Manufacturing Breakthrough Blog
Monday December 29, 2014
At the end of my post on Manufacturing Constraints, I asked the following questions for you to answer:
Re-cap of last posting
Does it make any sense for all steps to produce at their full capacity?
- Yes, because my efficiency numbers would not look good if I slowed down the steps. (0% chose this option)
- Yes, because if they weren’t producing at their full capacity, I wouldn’t produce enough. (0% chose this option)
- No, because if each step ran as fast as it could, there would be excessive WIP in the system. (97.06% chose this option)
- I’m not sure. (2.94% chose this option)
What are the effects of excess WIP within a process?
- Ties up cash and space (38.24% chose this option)
- Extends processing times (2.94% chose this option)
- Negatively impacts on-time delivery rates (0% chose this option)
- All of the above (58.82% chose this option)
Cost Accounting versus Throughput Accounting
In order to answer these questions, I am introducing this supplementary posting about a different way to analyze decisions that Operation’s people are forced to make on a routine basis. While most people use the traditional Cost Accounting (CA) methods to make decisions about proposed actions, I want to teach you about a different way to do so by introducing you to something referred to as Throughput Accounting (TA) which has its roots in the Theory of Constraints (TOC). In doing so, I want to emphasize that TA is not a replacement for CA, because public companies are required by law to satisfy and report profit information according to Generally Accepted Accounting Principles (GAAP). What I do want you to see is that TA is a better way of making real-time decisions. First, let me explain the basic metrics and calculations associated with TA and then present a basic example of how TA leads to better decisions.
Managers in all manufacturing organizations need a method of tying the impact of a proposed action on the company’s bottom line. For many years managers have been using traditional CA calculations to make decisions on proposed actions, but are these calculations the right ones? The basic difference between CA and TA is how each technique views the pathway to profitability. In the case of CA, this pathway focuses on cost reduction where the basic profit measurement of an organization is provided by its earning statement, expressed by the following formula:
Net profit = Sales – Expenses
Managers look at their own, isolated area and recognize the reality of this basic equation and assume that the least-cost alternative translates directly into bottom-line profitability of their own area of responsibility and expand this calculation emphasizing the independence of their own area of responsibility to:
Net profit = Sales – Manufacturing and Non-manufacturing expenses
These same managers believe that their responsibility is for costs only and that revenues are the responsibility of a different functional area. Add to this the belief that there is often a significant lag in time of a proposed expenditure and its appearance as part of the bottom line since the costs of products being produced are held as inventories at the various stages of production. But here’s the conundrum…..costs don’t tell the whole story.
One of the most important teachings of TOC is that the organization should be viewed as a system. TA teaches us that there are three basic measurements that must be used to determine the impact of decisions. These three measurements and their definitions are:
- Throughput (T) – The rate at which a system generates money through sales. Throughput corresponds to what CA refers to as contribution margin
- Inventory/Investment ( I ) – Some cash is expended to acquire the resources necessary to establish the operating capability in order to carry out the organization’s business model. These expenditures include the cost of inventory (raw material, work-in-process and finished goods), but also include property, plant, and equipment and other intangible things which we refer to as assets. Inventory/investment includes the capabilities of the system as well as raw materials and purchased parts, but it does not include direct labor or manufacturing overhead.
- Operating Expense (OE) – Cash is expended on a periodic basis to provide the ongoing capability to execute the organization’s business strategy/model. These expenditures relate to the time period, rather than to specific sales, and CA refers to them as period costs. Things like taxes, energy expenses, etc. are included in this category, but in a major departure from CA, TA includes all labor expenses.
What about net profit?
These three measurements form the basis for a decision making alternative to traditional Cost Accounting. But now, rather than breaking the expenses down into functional categories of manufacturing and nonmanufacturing expenses, the expenses are classified as being either truly variable with the sale of a single unit of product or as belonging to the time period with the equation for profit being:
Net Profit = Throughput – Operating Expense or
Net Profit = Sales – Variable Costs – Period Expenses
With this equation in mind, actions that result in increased T or decreased I and/or OE with directly lead to profitability improvements and are therefore, desirable actions. The implications of using TA as a decision guide for proposed actions is that by asking for the impact on these three variables, managers can more quickly, more easily and more accurately predict the effect of proposed actions on global net profit.
In my next posting, we will look at an example that should clearly demonstrate the difference between decisions made using traditional Cost Accounting (CA) and this new decision making tool, Throughput Accounting (TA). In closing, I want to emphasize again that TA is not a replacement for CA, but rather is a decision guide for determining the impact of potential actions on an organization’s net profit.