Manufacturing Breakthrough Blog
Monday December 19, 2016
One of the major differences between traditional cost accounting and throughput accounting is how inventory is appraised. The simple change in calculating money generated at the time of sale and not at the time it is produced is a shift in reality from a seller’s market to a buyer’s market. Cost accounting assumes that everything produced would eventually be sold (seller’s market). But in a buyer’s market, this is not the case. The bottom line is that you make a profit only when you sell products and not when you produce it. So the inevitable conclusion is that you need to measure sales rather than production. In this sense, throughput per unit for a given product is calculated as sales revenue per unit minus the cost of the raw materials or component parts added as follows:
- t = throughput per unit
- t = sales revenue per unit – raw material or component parts cost
So the total throughput per period of time for a product is the “t” value multiplied by the total quantity sold for that product. For example, if T1 denotes the total product for product 1, then T1 is calculated as follows:
- T1 = throughput per unit of product 1 x quantity (q) of product 1 sold
- = t1 x q1
From this equation, if T represents the total throughput for a manufacturer for a given time period, total throughput is calculated as follows:
- T = the sum of Throughput for each of n products sold by the company
= T1 + T2 + T3+ ……+ Tn
Before leaving this discussion of throughput, it’s important to remember that throughput measures output in dollars and not activity (e.g. work-in-process inventory). Activity that does not contribute to sales or the conversion of materials into products sold is essentially waste. Let’s now turn our attention to the subject of inventory.
The authors, Srikanth and Umble, explain that their definition of inventory is different than the traditional definition in two important ways. First, their definition of inventory does not add value to the product as it progresses through the process. Traditional cost accounting dictates that as material progresses through the process, it absorbs both labor and overhead. Because of this, the inventory value of material increases as it is processed through the various steps in the process. If, for example, a part’s raw materials are valued at $100, using the traditional costing method, that same part could be valued at $110 after the first step in the process. After it passes through all of the steps in the process, those same raw materials could grow to $175 and more when it’s delivered to the finished goods stocking area. Under the authors definition, the value of the part remains unchanged at $100 as it passes through the various processing steps. Therefore, the author’s definition of inventory is simply the amount of money tied up in materials the company intends to sell.
- I = purchased material value of raw materials, purchased parts, work-in-process
and finished goods inventories
The authors rightfully point out that this assumption of increasing “value” is very misleading. Not only has no value been created, it is very possible that value has actually been lost. As materials progress through manufacturing operations, they actually lose flexibility meaning that they could become limited to single type products. And if there is no demand for the product, not only was no value (or throughput) created, material was consumed and must be replaced when a different product is ordered. In order to avoid these distortions, the authors value inventory at the original value (or cost) of the material. Labor and other expenses incurred in the production process are accounted for in the next category – operating expense.
Operating Expense (OE) includes all of the money spent by the system with the exception of the money spent to purchase inventory (i.e. truly variable expenses) since this latter expense has already been accounted for in the definition of throughput. Operating Expense is money spent by the company to convert Inventory into Throughput.
- OE = actual spending to turn I into T
The authors explain that there are two critical differences between their definition and the traditional concept of the cost of operations. First, there is no fundamental difference between direct labor and indirect labor because both assist in the conversion of inventory into throughput. Therefore, all personnel-related expenses are included in OE.
The second difference is that for the most part, OE includes actual expenses. That is, it counts real money or checks written as opposed to elements such as variances. Under the traditional cost accounting procedure, if an operator is producing parts at a faster rate than the engineering standard for the operation, then that worker will be generating a positive variance and the cost of operations will be reduced. And this applies even if there is no demand for the product! Under the author’s definitions, the same situation results in no change in throughput (T), an increase in inventory ( I ), and no change in operating expense (OE) because the operator’s wages don’t change. The standard cost system views labor costs as infinitely variable while the author’s method (i.e. Synchronous Management measurement system), normal labor costs (excluding overtime) are viewed as fixed in the short term.
In part 4, we will demonstrate a simple example using T, I, and OE to illustrate the two author’s methodology.
As always, if you have any questions or comments about any of my posts, leave me a message and I will respond.
Until next time.
 L. Srikanth and Michael Umble, Synchronous Management – Profit-Based Manufacturing for the 21st Century, Volume One – 1997, The Spectrum Publishing Company, Wallingford, CT