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In this June 2005 issue of On Target :
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Theory of Constraints: Throughput Accounting
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What's On
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Bookshelf
Theory Of Constraints : Througput Accounting Throughput Accounting is a management accounting system based
on the Theory of Constraints (TOC). TOC views any company as a
system. One of the most fundamental concepts is the recognition
of the important role that the system's constraint has, and
because of this concept Throughput Accounting does not allocate
costs to products. As a matter of fact, one of the basic ideas
of Throughput Accounting is that if we want to make good
decisions we should not calculate the cost of products.
TOC uses the chain analogy to exemplify some of its
principles. If we pull a chain, where will it break? On its
weakest link (i.e. only one link will break). If we want to
increase the chain's strength, what should we do? We should
strengthen its weakest link, this system's constraint.
Strengthening any other link before strengthening the weakest
link would be a waste of time and resources, because it is the
weakest link that is determining the maximum performance of all
the chain. The system's constraint dictates its performance
therefore, if we want to increase the system's performance we
have to identify and explore the system's constraint.
A company's goal is to make money now and in the future. To
make the bridge between NP and ROI, TOC has three measurements.
To judge if a company is moving towards its goal it is necessary
to answer "Three simple questions :
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How much money is generated by our company?
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How much money is captured by our company? and
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How much money do we have to spend to operate it?
The measurements are intuitively obvious. What is needed is
to turn these questions into formal definitions.
TOC's measures are :
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Throughput (T): the rate at which the system generates money
through sales.
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Investment (I): all the money the system invests in
purchasing things the system intends to sell.
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Operating Expense (OE): all the money the system spends in
turning investment into throughput.
Throughput
Throughput is defined as all the money that
enters the company minus what it paid to its vendors. This is
the money that the company generated. The money paid to the
vendors is money generated by other companies.
To calculate the throughput per unit of each product we need
to subtract the Totally Variable Cost (TVC) from its selling
price. CTV is the cost that varies for every extra unit produced
(in most cases its only raw material). This will tell us how
much money the company generates with the sale of one unit of
the product. To calculate the company's total throughput all we
need to do is add the total throughput of each product (which is
the throughput per unit multiplied by the sales volume).
Investment
All the money the system invests in purchasing
things the system intends to sell. This measure and the
conventional accounting measure of assets might be mistaken as
being the same, but differ drastically when referring to work in
process and finished goods inventory. What value should we
attach to a finished product stored in a warehouse? According to
the definition given above, we are allowed to assign just the
price that we paid to our vendors for the material and purchased
parts that went into the product. There is no added value by the
system itself, not even direct labor." The value given to
the work in process (WIP) and the finished goods inventory is
their TVC. One of the objectives here is to eliminate the
generation of apparent profits due to the cost allocation
process. With this methodology it is not possible to increase
short term profits increasing WIP and finished goods inventory
(delaying the recognition of some expenses that will certainly
decrease profits of future periods).
Operating Expense
Taking added value out of inventory does
not mean that we do not have these outlays of money. There is no
added value to the product. Operating Expense (OE) is
intuitively understood as all the money we have to pour into the
machine on an ongoing basis to turn the machine’s wheels. OE
includes wages (all payments for human capital, from the company’s
CEO to its direct labour) rents, energy, etc. TOC does not
classify them as fixed, variable, indirect, direct, etc. OE is
simply all other accounts that did not go into Throughput or
into Investment. The increases or decreases in OE are analysed
on a case by case basis, where its impact on the bottom line is
taken into account.
TOC says that these three measures are sufficient for us to
make the bridge between NP and ROI and the managers' daily
actions. Below we have the formulas that show this bridge:
NP = T – OE
ROI = (T - OE)/I,
where :
With these three measures (T, I and OE) we can know the
impact a decision has on the company's bottom line. The ideal is
a decision that increases T and decreases I and OE. But, any
decision that has a positive impact on ROI is a decision that
takes the company towards its goal. The final judge, the one who
decides if it is a good decision or not, is ROI.
When the company has a constraint in its production process,
we have to decide which products are more important to the
company, as we do not have enough capacity to sell everything
the market wants.
We have to bear in mind that the constraint is the time
available on the constraint resource. To increase the company's
throughput we have to maximize the utilisation of this time.
We want to sell the products we the highest throughputs and,
at the same time, sell the products that use less time on the
constraint. We will have a problem when comparing two products;
one has a higher throughput and the other uses less time on the
constraint. How to decide which one is best for the company?
To solve this problem we need a measurement that takes into
account that we want to maximise the company's throughput.
On one hand we have the product's throughput, on the other
the minutes it uses of the constraint. To decide which one most
contributes to the company's bottom line we need to divide the
product's throughput by the time it uses on the constraint,
finding the product's Throughput per time of the constraint. But
this measure only identifies the most profitable product when
the company does not have enough capacity to sell everything the
market wants.
When the company has more capacity than the market demands,
the constraint is not the company's available capacity. In this
case the criteria of comparison between products should be the
throughput per unit, because there is no resource limiting the
company's performance. Any product's sale whose price is bigger
than TVC, and that doesn't increase OE, contributes for the
increase of the bottom line.
It must be noted that the throughput per time of the
constraint or the throughput per unit should never be the only
measurements taken into consideration to evaluate a decision.
Whatever the decision being taken, it is necessary to quantify
its impact on the company's NP and ROI.
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