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About the author Ross Maynard page 38

Throughput accounting: better thinking – better results

believe that the role of the in is to provide timely and actionable I management information to managers for the purposes of reviewing performance, planning improvement activity and making business decisions. Unfortunately, in many , we do not meet this requirement very well! The problem, I believe, is our obsession with unit or product costs. This obsession is easy to understand; in life, we buy stuff in units and we sell things the same way. Our minds have become trained to the idea of units; and because we pay the same price per unit for one carton of milk as for five, it is easy to think that it costs the same to sell one carton as it does five. Of course it does not, and in fact and price have nothing to do with each other at all. Price is set by the market: by the features and benefits your product or service offers compared to the competition; and by how well you manage product and corporate image. Cost is a function of the process through which you produce the product or service. Price is based on units because it is easy to understand and easy to make transactions that way. That does not mean that cost has to be on the same basis.

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Throughput accounting: better thinking – better results

It is the total process costs we should be working with, not some notional unit cost based on a load of assumptions that few people know in detail, still less understand.

Which is the most profitable product? Women’s shirts Men’s shirts We do not need to work out a standard product cost here. Our Weekly market demand 120 units 120 units conventional unit-cost thinking tells us that women’s shirts will Price per unit, 105 100 € be more profitable: they require less total machine time, which Material cost per unit, 45 50 means lower absorption of overheads and thus a higher unit € Cutting time, minutes per shirt 2 10 . This suggests that we should meet the full market demand for women’s shirts and fill any spare capacity with Sewing time, minutes per shirt 15 10 men’s shirts. Total processing time, minutes per shirt 17 20 Unfortunately this is the wrong answer. Shirt-making business: management information Let us say we have 2,400 minutes of available time each week Table 1 on the cutting machine and 2,400 minutes on the sewing machine. We cannot meet the market demand for 120 shirts of ‘But,’ I hear you cry, ‘having a cost per unit means we can both types of shirt per week because the capacity of the sewing calculate a profit margin per unit.’ Trouble is there is no such machines is limited to 2,400 minutes per week. This is not thing as a cost per unit. If you invest in a process – people and considered in the standard cost calculation, and if we follow equipment – but only manage to sell one unit of output, then your cost per unit is going to be a disaster. You start to build a conventional cost calculation based on machine or labour market reaching, perhaps, 50% capacity, and things start to minutes, we get the profit statement shown in Table 2. 36 look better. Reach 75% capacity and you should be doing We have made a weekly loss. pretty well. Notice I have used the term ‘throughput’ in the table. This is a What matters here is not the supposed cost per unit, but the term that derives from Eli Goldratt’s book: The Goal 2 and his total you are generating, compared to the total cost of work on . Throughput accounting seeks the process, its effectiveness, including its capacity, and how you to align costs with the flow through a value stream or business plan to improve the overall picture. It is the total process costs process in order to drive improvement. we should be working with, not some notional unit cost based on a load of assumptions that few people know in detail, still less While traditional accounting practices developed in the era of understand. After all, we do not cost-reduce a product, except mass production and are based on the concept of economies by a complete redesign; we can only cost-reduce the process of scale, throughput accounting is rooted in the world of through which we create the product or service. Unit cost tells multiple products, mass customisation, and complex mix us nothing about that. decisions. Throughput accounting is based on the concept of To be a bit more technical, it is the costs and of the economies of flow: that we increase profitability and reduce process we are interested in if we want to make a real impact. cost by increasing the rate of flow through the whole process Let us consider a simple example that I have adapted from or value stream. Thomas Corbett’s book: Throughput Accounting .1 Throughput accounting postulates that every business You operate a small, but fashionable shirt-making business. Your process has at least one constraint, be it equipment, skill or business process comprises two stages: cut material; and sew procedure/policy. It rejects the philosophy of traditional cost shirt. You compile the management information shown in Table 1. accounting that profitability is maximised when machine and labour utilisation are maximised, but, in contrast, argues that we Women’s shirts Men’s shirts improve the profitability of a process only by improving the flow through the whole process, to demand. Thus, the Weekly output 120 units 60 units Accounting Dictionary defines throughput accounting as: a Revenue, 12,600 6,000 € system that seeks to maximise the Material cost, 5,400 3,000 return on bottleneck activity. € Throughput, 10,200 € At this point a few throughput accounting definitions are in Operating , 10,500 order: € Net profit (loss), (300) n € Throughput is defined as net less total variable cost: total variable cost is usually taken as material cost only, Shirt-making business: profit statement though there may be other truly variable costs in a Table 2 particular process 35-38 accounting.qxp:Layout 1 23/11/11 16:15 Page 3

