Making Better Decisions.

Throughput Accounting calculates the impact that a decision will have on a company's overall performance. It does this without allocating costs to products

Traditional cost accounting has suffered severe criticisms in past years. It seems that everyone agrees that it is obsolete. Two questions summarize most of the discussions about this:

1. Can cost methods change so that they can give us good information?

2. Do costs need to be allocated to products to make good decisions?

Those that believe that the problem with the prevailing management accounting system is that it does not allocate costs well to products tend to advocate Activity-Based Costing (ABC) as the solution. ABC tries to better allocate the costs to products. These people would answer "yes" to both questions above.

But there are some people who believe that you should not allocate any costs to products. Throughput Accounting (TA) is based on this. It does not allocate any costs to products. It does not calculate the cost of products. These people would answer "no" to both questions. They believe that allocation is not able to give us good information anymore, because it is based on erroneous assumptions.

You can talk about how allocation can be improved or how allocation cannot be improved. Or you can talk about if you need allocation or not. This article concentrates on the second question. Even if more complicated allocation methods can solve the problem of traditional cost accounting, do you need them? Is there a simpler way to make good decisions? If that simpler way exists, then, even if allocation methods give good information, you would not need them.

Any organization needs an information system that will tell its managers if what they are doing is taking the organization toward its goal. You can use a compass as an analogy to management accounting. The compass shows us the direction you are going and you can then certify ourselves if you are in the right course or if you need to make some corrections in our course.

The owners determine the North of an organization (its goal). In the case of the organizations that you will talk about here, suppose that the goal is to make money now and in the future. The performance measurements used to verify if the company is going towards its goal are Net Profit (NP) and Return on Investment (ROI). These two measurements give the position of the company in relation to its goal, but they are not very useful to make day-to-day decisions.

For the managers' day-to-day decisions it is necessary to have a bridge between their decisions and actions and the profitability of the company. Today most companies use traditional cost accounting as this bridge.

The Theory of Constraints (TOC) TA is based on TOC, so you first need to understand the basic concepts behind TOC. TOC sees any company as a system; that is, a set of elements between which there is a relationship of interdependence. Each element depends on the others in some way, and the global performance of the system depends on the joint efforts of all the elements of the system. One of the most fundamental concepts is the recognition of the important role that the system's constraint has.

Eliyahu Goldratt, in "What is this thing called the Theory of Constraints, and how should it be implemented?" (Croton-on-Hudson, North River Press, 1990) says, "Every action taken by any organization any part of the organization - should be judged by its impact on the overall purpose. This immediately implies that, before you can deal with the improvement of any section of a system, you must first define the system's global goal; and determine the measurements that will enable us to judge the impact of any subsystem and any local decision, on this global goal... A system's constraint is nothing more than what you feel to be expressed by these words: anything that limits a system from achieving higher performance versus its goal... In our reality any system has very few constraints... and at the same time any system in reality must have at least one constraint."

Following this reasoning Goldratt created TOC's process of ongoing improvement, always focusing the efforts towards the system's goal. This process has five steps:

1. Identify the system's constraint(s).

2. Decide how to exploit the system's constraint(s).

3. Subordinate everything else to the above decision.

4. Elevate the system's constraint(s).

5. If in the previous steps a constraint has been broken, go back to Step 1. But do not allow inertia to cause a system constraint.

TA's Performance Measurements To judge if a company is moving towards its goal, it is necessary to answer three simple questions: How much money is generated by your company? How much money is captured by your company? And how much money do you have to spend to operate it? The measurements are intuitively obvious. V/hat is needed is to turn these questions into formal definitions. Below you have the formal definitions.

If the system generates money by earning interest at a bank, it is definitely throughput, or the rate at which the system generates money. Most production managers think that if they have produced something, it deserves to be called throughput. Throughput should not he associated with shuffling money internally. Throughput means to bring fresh money from the outside, thus the additional words-through sales.

Throughput is fresh money that has two sides, Revenue and the Totally Variable Costs (TVC). The use of the words variable and cost may be contusing with the measures used in cost accounting. The fundamental element here, without any doubt, is the word Totally, or Totally Variable in relation to the units sold.

