A major focus within the Theory of Constraints is on increasing sales, rather than cutting costs. To keep the focus on sales, implementers of the process use an accounting method known as Throughput Accounting.
The following is the third entry in a series of posts that explore the Theory of Constraints and it’s methodology.
Part one of the Theory of Constraints series, offered a broad overview of the process, defined constraints, and provided a simple breakdown of the Five Focusing Steps. Part two in the Theory of Constraints series, expanded on the Thinking Process behind the Theory of Constraints. Part three will now look into Throughput Accounting that is associated with the process.
If we think in terms of conventional accounting, then inventory is considered an asset because in theory, it could be sold and converted into cash. This can often be misleading though and cause a false sense of security. A stockpile of inventory which appears to be increasing assets based off inventory that “could” be sold is a scary way to do business in today’s economy. Looking at a piece of paper that shows you have increased your assets based off your inventory is known as a “paper profit.” The longer you sit on your inventory, the more obsolete it becomes. The product’s value begins to decrease and whatever space that inventory is taking up, is costing you money everyday it sits unsold.
The mindset in traditional accounting methods is to keep a strong focus on how to cut expenses with a major focus on the following:
- Net Profit
- Return On Investment
- Cash Flow
Throughput Accounting takes a slightly different approach to accounting. To help alleviate any misinterpretation of numbers that conventional accounting methods produce, Throughput Accounting keeps an emphasis on the following:
Throughput: The rate at which you generate money through sales.
- Time is taken into consideration when accounting for throughput. Instead of using product profitability comparisons, you can measure the time it takes to produce a specific unit and calculate the Throughput for each unit.
- The money sent back to the suppliers is deducted from the Throughput figure. For example, a table selling for $20 and made up of $5 worth of plastic and other materials would have a contribution of $15 per unit. If then, 10 tables can be produced for confirmed sale per hour, the throughput for that unit is $150 per hour.
- Anything that is in storage is not accounted for in Throughput because it is not generating money.
- Typically, labor costs are not a factor in the Throughput calculation.
Investment: Any money tied up in the system which can be split up into two separate categories.
- Raw materials, work in progress and finished goods
- Investments- as in anything owned by the organization to generate Throughput. This could include machinery, fixtures and fittings.
Operating Expense: All the money used to convert Investment into Throughput.
- This would include all regular labor expenses, but not variable costs like payroll, utilities, taxes, etc.
Measuring the Constraints
Once you have calculated out your figures for each category; Throughput (T), Investment (I) and Operating Expense (OE), the measurements can be used throughout the organization to predict and help with future decisions.
- Profit = T – OE
- Return on Investment = T – (OE/I)
- Productivity = T/OE
- Cash Flow = T – I – OE
Using the Throughput Accounting method to measure the dollars and sense of your organization, keeps the focus on what the Theory of Constraints strives for, making money today, tomorrow and the long-term future of the organization.
Sticking with a conventional accounting methods can lead to the overproduction of inventory, which as Throughput Accounting points out, does not make money for the organization. When you tie up valuable cash flow in the costs associated with making and storing the goods, your profit margins decrease significantly.
Stay tuned for another post in this series that will compare and contrast the Theory of Constraints with Lean processes.