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