Financial Basics

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Common-sense financial literacy
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What measurements should we use?

Operational Measures
—Throughput (“T”)
—Investment (“I”)
—Operating Expense (“OE”)
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RM
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-
Flow of money
I
Goal
Units
OE
+S

Throughput (“T”)

—The rate at which Contribution Rupees are coming into
organization.
—Only Rupees generated by the system are counted; e.g.,

Rupees spent on purchasing raw material or services do
not count as they are passed on to your suppliers.
—T=(Net sales-all truly variable costs)
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Investment (“I”)

—All the money currently tied up inside the system.
—All the inventory in raw material, WIP, or in Finished Goods.
—Money blocked in plant and machinery.
—Receivables are also part of “I”.
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Operating Expense (“OE”)

—All the money that system spends on converting inventory
into throughput.
—All the expenses are clubbed together as “OE” and are

thought as fixed.
—All employee expenses are part of “OE”.
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Financial Links

Is there any link between the new Operational Measures “T”,
“I”, & “OE”, and conventional measures as “P”, “ROI”, &
“Cash Flow”?
—P = T- OE
—ROI = P/ I = (T-OE)/I
—What happens to P, ROI & cash flow when we improve

either “T”, “I” or “OE”, keeping other two as constant?
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Financial Links

—If we increase T keeping I & OE constant, P=(T-OE)
improves, ROI= NP/I improves, and so does the cash flow.
—If we decrease I, keeping T & OE constant, P improves due

to reduced carrying cost, ROI improves, and of course cash
flow improves.
—When we reduce OE keeping T, and I constant, P, ROI, and

cash flow improve.
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Financial Links

—Improving Throughput, Investment and Operating Expense
have a positive co-relation with improving P, ROI, and cash
flow.
—Throughput, Investment and Operating Expense are
valuable operational measures that can guide our day to
day actions to making money now and in future.
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Using T, I, & OE for Investment Decision Making
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Thinking Bridge Example

Demand = 3,500 Drives
Price = $400 each
Raw Material = $80/Drive
Employee Wage = $18/hr
Number of Employees = 4 (1/workstation)
Each Employee Works 2,080 hrs/year (40 hrs/week, 52 weeks/year)
Other Expenses = $900,000
Drive Manufacturing Process:
Workstation Processing Time
101 15 minutes
102 25 minutes
103 10 minutes
104 5 minutes
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Total Time 55 minutes
Labor & Overhead Allocation

Cost Calculation Rate per
Elements Direct Labor
Minute
Direct Labor $18/hr / 60 minutes / hour $ 0.30

=
Overhead (4 direct labor employees) * (2,080 hrs/yr)
= 8,320 direct labor hours per year
(8,320 direct labor hours per year) * (60 min/hr) = $ 1.8029
= 499,200 direct labor minutes per year
$900,000 / (499,200 direct labor minutes)
Combined $ 2.1029
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Standard Cost of One Drive

Cost Element Cost
Raw Materials $ 80.00

Direct Labor (55 minutes @ $ 0.30) $ 16.50
Overhead (55 minutes @ $ 1.8029) $ 99.16

Standard Unit Cost $ 195.66
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Scenario 1

• An Engineer proposes buying a new fixture to reduce total processing
time by 3 minutes.
• The new fixture would allow some work to be transferred from
workstation 101 to 102.
Proposed Change:
Workstation Original Proposed

Processing Time Processing Time
101 15 minutes 10 minutes
Total Time 55 minutes 52 minutes
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Scenario 1 – New Drive Cost

Cost Element Cost

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Scenario 1 – Cost Savings per Drive
Original standard unit cost $195.66

New standard unit cost $189.35
Cost savings per unit $ 6.31

Annual volume X 3,500 units
Total annual cost saving $ 22,085
Less: Cost of fixture 5,000

First year cost savings $ 17,085
IRR = 400%, Payback Period < 3 Months

Is this proposal an improvement?
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Scenario 1 – Global Measurements Thinking Bridge Analysis

• When using the global measurements (T, I, & OE)
technique for the financial analysis of a proposed
expenditure, we need to ask 5 questions:
1. What prevents the firm from increasing throughput?