A TVC is that amount incurred when one more product is sold. You have product and company's throughput. A product's throughput is its price minus its Totally Variable Cost (TVC). A product's contribution to the company's throughput is its throughput multiplied by the number of units sold. Consequently, a company's throughput is the summation of all the products' total throughput. Throughput is the only of the three measurements to identify with individual products.

Inventory: all the money the system invests in purchasing things the system intends to sell. This measure and the conventional accounting measure assets might he mistaken, but differ drastically when referring to work in process and finished goods inventory. In TOC there is no added value to the product. Goldratt says, "Added value. To what? To the product. But our concern is not the product, but rather the company. So what you actually ask ourselves is, 'When is the only point in time that you add value to the company?' Only when you sell, not a minute before. The whole concept of adding value to a product is a distorted local optimum."

Operating Expense: all the money the system spends in turning inventory into throughput. "Taking added value out of inventory does not mean that you do not have these outlays of money," says Goldratt. "Operating Expense (OE) is understood as all the money you have to pour into the machine on an ongoing basis to turn the machine's wheels?"

TOC does not classify them as fixed, variable, indirect, direct, etc. OE is simply all other accounts that did not go into Throughput or into Inventory. The increases or decreases in OE, are analyzed on a case-by-case basis, where its impact on the bottom line is taken into account. The most common error is to think TOG tags GE as fixed. TOC does nor classify the expenses as fixed or semi-variable, what really matters is if it is totally variable or not totally variable.

TOC says that these three measurements are sufficient to make the bridge between NP and ROT and the managers' daily actions. These are the formulas that show this bridge:

NP = T - OE

ROI = (T - OE)/I

With these three measurements (T, I and GE) you can know the impact a decision has on the company's bottom line. Any decision that has a positive impact on ROI is a decision that takes the company towards its goal. You do not need to calculate the NP for all the company, neither the ROI. You can calculate the incremental NP and ROI. If they are positive and if the ROI is equal to or greater than a predetermined ROI, then it is a good decision.

"In evaluating any action, you must remember that you have three measurements, not just one. Otherwise extremely devastating actions will be taken. This means that the final judge is not the measurements themselves, but the relationships between these measurements," says Goldratt. This is exactly what TA tries to do and that is why TA does not allocate costs to products. To measure the impact of a decision on the company's NP and ROI you do not need to calculate the cost of products.

A fourth measurement Now, to be able to calculate the impact on the three measurements, especially throughput, you need to understand the relationship between the system's capacity constraint and the company's products. When a company does not have enough capacity to deliver what the market wants, the company has to decide what it will sell and what it will not sell.

In this case, to increase throughput the company needs to squeeze the maximum it can from its available capacity. As Goldratt has shown, a production process is much like a chain, it has one weak link. The capacity of the production processes is dictated by one weak link, the bottleneck. If the company wants to increase its throughput it has to explore this resource.

Let us suppose that our company has a bottleneck. The available time on this resource is limited. Different products use the constraint's time differently. One product might need five minutes on the constraint while another needs half an hour. It is obvious that the one that uses less time should have a preference.

You also want to increase the company's throughput. Different products have different throughput. A product that has a throughput of US$100 should have preference over another product whose throughput is US$40.

As you can see, you want to give preference to products that have a bigger throughput and at the same time, give preference to products that use the least time on the constraint. You will have a problem when, comparing two products, one has a greater throughput, while the other uses less time on the constraint. To solve this problem you need to have a relative measurement that takes into account that you want to maximize throughput and at the same time minimize the time spent on the constraint.

To decide which one most contributes to the company's bottom line you need to divide the product's throughput by the time it uses on the constraint, finding the product's throughput per time of the constraint.

To better understand this measurement all you need to do is think as if the company is selling its most scarce resource, the time of the constraint. The products that better pay for the time they use are the ones that most contribute to the company's bottom line.