Operations Management Number 6 www.iomnet.org.uk 2011

n Investment is defined as the money tied up in the process or value stream – that is, the equipment, inventory, Women’s shirts Men’s shirts facilities, buildings and other and liabilities that form Weekly market demand 120 units 120 units part of the value stream or process; note that throughput Price per unit, 105 100 accounting values inventory strictly on totally variable € Material cost per unit, 45 50 cost – material cost – only, without labour or overhead € Throughput per unit 60 50 n is the other direct costs associated with the value stream or process excluding any allocations of Sewing time, minutes per shirt 15 10 corporate or other external overheads Throughput per minute of constraint resource 3.53 5.00 n Net profit, also called value stream profit = throughput less operating expense Shirt-making business: process analysis Table 3 Proponents of throughput accounting argue that only three business ratios are needed for decision-making and performance The figures are slightly odd looking because we are only improvement of business processes: considering one week’s data and comparing it to total n Return on investment is net profit divided by investment, investment in the process. Nevertheless it is evident that we expressed as a percentage, and is a useful measure to have developed a more profitable product mix by ignoring what compare value streams; we can improve a value stream’s conventional told us and by focusing instead on return on investment by increasing the revenue of the value the constrained resource. stream, by reducing inventory as we improve flow and by Unit costs and unit profitability tell us nothing. What we should reducing waste be interested in is the cost of the process as a whole and, in n Productivity is defined as throughput divided by operating particular, the capacity of the resources in the process. Any expense, expressed as a percentage; this is a reflection of resources that are at or near full capacity are constraints. If we the level of contribution in the value stream then have product-mix decisions to make then we need to consider the throughput per unit of constrained resource. The n Investment turns is defined as throughput divided by total amount of machine or labour minutes absorbed in the investment, expressed as a ratio; any decision that improves product is of no relevance. It is the constraint alone that restricts this ratio for a value stream will inevitably improve the the flow through the process and that needs to be considered profitability of the value stream and thus the investment in our calculations. The constraint should also be our priority for 37 turns measure is a useful first-cut way of ranking alternative improvement: improve the constraint and you improve the decisions flow through the whole process. Lean techniques come into In our shirt-making example above, total throughput is play here. 10,200 with the proposed product mix. If we assume an € Let us consider one final element in our shirt-making example. investment of 500,000 in the process, then we have a € We have the opportunity either to invest 10,000 at the negative weekly throughput return on investment - net profit € cutting process to deliver 30% – 720 minutes per week – extra ÷investment. Throughput productivity for the week is 97% - capacity or to invest 100,000 at the sewing process to deliver 10,200 ÷ 10500; and throughput investment turns are 0.0204 € 30% – 720 minutes per week – extra capacity. (10,200 ÷ 500,000). Which option should we choose? As we have discussed, throughput accounting seeks to A 10,000 investment at the cutting process might well maximise the return on the process constraint, so we need to € consider the capacity of our resources. In the shirt-making improve efficiency metrics at the process through faster cycle example we are limited to 2,400 minutes per week on both times. However, we already have plenty of spare capacity at this our cutting machines and our sewing machines, and it is the process and the investment will yield no financial benefit. sewing machines that are the constrained resource. At the sewing process, the 720 minutes per week extra capacity would allow us to fulfil market demand completely for both Throughput accounting says we should analyse the process’s types of shirt. An additional 40 women’s shirts per week could throughput according to the constrained resource – see Table 3. be produced and sold, generating an additional 2,400 throughput Although it is women’s shirts that have a higher throughput per € unit, it is the men’s shirts that maximise the throughput per minute of available sewing machine time – the constrained Women’s shirts Men’s shirts resource. Let us look at the profit statement if we now meet Output 80 units 120 units the full market demand for men’s shirts and fill any spare Revenue, 8,400 12,000 capacity with women’s shirts – see Table 4. € Material cost, 3,600 6,000 € Total net profit is increased. Let us also look at the throughput Throughput, 10,800 accounting ratios: € Operating expense, 10,500 € n Weekly throughput return on investment is 0.06% Net profit (loss), 300 n Throughput productivity for the week is 103% – an € improvement Shirt-making business: revised profit statement n Throughput investment turns are 0.216 – an improvement Table 4 35-38 accounting.qxp:Layout 1 22/11/11 16:19 Page 4

Throughput accounting: better thinking – better results

per week. This is pure profit as our overheads – operating – have already been covered. The investment would pay back in 42 weeks, and all the throughput accounting ratios would improve. Only 600 additional minutes are needed at the sewing process to meet market demand, leaving 120 minutes per week spare capacity. This offers the potential for new product development, new markets and new . These decisions are all made by looking at the process as a whole, its costs, revenues and resources and their capacity. We use the throughput per minute of constrained resource to make decisions, supported by the three key throughput accounting ratios. I believe that throughput accounting meets the requirement of accountants in business: to provide timely and actionable management information to managers for the purposes of reviewing performance, planning improvement activity and making business decisions. Is it time you changed cost reporting and performance analysis in your business? Throughput accounting is easy to understand, straightforward to implement and provides valuable tools for understanding and improving business processes. By contrast, complex standard cost calculations are unhelpful and, in many cases, actually counterproductive.

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About the author

oss Maynard is a Fellow of the Chartered Institute of Management Accountants and a consultant specialising in throughput accounting and R lean service improvement.

References

1. CORBETT,THOMAS, Throughput Accounting, North River Press, 1998 2. GOLDRATT, ELIYAHU M and COX, JEFF, The Goal: A Process of Ongoing Improvement, 3rd revised edition, Gower Publishing Ltd, 2004

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