2. Will the total amount of throughput change?
3. Will the operating expenses of the firm change?
4. Will the amount of investment of the firm change?
5. What is the real economic effect of the proposal?
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Scenario 1 – The Five Questions

1. What prevents the firm from increasing Throughput?
o Note: This question does not arise in least product cost
thinking bridge.
o Strategic Control Point is 102, however the company could
produce 4,622 drives/yr. (124,800 min. / 27 min. of 102) &
demand is 3,500 drives.
2. Will the total amount of Throughput change?

o No, the engineer’s proposal has no effect on volume of sales,
neither sales revenue or variable cost (raw materials).
3. Will the Operating Expenses of the firm change?

o Do we have the same number of employees?
o Has our overhead changed?
o No, these all remain the same
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5. Will the amount of Investment of the firm change?
o Investment increases by $5,000

Global First Year Subsequent
Measurement Years
s
T no change no change
I + $5,000 no change
OE no change no change
Cash Flow - $5,000 no change
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Scenario 2

• Everything is the same as in scenario 1, except the firm is
currently producing and selling at its capacity of 4,992
units.
• The engineer makes the same proposal.
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Scenario 2 – Cost Savings per Unit


Annual volume X 4,992 units
Total annual cost saving $ 31,500
Less: Cost of fixture 5,000

First year cost savings $ 26,500
IRR = 630%, Payback Period about 2 Months

Is this proposal an improvement?
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1. What prevents the firm from increasing
throughput?
o Strategic Control Point (Capacity Constrained
Resource) is 102.
o The proposal increases the time required at
workstation 102 from 25 minutes to 27 minutes.
o The company can only produce 4,622 drives/yr.
(124,800 mins. / 27 min of 102) & demand is 4,992
drives.
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Lost Sales Volume:
Original capacity 4,992 units/yr
Capacity if proposal is - 4,622 units/yr
implemented
Reduction in productive 370 units/year
capacity
Throughput/Unit:
Price $400 /unit
Variable Expenses - 80 / unit
Throughput $320/ unit
$320 / unit
x 370 units/yr
Throughput lost - $118,400/yr
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— 4. Will the amount of investment of the firm

change?
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—5. What is the real economic effect of the proposal?
Global First Year Subsequent Years

Measurements
T - $118,400 - $118,400
Cash Flow (= T-I-OE) - $123,400 - $118,400
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Scenario 3

• Let’s start with the original case.
• Demand is 6,000 drives.
• The firm is currently operating at a level of 4,992
drives.
• The plant engineer makes a similar suggestion, but this

time the effect is to increase the time required to
produce the product by 3 minutes.
o 5 minutes is added to workstation 101’s processing time.
o The processing time of 102 is decreased by 2 minutes.
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Scenario 3 – Proposed Change

Workstation Original Processing Proposed
Time Processing Time
Total Time 55 minutes 58 minutes
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Scenario 3 – Least Product Cost Thinking Bridge

Cost Element Cost


Cost increase per unit $ 6.31
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1. What prevents the firm from increasing
throughput?
o Workstation 102 restricts our ability to serve all
of potential customers that would like to
purchase our drives.
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Additional Sales Volume:
Capacity if proposal is 5,426 units/yr
implemented
Original capacity 4,992 units/yr
Increase in productive capability 434 units/yr
Throughput/Unit:
Price $400 /unit
Variable Expenses - 80 / unit
Throughput $320/ unit
$320 / unit
x 434 units/yr
Additional Throughput $138,880/yr
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4. Will the amount of investment of the firm
change?
Global First Year Subsequent Years
Measurements
T + $138,880 + $138,880
Cash Flow (= T-I-OE) + $133,880 + $138,880
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Summary - Examples

