Throughput Accounting

30/07/2020 0 By indiafreenotes

Throughput Accounting (TA) can be understood as a simplified accounting system based on Theory of Constraints (ToC) principles. TA makes growth-driven management and decision making simpler and understandable even for people not familiar with traditional accounting.

Beyond simplifying, TA has a different approach compared to traditional accounting. The latter will focus on cost control (cost of goods sold) and minimizing the unit cost while TA strives to maximize profit.

Throughput Accounting sets the base for Throughput Analysis, helping to make decisions in the ToC way.

Throughput Accounting focuses on increasing revenue (throughput), improving cash flow (investment) and providing capacity (operating expense). Every management decision is made based on expected changes in throughput, investment and operating expense. Throughput Accounting allows managers to take a more balanced approach to decision making, giving an accurate picture of the results of decisions. Throughput Accounting also demonstrates ways to make more profitable pricing and marketing decisions.

Throughput Accounting shifts the emphasis in decision making from managing costs and budgets to maximizing throughput and profitability. It emphasizes the improvement of flow through the system, providing feedback on the financial impact of the constraint. It drives management decisions to improve the constraint’s efficiency; ensuring all company resources support the constraint, so that profit can be maximized.

This approach differs substantially from Traditional Cost Accounting because the company is not focused on every machine and employee working at optimal efficiency. Instead, its basis is that if a company optimizes any non-constraint, it will overload the constraint and create excess inventory.

Throughput Accounting provides a way to measure productivity improvement efforts based on how they affect cost and throughput. It can be applied to decisions that affect all aspects of a company including product price, process improvement, reward structures, investment justification, transfer pricing, and performance management. The result is a thorough understanding of how a company is functioning as a whole and the ability to analyze the true impact of management decisions before they are made.

Throughput Accounting will probably not replace GAAP in short nor medium term, but provides a limited set of simple KPIs, sufficient to:

  • Manage and make decisions in a growth-oriented and ToC way
  • Allow faster reporting and near to real-time figure-based management
  • Help people in operations to understand the basics of accounting
  • Set a common base for controllers and operations to discuss decisions, investments, etc.

Throughput Accounting uses 3 KPIs and 2 ratios

Throughput (T)

Throughput, defined as the rate of producing goal units (usually money) and translates as revenue or sales minus totally variable expenses in accounting terms.

Totally variable expenses can be simplified to the cost of direct materials because labor is nowadays paid on a (relatively) fixed amount per time period, hence a constant expense to be considered as part of Operating Expenses.

Operating Expenses (OE)

Operating Expenses are all expenses, except the totally variable expenses previously mentioned in the calculation of throughput, required to run and maintain the system of production. Operating Expenses are considered fixed costs, even so they may have some variable cost characteristics.

Investments (I)

Investments, formerly call Inventories, is the amount of cash invested (formerly “tied”) into the system in order to turn as much of the Investments into Throughput as possible. This encompasses the stored raw material waiting to be transformed into sellable products as well as investments in capacities / capabilities to produce more units.

Net Profit (NP)

Net Profit is defined as Throughput minus Operating Expenses, or Sales – Total Variable Costs – Operating Expenses.

Return on Investment (ROI)

Return on Investment is the Net Profit compared to Investments (ROI = NP/I).

Drivers for achieving the Goal

Throughput Accounting offers a simplified way to identify and use the drivers to achieve the Goal, assuming the Goal is to make money now and in the future.

In a very simple way this can be summarized by the following picture which means strive to maximize Throughput while minimize the Operating Expenses and Investments.

ToC practitioners recognize that Throughput has no limit while Operating Expenses and Investments have limits beyond which no safe operations can be further envisioned.

The priority focus on improving T (focusing on the constraint exploitation) rather to go for all-out cost cutting explains the (usually) superior results when going the ToC way compared to unfocused improvements.

Throughput Accounting KPIs can be presented in a Dupont-inspired model in order to make the levers and consequences clear.