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. 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 and investments. They will, in fact, be wasting precious cash and missing out on opportunities to make more profit without additional investment.
The fundamental information you need
As we mentioned in our previous post, How to Find Out What is Actually Making Money in Your Company (and what isn’t) 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 called Throughput Accounting to provide real information, not balance sheet distortions. (NB 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.)
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 short-term 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 long-medium term 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, managers have difficulty making the connection between their actions and the bottom line results of the company.
Having the simple, practical ability to connect actions to results may upset the financial experts; they may argue that the simplistic definition that TOC 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.
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About the Author
Angela Montgomery Ph.D. is Partner and Co-founder of Intelligent Management and author of the business novel+ website The Human Constraint . This downloadable novel uses narrative to look at how the Deming approach and the Theory of Constraints can create the organization of the future, based on collaboration, network and social innovation. She is co-author with Dr. Domenico Lepore, founder, and Dr. Giovanni Siepe of ‘Quality, Involvement, Flow: The Systemic Organization’ from CRC Press, New York.