throughput acounting

HowtoGrowProfitwithThroughputAccounting

HowtoGrowProfitwithThroughputAccountingAPinnacleStrategiesWhitePaper

2010MarkWoeppelhttp://PinnacleStrategies.com Page1

Today,companiesarefocusedonincreasingthroughputtherateatwhichacompany

generatesmoneythroughsales.Theywanttoexpandproducts,customerbase,markets,andso

on.Theywanttogrowasmuchaspossible,asquicklyaspossible.Theydonotwanttofocuson

shrinkingtheircompanyorlaborforce.Yet,themostcommonlyusedfinancialtoolstell

companiestofocusoncuttingcostsinordertomaximizeprofits,makingexpensesthefocusof

companies,notsalesgeneration.Thisoftenleadsmanagementtomakedecisionsthatactually

harmacompany.

Companiesneedtousefinancialtoolsthatmovethemtowardtheirgoal.Throughput

Accountingprovidesmanagerswithatransparentandfocusedmethodtomakedecisionsthat

consistentlyleadthemintherightdirection.Throughbettermanagerialdecisionmaking,

ThroughputAccountingimprovesacompanysabilitytomakemoremoneynowandinthe

futurebecauseitapproachesaccountingfromacashmanagementbasis.Itmeetstheneedthat

companieshavetomeetmanagementchallenges,includingoutsourcingproducts,process

improvement,andpurchasingcapitalequipment.

IsTraditionalCostAccountingBadforDecisionMaking?

TheDecisionMakersDilemmaItisoftendifficulttoseehowdecisionsmadeinalocalareaaffecttheorganizationasawhole.

Thisisparticularlytrueofmanagerswhoarenotabletoseeoraffecteveryareaofthe

organization.Theorganizationalviewofmostmanagersistypicallylimitedtotheirownareaof

responsibilityandthosenearby.

Forabusinessleaderinanenterprise,theissueismoretroublesome,becauseheorshemust

concernthemselveswiththedecisionmakingofmultiplemanagersinvolvedinmanyaspectsof

theenterprise.Weknowfromexperiencethatlocalmanagersoftenmakedecisionsthatare

countertothepurposeoftheenterprise.Asinglepersonperiodicallymakingabaddecisionis

usuallynotsignificant,butifthereisasystemicerrorinmanymanagersunderstandingofthe

enterprisesfunctioning,manypoordecisionswillbemade,whichcouldcreatesignificant,long

lastingdamage.

Larger,subdividedenterpriseslosetheirsystemwideperspective,andmanagersareforcedto

relyondecisionrulesthataretypicallybasedonTraditionalCostAccounting;thebiggerthe

enterprise,thebiggertheproblem.

HowtoGrowBusinessProfitwithThroughputAccountingAPinnacleStrategiesWhitePaper

PinnacleStrategieshttp://PinnacleStrategies.com Page2

Thedecisionmakerisoftenforcedtochoosebetweendecisionsthatmakeintuitivesense,but

mustbejustifiedusingTraditionalCostAccountingmethods.

TheDecisionMakersChallengeManagersandsystemownersmustfindawaytopredictandaccuratelymeasuretheeffectof

localdecisionsontheglobalgoal.Thechallengeistogetlocalmanagerstothinklikebusiness

peopleandmakegooddecisionsbasedontheglobalsystemmeasurements.

Revenues Expenses Profit Returnoninvestment

Often,inanefforttomanagethedollarsinanorganization,thelocalmanagersmanage

budgets,which,whileimportant,donotmimicthedecisionsofthebusiness.Mostimportantly,

budgetmanagementassumesafixedrevenuesource,overwhichlocalmanagershaveno

control.Theresultisthatlocalmanagementdecisionsbecomeonedimensionalbasedon

expensesandlocaloptimization.Therealityisthateverylocalmanager,beingpartofthe

system,canhaveasignificantimpactontherevenuesofanenterprise.Everymanagershould

beusingthesamemethodstoevaluatethequalityoftheirdecisions;basedontheimpacton

netprofitandreturnoninvestment(shortandlongterm).