Least Product Global
Cost Measurements
(T, I, OE)
Scenario 1 $17,085 ($5,000)
Scenario 2 $26,500 ($123,400)
Scenario 3 ($36,500) $133,880
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Using T, I, & OE for Planning Decision Making

Consider a Simple Firm WXYZ

—Only two employees: Mr. M and Mr. N
—They can choose between any one of Four
Products: W, X, Y, or Z
—Unlimited materials and unlimited market
demand
—They each get paid $10 per hour.
—The Firm operates 8 hours a day.
—They get paid whether they produce
anything or not.
34
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WXYZ Poduct Flow and Routings Work Flow
Product W Product X Product Y Product Z
$50 $50 $55 $52

M M M M
6 8 5 5
RM RM RM RM
$5 $10 $10 $5
M N
10 10
RM RM
$5 N $5
Times are in minutes per part. 20
Raw material costs are dollares each. Production and Inventory
Market for W, X, Y and Z is open. Journal, Second Quarter,
M and N are only two resources-8 RM 1989, Fry & Cox
35
hrs/day at $10 per hour each
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Cash Flow Summary
WXYZ Products
Product Price Materials Labor Profit Margin (Price

Cost/Unit - Materials - Labor)
W 50 20 (36 min) $24.00
$6.00
X 50 25 (38 min) 18.67
$6.33
Y 55 25 (35 min) 24.17
$5.83
Z 52 20 (35 min) 26.17
$5.83
Production and Inventory Management Journal, Second Quarter, 1989, Fry and Cox 36
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So, What Product Should They Make?

—Decision suggested by Accounting: Produce items with
the HIGHEST PROFIT MARGIN
—That would be Z with a $26.17 Profit Margin selling at

$52 each
—($52)*(16 ea) - ($20)*(16ea) - (2 workers)*(8
hours)*($10/hour) = $352 /day
37
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What about Marketing

—Decision suggested by Marketing: Produce items
with the HIGHEST SELLING PRICE (paid on
Commission)
—That would be Y at $55 Sales Price Each

—($55)*(16 ea) - ($25)*(16ea) - (2 workers)*(8
38
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What about Production?

—Decision suggested by Production: Produce items that
keep machine at HIGHEST EFFICIENCY
—That would be X at $50 profit each

—($50)*(24 ea) - ($25)*(24ea) - (2 workers)*(8
39
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But, If We Think Globally!

—Decision based upon producing items that provide
the MOST THROUGHPUT PER UNIT OF CONSTRAINT
TIME for the SYSTEM
—That would be W at $50 profit each

—W: ($50)*(24 ea) - ($20)*(24ea) - (2)*(8)*($10) =
$560 /day
40
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Product Option Summary

—Does it really make any difference what you choose
to do?
—Mr. N is 100% busy for every product! That’s 100%
efficiency! You can’t get better than that, can we?
Product Profit/Day
Compare
—Acctg-Profit Margin Z $352 100%
—Sales-Hi Sales Price Y $320 90%
—Production-Efficiency X $440 125%
—TOC Measure W $560 159% 41
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Worse Effects from Non-Global Thinking

—What we have to put up with:
—Decisions are based on combined opinion of

accounting, production and sales.
• That is, “They change decisions weekly!”
—Shop is measured on performance/efficiency

• Shop floor struggling for efficiencies. So, we produce
extra when machines are running. We pull jobs out of
sequence. We shift parts ahead or back to meet
efficiency quotas. Out of Synch.
42
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The Resulting Effects of Non-Global Thinking

—Product Group finds we have high efficiencies and
yet our production is unacceptable to meet
objectives.
• Use overtime to improve numbers
—Plant Manager sees frequent overtime, late

shipments, long queues. Orders additional capacity
(more machines, out sources work).
• Increases costs to produce more of the low throughput
products.
• Reduces the profit of the firm.
43
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Strategy
Constraints Management

