as product cost plus standard gross margin, the predominant method in Cost Accounting, is that product cost distortions will carry into product pricing.  The resulting effect is that it is possible that some products will appear to be profitable when they are not and, conversely some products that appear to not be profitable, really are.

A second problem with Cost Accounting is that factories are encouraged to produce excess inventory. Why is this?  Producing excess inventory usually happens because of Cost Accounting’s impulse for higher levels of manpower efficiency and equipment utilization in non-constraints.  It is because of this that inventory accumulation can be driven by the counterintuitive effect it has on earnings.  So, what does this mean?  What happens as a result of this inventory accumulation is that rather than being expensed on the income statement in the accounting period they were incurred, the cost of inventory gets recorded on the balance sheet as an asset.  The resulting effect is that an inventory profit may be reported, and businesses can use this to enhance their reported earnings.  The problem is that it has absolutely nothing to do with real income and profitability. If inventory can’t be sold, guess what happens.  If it isn’t sold, then it becomes a depreciation expense on the income statement and an inventory loss will be the end result.

Ricketts explains that a third problem with Cost Accounting is concerned with management priorities.  This means that operating expense will be managed closely because it is well-known and under direct control.  Unlike operating expense, revenue is seen as less controllable because of the perception that it is dependent upon the markets and customers. Inventory is a distant third in management priorities because, as just stated, reducing it will have an adverse effect on a company’s reported income.

Even though most businesses practice it, the key to profitability is not through how much money a company can save, but rather through how much money a company can make! And believe me, these two concepts are drastically different.  Let’s now look at a different accounting method referred to as Throughput Accounting (TA), once again by looking at [1] John Rickett’s book, Reaching the Goal.

[1] John Arthur Ricketts, Reaching the Goal – How Managers Improve a Services Business Using Goldratt’s Theory of Constraints, 2008, IBM Press

Another New Book Part 8

In my last post I explained that this series of posts was taken from my newest book, Theory of Constraints, Lean, and Six Sigma Improvement Methodology - Making the Case for Integration, I will be discussing how I present the basics of TOC to those readers who may not be familiar with it.  In my last post I demonstrated the concept of the constraint by presenting a simple piping system used to transport water.  In this post I will lay out how these basic concepts apply to a simple manufacturing process.

The figure below is a simple four-step diagram of a manufacturing process used to produce some kind of product. Based upon what you have learned from seeing the piping system, ask yourself which step is limiting the production of this product through this process and why it is the limiting process step. Let’s look at some different scenarios to help answer this question in more depth.

The first question we should ask is, based upon the processing times of each step, how long does it take to process a single part through this process? For the first part of this process, the processing time for one part would be the sum total of each of the individual processing times as follows:

7 Days +14 Days + 21Days + 7 Days = 49 Days

The next question to answer is, once the production line is full, what is the output rate of this simple process? The answer to this question is that because Step C, at 21 days, limits the output rate, then the rate of this process, as it currently exists, is one part every 21 days. The figure below summarizes this process with the constraint highlighted. Let’s now look at some additional scenarios that will have an impact on this manufacturing process.

Suppose that Step A has problems and goes down for 7 days, what would happen to the output rate of this process? The simple answer is, nothing changes because it only takes 7 days to complete, so there are still 7 days of buffer time left over to supply Step B. Now suppose Step B goes down for 7 days. Again, nothing changes, because it only takes 14 days to complete, so it should still be able to supply Step C in time before it is starved. Finally, if Step D goes down for 7 days, throughput remains the same because it has a time buffer of 14 days due to Step C’s extended processing time.

Unfortunately, if Step C goes down for 7 days, you will have lost 7 days of throughput that is lost forever! Now let’s look at how to increase the throughput of this process.  If you are able to reduce the processing time on Step A from 7 days to 4 days, what would happen to the output of the process? The simple fact is that if you reduce the processing time on Step A from 7 days to 4 days, throughput remains the same because of Step C’s longer processing time. Likewise, if you reduce the processing time on Step B from 14 days to 7 days, what happens to the output of this process? If you reduce the processing time on Step B from 14 days to 7 days, no throughput improvement will occur, again because of Step C’s longer processing time. If you reduce the processing time on Step D from 7 days to 4 days, what happens to the output of the process?

Just like the other examples, if you reduce the processing time on Step D from 7 days to 4 days, not much happens, again because of Step C’s longer processing time. So, based on all of this, what is the only way to increase the throughput of this process? The simple answer to this question is that if you want to increase the throughput of this process, you must focus all improvements on the constraint operation and reduce its processing time!

For example, what happens to the throughput of this process if you reduce the processing time in the constraint from 21 days to 18 days as in the figure below? The immediate effect of this time reduction is that you improve the throughput of the process from one part every 21 Days to one part every 18 Days, or a 17 percent increase! Because of the impact of your constraining step on the output, doesn’t it make sense to focus most of your improvement efforts on the constraint? Exceptions to this would be if there are quality issues causing scrap or excessive rework with Step D or prolonged delays within Step B. This, of course, assumes that the demand for your product is high enough to be able to sell the additional product.

The next, most obvious question you might ask is, how do you reduce the processing time in the constraint? The answer to this question is the essence of this book. By reducing waste (through Lean tools and techniques) and variation (through Six Sigma tools and techniques), focusing primarily on the system constraint. In other words, by doing things like off-loading work from the constraint to non-constraints, or by eliminating scrap or rework conditions in the constraint and non-constraint process steps after the constraint. The key factor to remember is that if you want to maximize the output of your manufacturing process, you should never allow the constraining operation to sit idle because every minute lost on your constraining operation is lost forever!

In my next post, we will discuss a different subject.

Bob Sproull