ThePitfallsofTraditionalCostAccountingTraditionalCostAccountingfailstoprovidethisguidancetomanagers.Itsimplycant.Itis

basedonseveralassumptionsthatwhile,atonetime,werevalid,arenolongerareflectionof

therealitythatmanagersfindthemselvesin.

Traditionalcostaccountingsprimaryoperatingassumptionisthatlaborexpenseisdirectlyand

positivelycorrelatedtoprocessoutput.Ittreatseveryresourceasthingswithapproximately

thesamequality,ignoringtheexistenceofaprocessconstraint.However,theTheoryof

Constraintsclearlyshowstheimportanceofunderstandingconstraintsinmaximizing

throughput,andhowvitalitisforallpartsofacompanytomanagearoundandtothe

constraintresource.

Itisonlywhenallpartsofanorganizationworktogethertosupporttheconstraintfromsales

toR&Dtomanufacturingthatthroughputcanbeachieved.Ifanypartoftheorganization

ignorestheeffectsoftheconstraint,throughputwillbeaffected.Thus,itisnotanyrandom

partofthesystem,suchaslaborefficiency,thatdeterminestheentiresystemsthroughput,



butwhatlimitsthesystemfromachievingmorethroughput.TraditionalCostAccounting

ignoresthispointoffocusandgivesequaltreatmenttoallareas.

Givingequaltreatmenttoallareasandignoringtheconstraintresultsinaninabilitytoconsider

thetrueimpactthateachareaofthecompanyhasonthroughput.Thiscancausemanagement

tomakedecisionsthatharmthehealthofcompany.Considerthefollowingexamples:

Ifanengineerfindsawaytoimproveprocessesatanonconstraint,willitincreasethroughputiftheconstraintisunaffected?

Ifproductsareoutsourcedtocutlaborcosts,willtheactualspenddeclineorrealthroughputincrease?

Ifpurchasingdiscoversacheapersupplierforapart,whatwilltheimpactbeonthroughputandtheconstraint?

Whilethesedecisionscanshowimprovementusingtraditionalcalculations,theymay

ultimatelyreducethroughput.Itisonlywhenmanagementconsiderstheconstraintinits

decisionsthatthroughputwillbeincreased.

TraditionalCostAccountingalsoleadsdecisionmakersastraybyallocatingfixedexpensesto

theproductionofanincrementalunitofproduction.Bytreatingmaterial,laborandoverhead

costsasvariablecosts,itignorestherealitythatlaborandoverheadexpensesareusuallyfixed

onincrementalvolume.Laborandoverheadarenotvariableproductioncosts,theyreperiod

costs.Whenacompanyreceivesaneworder,ittypicallydoesnothireadditionalemployees,

terminatecurrentemployees,opennewmanufacturingsites,orclosecurrentsites.The

numberofemployeesandplantsstaythesame,asdothecostsrelatedtothem.Yet,managers

aremakingdecisionsbasedonfaultynumbersthatstateotherwise.

AnotherproblemwithTraditionalCostAccountingisits(unintentional)encouragementof

inventorycreation.Theprimarypurposeofmanufacturingistoproduceproductstosell,but

theleadersofthisfunctioncanlosesightofthegoalwhenlaborandoverheadcostsare

absorbedintoinventory.Absorbingcostsintoinventoryactuallyencouragesthecreationof

inventoryanddiscouragesthereductionofinventory.Byproducingalargeinventoryinorder

todeferlaborandoverheadcostsuntilaproductsells,itmayappearthatacompanyismore

profitablethanitreallyis.Conversely,whenexcessinventoryisremovedfromthesystem,it

mayappearlessprofitable.Essentially,TraditionalCostAccountingencouragesthecreationof

excessinventoryevenifsalesarelow,consumingcashatatimewhenacompanymayleast

affordit.



ProductOutsourcingACaseStudy

MalteseFinders,Inc.producesgolddetectors1.Managersusethecostofproducingpartsin

house(standardlaborrates)toevaluateproductivityandmakethedecisiontooutsourceparts

ifitischeapertobuythantoproduceitinhouse.Ifsomeonecansellthemacomponentfor$5

thatcosts$10internally,outsourcingwillincreaseprofit.