When you use this measurement the assumption is that the market demands more than the company can produce. But this is not always the case. When the company has more capacity than the market demands, the criteria of comparison between products should be the throughput per unit, because there is no resource limiting the company's performance. Any product sale that increases the company's throughput and that doesn't increase GE (or at least does not increase it more than it increased throughput), contributes for the increase of the bottom line.

TOC doesn't make any correlation between production volume, or other system's variables, with GE. The assumption is that the person making the decision is able to quantify the impact it will have on GE, and therefore there is no need to try to discover any kind of relationship between GE and some variable of the system.

Any way, throughput/time of the constraint or throughput/unit should not be considered alone when evaluating a decision. Whatever the decision, it is necessary to quantify its impact on the three basic measurements so that you can know the impact the decision will have on the company's NP and ROI.

Basic Difference between Throughput Accounting and Cost Accounting Methodologies The basic difference is that TA does not trace costs to products as do the cost accounting methodologies. TA does not calculate the cost of a product, to make decisions it uses the throughput per unit of product, the time each product uses of the CCR and the company's operating expenses.

This difference is due to a basic difference in viewing improvement. One assumption behind cost accounting methodologies is that high local efficiencies will lead to high global efficiency.

What this means is that cost accounting is based on the assumption that maximizing the use of all the activities (high local efficiencies) will lead to a better profitability. Because of this assumption it gathers data on the use of all resources/activities. It wants to make sure that all resources/activities are being efficiently used. The concept of the cost of a product is a result of this search for high local efficiencies.

As seen, TA's basic assumption is the complete opposite of cost accounting's assumption. TA is based on the assumption that a company has very few constraints and that if you increase the efficiency of non-constraint resources you will not be improving the company's performance (as a matter of fact you might actually be decreasing it's performance). It argues that if you view a company as a system you will not want to maximize the use of every resource and activity because you know that in a system there are constraint and non-constraint resources/activities. The only place where you want high local efficiencies is on the constraints.

This basic difference will lead managers to act very differently. In a cost accounting environment managers will be induced to focus their efforts in increasing efficiencies anywhere, as this will reduce the cost of products. In a Throughput Accounting environment managers will be induced to focus their efforts in increasing the efficiency of the constraint.

Throughput Accounting Statements Now you will see how you can turn these concepts into useful tools for management You will see what Throughput Accounting Statements are trying to do, and help managers answer the three questions: What is the impact of the decision on Throughput? What is the impact of the decision on Operating Expense? What is the impact of the decision on Inventory?

Table 1 shows the Statement for the company's operating expense. Table 2 shows the data on all the company's products. To build this statement the company needs to have the data on its products' price, TVC and time on the constraint, the other columns of Throughput per Unit and Throughput/Time on the Constraint are a result of these data. The products are presented in a decreasing manner according to their throughput/time on the constraint.

In column E you have the Time on the Constraint. Here you need to add up the times that all the parts that compose the final product use of the constraint. This is the only process time that this methodology requires. You only need to have trustworthy data on the constraint.

In this statement you can manipulate the selling price, the TVC and the product's time on the constraint to evaluate the impact of decisions on the company's profitability. With this statement ready, the company may then do the forecast of its financial performance according to the sales mix or even may do various simulations to see the impact of a decision on the company's bottom line. The statement to do these forecasts and/or simulations is the one shown on Table 3.

In this statement you enter the sales forecast for each product and you accumulate the utilization of the constraint and the total throughput per product. If there is an internal constraint the Demand/Capacity of the Constraint will be greater than 100%. In the example the company has a capacity constraint, its Demand/Capacity of the Constraint is 154%, which means it would need over 50% more capacity to deliver all the demand.

After the Demand column you have the columns for Maximum Throughput Mix and Sales Mix. The Maximum Throughput Mix is generated automatically by allocating the available capacity from top down. In other words, you assume you will produce and sell only the most profitable products until there is no capacity left. In the example the Maximum Throughput Mix is 5,000 Reds + 1,500 Blues + 7,200 Yellows + 775 Greens. You do not have any capacity left to produce the remaining demand for Green and Orange.

