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In this June 2005 issue of On Target :
Theory of Constraints: Throughput Accounting
What's On
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 :
How much money is generated by our company?
How much money is captured by our company? and
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 :
Throughput (T): the rate at which the system generates money through sales.
Investment (I): all the money the system invests in purchasing things the system intends to sell.
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 :
T = Total Throughput
OE = Total Operating Expense
I = Total Investment
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.
What's On
June 11- August 27, 2005
Advanced Management Accounting & Advanced Strategic Management Accounting 12-day Seminars (5th Batch) in the Philippines by cmaphilippines and ICMA
August 13-15, 2005
Advanced Management Accounting, 3-Day Seminar in Sri Lanka
Conducted by the Institute of Chartered Accountants of Sri Lanka and ICMA
August 4-5 and 8,9 2005
Advanced Strategic Management Accounting, 4-Day Seminar in Sri Lanka
Conducted by the Institute of Chartered Accountants of Sri Lanka and ICMA
August 7, 10, 21, 28 and September 4, 2005
Strategic Cost Management, Monash University
[approved as a CMA subject by ICMA as equivalent to Advanced Management Accounting]
August 15- Launching of the CAT program by the Australian Institute of Finance and Management and ICMA
CMA Batch 6 - August 20 - November 5, 2005
Advanced Management Accounting & Advanced Strategic Management Accounting 12-day Seminars (6th Batch) in the Philippines by cmaphilippines and ICMA
August 13 - September 24, 2005
CAT Batch 3 in the Philippines by cmaphilippines and ICMA
September- ICMA AGM (date to be advised)
November- CMA Summit-Philippines (date to be advised)
November- Batch 3 CMA Philippines (date to be advised)
Book Shelf
In this column I have sometimes reported on articles that discuss ‘generic’ skills required of professional accountants. This time I have found an article about an often not considered skill required in business. Indeed a skill that people at all levels of the organisation have to think about, not just accountants. Some may see the article as ‘tongue-in-cheek’ but you never know when our behaviour can cause offence. And if that offence is felt by our customers or suppliers, who knows what the consequences might be?
I am referring to an article in the May, 2005 issue of AFR Boss magazine, a journal where I always find something interesting and thought provoking. (Published with the Australian Financial Review on the second Friday of each month, articles are also available on its website: http://www.afrboss.com.au.) “Boss manners: Going up in the world” by David Meagher discusses the delicate subject of elevators (am I old-fashioned in referring to these as lifts?), escalators and doors, and who enters or exits first. Circumstances should guide our decisions, not age or gender. “If a male and female are waiting for a lift, it would be polite for the man to allow the woman to enter first. ... But if there are 10 people waiting, the person closest to the lift door enters first, no matter what their gender.” The justification, it seems, is that in an office building, speed is the most important issue, not “fussing about ...” Those ubiquitous mobile phones (*!*) are also mentioned.
For the busy professional, AFR Boss magazine, often reproduces selected articles from highly regarded business journals by well-known writers, and regularly reviews recently published books and articles in leading edge journals. In the May issue, for example, Malcolm Rimmer of La Trobe University reviews articles from MIT Sloan Management Review, MIS Quarterly and Journal of Marketing Research.
A reminder that I am always looking for contributions to this column. Readers should not feel constrained and may even be able to have some fun writing about their reading. Remember, “if it’s not fun, why do it?” And who knows where your efforts will lead you.
Bill Richardson
Please feel free to share anything that you have found interesting. You can send your ideas to: Bill Richardson, Dept of Accounting & Finance, Monash University, PO Box 197, Caulfield East VIC 3145.
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