Thisdecisionresultedinrigorousenforcementofapolicytooutsourceallpartsthatwere

cheaperfromoutsidevendors.Partsthatcouldbepurchasedcheaperwerenolongerproduced

inhouse,butpurchasedfromacompetitivesupplier.Asaresult,60%ofitspartswere

outsourced.

Despitereducingcapacityandworkforce,thepolicyandactionsdidnotincreaseprofit.

Managementexaminedthecostsofpartsagain,discoveringthatevenmorepartswerenow

cheapertooutsource.Theadditionaloutsourcingofpartsfailedtoincreaseprofit.Instead,

profitdeclinedfurther.

Managementclosedoneplant,increasedproductionhoursintheremainingplants,and

purchasedadditionalinventorytokeepproductionrunning.Thecompanywasabletoproduce

moreproductsthanever.Eventhoughsaleswerenotincreasing,inventorywasincreasing,and

theyshowedalargeprofit.

Butthecompanyhadalotofinventoryandnoonewasbuyingit.Itwasstillspendingmoneyto

createproducts,butdespitetheprofitontheledgersheet,moneywasnotcomingintomeet

expenses.MalteseFindershadtofileforbankruptcyandchangethenameoftheircompany.

PurchasingCapitalEquipmentACaseStudy

SimpleStrategiesproducespartsforradios.PriortoshiftingtoThroughputAccounting,Simple

Strategiesundertookastrategytoreducecostsbyreducingtheprocesstime.Oneofthese

decisionswasthepurchaseofnewmanufacturingprocessequipmenttoreduceprocesstime

by8%.Unfortunately,thiswasforanonconstraintresource.

Thedecisionwasfocusedonalocalarea,viewinglaborandoverheadasequals,without

considerationofconstraints.Thenumberofemployeeswasnotreduced,andthepricepaidto

vendorsforrawmaterialswasnotreduced,sothecostsavingsdidnotmaterialize.Infact,the

onlyeffectwasthecashpaidoutforthenewprocessequipmentreducedthecashonhand.

1Atruestory,butthenameshavebeenchangedtoprotecttheguilty.



SwitchingtoThroughputAccounting,managementchangeditsfocusfromspeedingupthe

processtimeinindividualareastoreducingthetimeontheconstraint.Byinvesting$3,000in

theconstraint,thetimeontheconstraintwasreducedfrom15minutesto10minutesperunit.

Outputincreased80%andthecompanyadded$10milliontoitsbottomline.

HowCanThroughputAccountingHelp?

ThroughputAccountingfocusesonincreasingrevenue(throughput),improvingcashflow

(investment)andprovidingcapacity(operatingexpense).Everymanagementdecisionismade

basedonexpectedchangesinthroughput,investmentandoperatingexpense.Throughput

Accountingallowsmanagerstotakeamorebalancedapproachtodecisionmaking,givingan

accuratepictureoftheresultsofdecisions.ThroughputAccountingalsodemonstrateswaysto

makemoreprofitablepricingandmarketingdecisions.

ThroughputAccountingshiftstheemphasisindecisionmakingfrommanagingcostsand

budgetstomaximizingthroughputandprofitability.Itemphasizestheimprovementofflow

throughthesystem,providingfeedbackonthefinancialimpactoftheconstraint.Itdrives

managementdecisionstoimprovetheconstraintsefficiency;ensuringallcompanyresources

supporttheconstraint,sothatprofitcanbemaximized.

ThisapproachdifferssubstantiallyfromTraditionalCostAccountingbecausethecompanyis

notfocusedoneverymachineandemployeeworkingatoptimalefficiency.Instead,itsbasisis

thatifacompanyoptimizesanynonconstraint,itwilloverloadtheconstraintandcreateexcess

inventory.

ThroughputAccountingprovidesawaytomeasureproductivityimprovementeffortsbasedon

howtheyaffectcostandthroughput.Itcanbeappliedtodecisionsthataffectallaspectsofa

companyincludingproductprice,processimprovement,rewardstructures,investment

justification,transferpricing,andperformancemanagement.Theresultisathorough

understandingofhowacompanyisfunctioningasawholeandtheabilitytoanalyzethetrue

impactofmanagementdecisionsbeforetheyaremade.