With this you have calculated the maximum profit the company can generate in the period being analyzed (US$123,400.) In the majority of the cases the companies cannot impose a product mix to the market. What happens is that many products, even when not very profitable for the company, need to be sold to satisfy the market and guarantee the company's future.

Therefore, it is necessary to find a sales mix, starting from the demand. In column J of Table 3, the company should enter its sales mix. Here the quantity to be produced and sold shall never exceed the demand quantity of column H. If you have an internal capacity constraint you need to decide what products you are not going to supply part of the demand, or even all of it. Here there is no way out and in this statement the accumulated utilization (column K) cannot go over 100%. This compels the company to make a decision about what clients and products are more important, always taking into account the financial aspects and the marketing aspects.

In the example, the company decided that for marketing reasons, it should sell 50% of the demand for product Orange, even though it is the least profitable product. To be able to do this the company has to decide where it will free capacity. In other words, what product(s) it will stop producing to be able to produce product Orange? This company decided to sell only 400 Blues and 150 Greens.

In the columns 'Accumulated Utilization of the Constraint' and 'Total Throughput per Product' you always have two divisions. The first one shows the results for the mix of maximum profit and the second one shows the sales mix results. At the end of the statement you calculate the company's total throughput, then subtract the OE from it and find the company's NP. Right after that you have the company's investment and its ROI.

If the company has no capacity constraint, there will be no difference between the maximum profit mix and the sales mix columns. With these statements ready, the company can start analyzing the impact of decisions on the company's profitability.

Making Decisions When making a decision you should estimate the impact it would have on the company's throughput, inventory and operating expense. Again here, you see the importance of the constraint. The variation in OE and Inventory are easier to estimate and they are entered directly on these statements.

Using the example above, suppose that you want to know what the impact on profitability would be if you decreased a part's time on the constraint, offloading it to another resource in the company. This change in process will increase the part's TVC by US$5 and will require the hiring of another worker. This worker will cost the company US$1,000 a month.

This raw material is part of product Yellow, which means that its TVC will increase by US$5, going to US$35. With this the company will be able to reduce this product's time on the constraint by one minute, from four to three minutes.

The OE statement would now be like Table 4. As Yellow's TVC and time on the constraint also changed, you have to introduce these changes in the products' database, Table 5. Product Yellow's throughput/time on the constraint increased from 13 to 15.67, making it go from the third to second most profitable product. You now have to estimate the impact on the company's throughput.

To estimate this impact the company first has to make the decision of how to use the capacity freed by this process. As now every Yellow will use only three minutes of the constraint instead of four the company still has 7,200 minutes of available capacity.

Depending on which product it decides to produce and sell, its total throughput will increase more or less. In this case the company decided to use these 7,200 minutes to make product Green, as shown on Table 6. As each Green uses eight minutes of the constraint the company can make an extra 900 units. This will make Green's total throughput increase by US$72,000 (900 units x US$80). Yellow's total throughput, on the other hand, will decrease US$36,000 due to the US$5 increase in its TVC (7,200 units x US$5). Therefore, the company's total throughput will increase US$36,000. As OE increased US$1,000, the Net Profit increased US$35,000.

In this case, where there was no variation in Inventory, it is enough to measure the impact on NP. As long as NP increases (as long as T increases more than OE) it is a decision that will increase the company's profitability. When there is an increase in Inventory you have to verify if the increase in NP (if there is an increase in NP) is enough to pay for the increase in Inventory.

These statements allow for forecasts and simulations. In a very short time managers can simulate some improvement suggestions, appropriation requests, clients' proposals, etc. The decision process becomes much more transparent and accessible.

These statements on their own are not sufficient for managers to make decisions, but they are necessary for them to do so. Without such statements managers are making decisions without knowing the impact of these on the company's profitability.

Conclusion You have seen a method that allows you to make decisions without the need to allocate costs to products. It is a simple and logical method. It also supplies trustworthy information fast, enabling managers to make good decisions fast. These are the qualities a management information system should have and that today no other system has.

