THROUGHPUT ACCOUNTING

Throughput Accounting is a management accounting system based on the Theory Of

Constraints (TOC). TOC views any company as a system. One of the most fundamental
concepts is the recognition of the important role that the system's constraint has, and
because of this concept Throughput Accounting does not allocate costs to products. As a
matter of fact, one of the basic ideas of Throughput Accounting is that if we wantto make
good decisions we should not calculate the cost of products.

TOC uses the chain analogy to exemplify some of its principles. If we pull a chain, where will
it break? On its weakest link (only one link). If we want to increase the chain's strength,
what should we do? We should strengthen its weakest link, this system's constraint.
Strengthening any other link before strengthening the weakest link would be a waste of
time and resources, because it is the weakest link that is determining the maximum
performance of all the chain. The system's constraint dictates its performance
therefore, if we want to increase the system's perfomance we have to identify and explore
the system's constraint. A company's goal is to make money now and in the future. To
make the bridge between NP and ROI TOC has three 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 our company? How much money is captured by our company? And
how much money do we have to spend to operate it?[I] The measurements are intuitively
obvious. What is
needed is to turn these questions into formal definitions.[II]
TOC's measures are:
Throughput (T): the rate at which the system generates money through sales.
Investment (I): all the money the system invests in purchasing things the system intends
to sell.
Operating Expense (OE): all the money the system spends in turning investment
into throughput.
Throughput - Throughput is defined as all the money that enters the company minus what it
paid to its vendors. This is the money that the company generated. The money paid to the
vendors is money generated by other companies. To calculate the throughput per unit of
each product we need to subtract the Totally
Variable Cost (TVC) from its selling price. CTV is the cost that varies for every extra unit
produced (in most cases its only raw material). This will tell us how much money the
company generates with the sale of one unit of the product. To calculate the company's
total throughput all we need to do is add the total throughput of each product (which is the
throughput per unit multiplied by the sales volume).
Investment - All the money the system invests in purchasing things the system intends to
sell. This measure and the conventional accounting measure Assets might be mistaken, but
differ drastically when referring to work in process and finished goods inventory. ìWhat
value should we attach to a finished product stored in a warehouse? According to the
definition given above, we are allowed to assign just the price that we paid to our vendors
for the material and purchased parts that went into the product. There is no added value by
the system itself, not even direct labor."[III]The value given to the work in process (WIP)
and the finished goods inventory is their TVC. One of the objectives here is to eliminate the
generation of ëapparent profitsî due to the cost allocation process. With this methodology it
is not possible to increase short term profits increasing WIP and finished goods inventory
(delaying the recognition of some expenses that will certainly decrease profits of future
periods).
Operating Expense- "Taking added value out of inventory does not mean that we do not
have these outlays of money."[IV] There is no added value to the product. Operating
Expense (OE) is intuitively understood as all the money we ìhave to pour into the machine
on an ongoing basis to turn the machineís wheels?"[V] Wages, from the companyís CEO to
the direct labor, rents,energy, etc. 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
Investment. 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.
TOC says that these three measures are sufficient for us to make the bridge between NP
and ROI and the managers' daily actions. Below we have the formulas that show this
bridge:
NP = T - OE
ROI = (T - OE)/I
where:
T = Total Throughput, TTp
OE = Total Operating Expense
I = Total Investment
With these three measures (T, I and OE) we can know the impact a decision has on the
company's bottom line. The ideal is a decision that increase T and decreases I and OE. But,
any decision that has a positive impact on ROI is a decision that takes the company towards
its goal. The final judge, the one who decides if it is a good decision or not, is ROI.
When the company has a constraint in its production process, we have to decide which
products are more important to the company, as we do not have enough capacity to sell
everything the market wants.
We have to bear in mind that the constraint is the time available on the constraint resource.
To increase the company's throughput we have to maximize the utilization of this time.
We want to sell the products we the highest throughputs and, at the same time, sell the
products that use less time on the constraint. We will have a problem when comparing two
products, one has a higher throughput and the other uses less time on the constraint. How
to decide which one is best for the company?
To solve this problem we need a measurement that takes into account that we want to
maximize the company's throughput.
On one hand we have the product's throughput, on the other the minutes it uses of the
constraint. To decide which one most contributes to the company's bottom line we 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. But this measure only identifies the most profitable
product when the company does not have enough capacity to sell everything the market
wants.
When the company has more capacity than the market demands, the constraint is not the
company's available capacity. In this case the criteria of comparison between products
should be the throughput per unit, because there is no resource limiting the company's
performance. Any product's sale whose price is bigger than TVC, and that doesn't increase
OE, contributes for the increase of the bottom line.
Anyway, the thorughput per time of the constraint or the throughput per unit should never
be the only measurements taken into cnsideration to evaluate a decision. Whatever the
decision being taken, it is necessary to quantify its impact on the company's NP and ROI.