ProcessImprovementACaseStudy

TalentedEnterprisesproducespartsforcameras.Itsprimarymeasureofproductivityislabor

absorptionundertheassumptionthatifmoreworkisbeingdonetocreateinventory,profits



willincrease.However,usingthismeasureresultedinactionstoincreaseinventoryandbuild

stockproductsratherthanfillactualcustomerorders.

Processimprovementswereimplementedtoreducecosts.Effortsweremadetodecreasethe

laborinvolvedinproducingparts.Thiswasdoneforalloperations.Manynonconstraints

becamefaster,producingevenmoreworkthantheconstraintscouldhandle.Eventhough

laborwentdown,inventoryincreasedanditbecamemoredifficulttofulfillordersontimeand

toproperlyprioritizemanufacturingjobs.

Whenmanagementlearnedaboutthroughput,itshifteditsfocusfromabsorbingcostsinto

inventorytoincreasinghowquicklyworkcouldbecompleted.Emphasiswasgiventoimproving

constraints.Byinvesting$25,000inthefacilityandaddingtwoadditionalemployeestotheday

shift,outputincreased73%.UnderTraditionalCostAccounting,theseexpenseswouldnot

havebeenjustifiedbecauselocaloutputefficiencywouldhavedeclinedonaperlaborhour

basis.However,thecostwasminimalcomparedtotheincreaseinthroughput.

HowtoUseThroughputAccountingtoMakeDecisions

Whendeterminingwhataffectadecisionwillhave,managementneedstoconsiderthe

following:

1. Willthedecisionincreasethroughput?How?a. Willthechangeincreaseordecreasesales?b. Willthechangeaffectyourrawmaterialcosts?c. Willthechangeaffectyourprices?

2. Willthedecisionreduceinvestment?How?a. Willthechangeincreaseordecreaseyourinventories?b. Willthechangeincreaseordecreaseyourreceivables/payables?

3. Willthedecisionreduceoperatingexpense?How?a. Willactualcashoutlaysbereduced?b. Willthechangeincreaseordecreaseyourstafflevels?Whoisleavingthe

company?

c. Willthechangeincreaseordecreasethenumberofoutsidecontractorsyouneed?Willyousendmoreorlessdollarstooutsideentities?

Thechangeinthroughputlessthechangeinoperatingexpenseisthechangeinprofit(TOE=

PROFIT).Ifthechangeinprofitispositive,youcanbeassuredthatthedecisionwillleadthe

organizationtowardsmakingmoreprofit.



Ifprofitdividedbyinvestment[(TOE)/I]isgreaterthan1,thereturnoninvestment(ROI)will

bepositiveandyoucanbeassuredthatthedecisionisafavorableinvestment(notaloss).

HowtoUseThroughputAccountingforProductProfitability

ThroughputiscreatedwhenaproductissoldandisexpressedasaRATE.Theamountof

throughputisthesellingpricelesstotalvariableexpense(TVE).TVEisdefinedasmoneythatis

onlyspentwhenthereisasale.Therateatwhichproductsgenerateprofitisdeterminedby

thethroughputperunit,dividedbytimeontheconstraint.

Knowingwheretheconstraintisnowandwhereitwillbeinthefuturehelpsqualifydecisions

thatimpactprofit.Timeonconstrainttellsmanagementtherateatwhichaproductis

contributingtoprofit,thushelpingmanagementjudgethebenefitofchangesinthe

manufacturingprocess.

ProfitabilityAnalysisACaseStudy

DynamicSolutions,Inc.sellsthreemajorproducts.Productionofeachoftheseproducts

requiresdifferentvariableexpensesanddifferentratesofresourceconsumption.

Product SellingPrice MonthlyDemand ContributionMargin(CM)

A $200 100 $150

B $175 50 $40

C $100 75 $45

Operatingexpensesare$16,000permonth.TheconstraintistheQResource.

Throughput=SellingPrice TVE

RateofProfit=Throughputperunittimeonconstraint

ThroughputOperatingExpense=PROFIT;Ifprofitis

positive,thedecisionwillincreaseprofit.

