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