However, Throughput Accounting concepts will conflict with many existing measurements and mental models in the company. These conflicts stem from a basic assumption behind TOC: that local optimizations do not lead to global optimization. Many measurements being used today are based on the exact opposite of this assumption: local efficiencies lead to global efficiency. If these conflicts are not properly dealt with the company will not be able to enjoy all the benefits that this new methodology can offer.

What Throughput Accounting does is calculate the impact a decision will have on the company's overall performance. It does this without allocating costs to products. The only basic assumption behind this method is, as Goldratt says, "In the goal only one assumption is postulated. The assumption that you can measure the goal of an organization by Throughput, Inventory and Operating Expenses. Everything else is derived logically from that assumption."

If you agree that using these three global measurements you can measure the impact any decision will have on the company's overall performance, then why allocate costs to products?

Thomas Corbett, Arthur Andersen Business Consulting - Boston, is a PhD candidate at FGV - Sao Paulo, Brazil, and author of Throughput Accounting, North River Press, 1998.

                             Operating Expense
                                 Month xx
Item                  US$
Wages               550,000
Sales and Marketing 250,000
Transport            18,000
Financial Expense    11,000
Depreciation         10,000
Others               20,000
Total               914,000
                         Data Base of the Products
                                 Month xx
A         B    C  D (B - C)      E       F (D /E)
Product Price TVC Throughput  Time on   Throughput/
                   per Unit  Constraint Time on CCR
Red     125   51      74         4         18.50
Blue    237   83     154        10         15.40
Yellow   82   30      52         4         13.00
Green   155   75      80         8         10.00
Orange   60   27      33         4          8.25
                       Maximum Profit Mix/Sales Mix
                                 Month xx
                  Capacity of Constraint = 70.000 minutes
                   Demand/Capacity of Constraint = 154%
G           H          I         J            K                    L
Product   Demand   Max. Thr. Sales Mix  Acum. Utiliz        Total Throughput
        (Forecast)    Mix              of Constraint %        per Product
Red       5,000      5,000     5,000        28.6       28.6     370,000
Blue      1,500      1,500      400          50        34.3     231,000
Yellow    7.200      7.200     7,200        91.1       75.4     374,400
Green     1,500       775       150          100       77.1      62,000
Orange    8.000        0       4,000         100        100        0
G
Product
Red     370,000
Blue     61,600
Yellow  374,400
Green    12,000
Orange  132,000
Total Throughput 1,037,400   950,000
OE                 914,000   914,000
Net Profit         123,400    36,000
Inventory        5,500,000 5,500,000
ROI (annual)         26.9%      7.6%
                             Operating Expense
                                 Month xx
Item                  US$
Wages               551,000
Sales and Marketing 250,000
Rent                 55,000
Transport            18,000
Interest             11,000
Depreciation         10,000
Others               20,000
Total               915,000
                         Data Base of the Products
                                 Month xx
A         B    C  D (B - C)      E           F (D/E)
Product Price TVC Throughput  Time on   Throughput / Time
                   per Unit  Constraint   on Constraint
Red      125  51      74         4            18.50
Yellow    82  35      47         3            15.67
Blue     237  83     154        10            15.40
Green    155  75      80         8            10.00
Orange    60  27      33         4             8.25
                       Maximum Profit Mix/Sales Mix
                                 Month xx
                  Capacity of Constraint = 70,000 minutes
                  Demand/Capacity of Constraint = 143.7%
G           H          I         J           K                     L
Product   Demand   Max. Thr. Salex Mix  Acum. Utiliz        Total Throughput
        (Forecast)    Mix              of constraint %        per Product
Red       5,000      5,000     5,000        28.6       28.6     370,000
Yellow    7,200      7,200     7,200        59.4       59.4     338,400
Blue      1,500      1,500      400         80.9       69.1     231,000
Green     1,500      1,675     1,050         100       77.1     134,000
Orange    8,000        0       4,000         100        100        0
G
Product
Red     370,000
Yellow  338,400
Blue     61,600
Green    84,000
Orange  132,000
Total Throughput 1,073,400   986,000
OE                 915,000   915,000
Net Profit         158,400    71,000
Inventory        5,500,000 5,500,000