If(ThroughputOperatingExpense) Investmentis>1,ROIwillbepositive.



ProfitabilityAnalysisUsingTraditionalCostAccountingDynamicSolutions,Inc.

ProductA ProductB ProductC Total

Revenues

(100x$200) $20,000

(50x$75) $8,750

(75x$100) $7,500

TotalRevenues $36,250

TotalCosts

MaterialCosts

(100x$50) $5,000

(50x$35) $1,750

(75x$55) $4,125

TotalRMCosts $9,750

Wages $3,221 $425 $1,729 $4,975

Overhead 4,319 928 1,721 $6,668

TotalCosts $12,540 $3,103 $7,575

GrossProfit $7,460 $5,647 ($75)

GrossMargin/Unit

[$7,460100] $74.60

[$5,64750] $112.94

[($75)75] ($1)

ProductPreference #2 #1 #3

AccordingtoTraditionalCostAccounting,ProductCshouldbedroppedandProductBisthe

companysbestprofitgeneratingproduct.

DynamicSolutionsdiscoversthatitcannotdeliveralloftheunitsforProductAandB

demandedbycustomers.Itdoesnothaveenoughcapacity.So,itdecidestodeliverwhatitcan

whilelookingforahighergrossmarginproductandexploringitsoptionsforrestructuring.



MaximumProfitAvailableUsingTraditionalCostAccountingDynamicSolutions,Inc. UnitsSold CMperUnit TotalCM

ProductB 50 $40 $2,000

ProductA 100 $150 15,000

ProductC 0 $45 ____0

TotalCM $17,000

Operatingexpense 16,000

Operatingincomebeforetaxes

$1,000

ButwhatifDynamicSolutionshadusedThroughputAccounting?

ProfitabilityAnalysisUsingThroughputAccountingDynamicSolutions,Inc. ProductA ProductB ProductC

Averagesellingprice/unit $200 $75 $100

Variablecosts/unit 50 35 55

Throughput(CM)/unit $150 $40 $45

Constraintmin.requiredQresource

30 30 10

Throughputtimeonconstraint(Qresource)

$5.00/min. $1.33/min. $4.50/min.

ProductPreference #1 #3 #2

ThroughputAccountingshowsthatProductCisthebetterprofitmakingproductinthelong

termthanProductBbecauseithashigherthroughput(contributionmargin)andagreaterrate

ofprofit.



MaximumProfitAvailableUsingThroughputAccountingDynamicSolutions,Inc. UnitsSold CMperUnit TotalCM QResourceTime

UsedProductC 75 $45 $3,375 750 min

ProductA 100 $150 15,000 3000

ProductB 15 $40 __600 _450

TotalCM $18,975 4,200min

Operating

expense

16,000

Operatingincomebeforetaxes

$2,975

WhileTraditionalCostAccountingsfocusongrossmarginsofindividualproductswouldhave

DynamicSolutionsincreaseproductionofProductBanddropProductC,Throughput

Accountingshowsthatbymaximizingtherateofthroughputusingtheconstraint,Dynamic

Solutionscanrealizenearlythreetimestheamountofprofit.

Conclusion

Cuttingcostsisimportant,butitisnotthemostimportantfactorinmaximizingprofit.

Intodaysworldofglobalcapitalismandshareholderexpectations,companiesareseekingways

toexpandineveryareaprofit,quality,andsoon.Focusingsolelyoncuttingcostsdoesnot

producethebestresult.Youcanonlycutcostsforsolongbeforethereisnothinglefttocut.

Todaysmarketplacerequirescompaniestofocusonthroughput.Thisrequiresan

understandingofacompanysconstraintandhowchangeswillaffecttheconstraint.

ThroughputAccountingenablesmanagerstoexaminethelinkbetweenprocessconstraintsand

financialperformanceindecisionmaking.Thismakesitpossibletodeterminetherealimpactof

theirdecisions.Beforeadecisionismade,acompanycanlookattheimpactonthroughputand

compareittotheeffectonoperatingexpenseandtherequiredinvestment,solvingthe

decisionmakingproblemformanagers.



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