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
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