“Without this information I would have gone out of business long ago.” Those are the words of a CEO in a recent conversation and he was not talking about Cost Accounting. Cost Accounting is not giving companies all the information they really need. That may seem astonishing but it is a fact. There is a much simpler and more straightforward way to get real information from the numbers a company is producing to understand business performance. These numbers are what are needed to make the right decisions about what things are costing the company and where profit can most effectively be made. Without this information, leaders and managers will never know if they are taking the right action when it comes to evaluating costs, investments and how the business is doing overall. They will, in fact, be wasting precious cash and missing out on opportunities to make more profit without additional investment.
If you knew accurately what is actually making money in your company wouldn’t that then influence all your decisions regarding cost and investment? Well, isn’t that what accounting is for? The problem is, traditional accounting fails to give a complete and correct picture of what is happening dynamically.
Every company is trying to achieve a goal. Sometimes that goal is less clear than others, but generally speaking, people are aware that there is an economic point to what they are doing. As that is the case, they also need to know how to make the right decisions about where to spend money and how much activities etc. are costing. For this purpose most companies rely on cost accounting.
But what if the measurement system is not usefully designed to support decision-making? You will create wrong policies. By subordinating to wrong policies, you can actually damage the results of the organization.
You need to know your constraint
Every organization is a dynamical system and every system has a constraint, whether they know it or not. The constraint exists, and, ideally, we choose strategically where it is.
It turns out that the ability of any organization to achieve its goal is limited by a very small number of factors, indeed we can say it is limited by only one: the constraint. This knowledge about the constraint gives us a critical advantage:
The constraint determines the pace at which the system generates units of the goal, that is, the throughput of the system.
In for-profit companies, the units of its goal are linked to the generation of monetary profit. So if the constraint determines the pace of throughput we need to know exactly how everything happening in the company impacts the constraint.
Radical simplicity in complexity
How can we most effectively manage complexity? By anchoring our organization/system to one point, the constraint. By understanding interdependencies (the actual forces in a dynamical system) we can manage and lead the organization toward maximizing throughput (value). This corresponds, in dynamics, to the path of least resistance.
Traditional accounting methods will not help us with this, indeed they are blind to it. So what can we do? The good news is you don’t need to be a math genius. What is required for a truly accurate picture of what is going on in the company is Throughput Accounting from the Theory of Constraints. By adopting Throughput Accounting, we gain a much more accurate, and systemic picture of what is really happening in our company in terms of money in and money out. It also provides us with a much more accurate idea of the real profitability of any goods or services that we sell because it relates it the constraint of the organization.
Of course, when we adopt throughput accounting we cannot abandon tax, legal, financial, and general regulations and requirements that are mandatory in any country. On the contrary, we will have to use them alongside Throughput Accounting measurements.
Get ready for something radically simple and that – wait for it – makes complete sense.
The business performance metrics you need
Companies need to know what their constraint is (and every company/system has one) because the constraint determines the pace of throughput. So we need to know exactly how everything happening in the company impacts the constraint. The constraint is a positive because we can leverage it to guide the company to maximize throughput.
This radically simple way to govern complexity requires a radically simple way of counting, Throughput Accounting, to provide real information, not balance sheet distortions.
The basic indicators we use in the Theory of Constraints (TOC) are the following:
Totally variable costs (TVC): the monetary value of the raw material (and services connected to the product being sold, e.g. shipping) that goes into the product that we sell. Another way of looking at TVC is costs we would not have if we did not actually sell.
Throughput (T-put) (T) is the pace at which a company generates cash through sales. This is not a “static” measurement, in other words, it is not just the amount it generates but also the speed at which the amount is generated;
Inventory (I) represents all the raw material and services purchased that are necessary for producing the products and services that the company intends to sell, that is, Sales (S);
Operating expenses (OE): all the money the company spends to transform goods and services purchased into sales. They are essentially made of two components: fixed costs and investments;
Fixed costs are the expenses that the company sustains regardless of economic results and production volumes. There is little or no room for their reduction (think, for example, of salaries, leasing payments, mortgages, cleaning, and ordinary maintenance);
Investments are costs that the company plans and sustains in order to achieve results (i.e., extraordinary maintenance, purchase of machinery and equipment, consultancy expenses, training of staff, marketing campaigns).
Two basic equations
There are two basic equations in Throughput Accounting:
Throughput = Sales minus TVC
Net Profit = Throughput minus OE
The difference between Throughput and OE reflects the amount of money left in our hands after deducting the money we pay for OE from the money generated by sales. We must ignore the traditional measurements of cost accounting and consider the difference between T and OE as a close and accurate approximation of net profit.
If the difference between Throughput and OE is positive, then the impact of the net profit on the system will be positive, irrespective of the type of financial reporting the system is subject to. This is an important point as, in many cases, decision makers have difficulty making the connection between their actions and the bottom line results of the company.
We must emphasize that Throughput Accounting is for measuring speed of cash generation and there is no point in attempting any reconciliation with GAAP accounting (that must be done in parallel to meet legal and tax obligations).
Having the simple, practical ability to connect actions to results may upset the financial experts; they may argue that the simplistic definition that Throughput Accounting gives of net profit is mistaken. The financial definition of the net profit of a system may be more complex, but any system can be considered healthy if Throughput exceeds OE.
To learn more about Throughput Accounting contact us
Intelligent Management works with decision makers with the authority and responsibility to make meaningful change. We have helped dozens of organizations to adopt a systemic approach to manage complexity and radically improve performance and growth for 25 years through our Decalogue management methodology. The Network of Projects organization design we developed is supported by our Ess3ntial software for multi-project finite scheduling based on the Critical Chain algorithm.
See our latest books Moving the Chains: An Operational Solution for Embracing Complexity in the Digital Age by our Founder Dr. Domenico Lepore, The Human Constraint – a digital business novel that has sold in 43 countries so far by Dr. Angela Montgomery and ‘Quality, Involvement, Flow: The Systemic Organization’ from CRC Press, New York by Dr. Domenico Lepore, Dr. .Angela Montgomery and Dr. Giovanni Siepe.