Constraint Management Strategy
Lessons from the T, I, OE Example

• Primary focus on increasing “T”
• Allow “I” to seek its natural level (usually less than before)
• Capitalize on opportunities to reduce “OE”
o But ENSURE that capacity to generate “T” is not compromised.
o Don’t waste time or endanger future “T” by actively searching

for reductions in “OE” today.
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Why Gross Margin is Problematic

• Assumes cost per product is a reality.
Fixed Cost + Variable Cost

Product Cost =
Volume
• Assumes that all operations are equal.
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Analysis with Throughput Decision Support

1. Product Emphasis
2. Product Transitions
3. Product Design
4. Product Pricing
5. Capital Investment & Process Improvement
Expenditures
6. Capacity Constrained Resource Yield vs. Scrap
7. Outsourcing Decisions
8. Marketing Potential
9. Project Selection – Six Sigma & Lean
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Control: What Do We Want People to Do?

Traditional Management TOC
• Minimize costs in each • Maintain current expenses in
department every non-constraint.
• Don’t have unfavorable cost • Focus on increasing constraint
variances capacity to increase firm value.
• Maximize the output of every • Meet the production needs of
department to minimize the the constraint.
average cost per unit. Note:
Note: • Means think outside the box.
• Means thinking within the box. (Constraints management —
(Functional silo management maximizing the constraint’s
—maximizing each output will optimize overall
department’s output will value.)
optimize overall value.)
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TOC Continuous Improvement Ratios

Constraint utilization Throughput Improvement Product mix
rate efficiency efficiency
Constraint run time Throughput Delta (Variable costs

Constraint run time + operating
expenses)
Time available
Constraint
capacity
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TOC Performance Ratios —
Short-Term Measures

Performance Measure Constraint Utilization Rate Throughput Efficiency
Criteria
Value — Does a change in As utilization of the The greater the return for
the measure correlate with constraint increases, profits each hour of operations, the
changes in company value? and cash flow increase. larger the profits and cash
flow.
Direction — Does the The action directed is to For workers— move materials
measure identify or guide keep the constraint running through the constraint faster.
workers to actions that will as much as possible. For management— obtain
increase value? better prices for constraint
capacity.
Controllability — Can the Only to the extent the This is controlled by the
workers significantly workers can influence workers and by management.
influence the activities that activities that keep the
change the measure? constraint running.
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TOC Performance Ratios —
Long-Term Performance Measures

Performance Measure Improvement Efficiency Product Mix
Criteria
Value — Does a change in The relative efficiency of any The strategic plan is to
the measure correlate with added capacity will influence maximize long-term value. If
changes in company value? long-term competitiveness. the product mix changes, it
will not.
Direction — Does the Workers need to increase Management — Maintain
measure identify or guide capacity at the constraint, but long-term value and current
workers to actions that will not at any cost. Payback period cash flow. They must assure
may need to be considered as
increase value? the mix of orders matches
well.
these goals.
Controllability — Can the The workers are Managers set the production
workers significantly empowered to schedules.
influence the activities that continuously improve.
change the measure?
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Debunking the Setup Time & Batch Size Cost
Accounting Myth

— Labor & Overhead are Expenses, not Costs
— Operating Expenses are unrelated to Batch Size
— Cost Accounting view of “Product Cost” is False
• Throughput Margin Doesn’t Change
• Operating Expenses Doesn’t Change
• Contribution Margin is Wrong
— Batch Size is mostly a Cost Accounting Fabrication
• There are valid production constraints that dictate batch sizes
• But most batch size policies are fabricated based on dubious principles and
data
— Do Product Cost Variances Really Matter?
• Product Cost Variances are Symptomatic of a Wrong Method
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03-05-2013
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—Operating Expense (“OE”)

Copyright @ 2013 Avenir Management Services Pvt Limited - India

Copyright @ 2013 Avenir Management Services Pvt Limited - India

—Only Rupees generated by the system are counted; e.g.,

—T=(Net sales-all truly variable costs)

Copyright @ 2013 Avenir Management Services Pvt Limited - India

—All the inventory in raw material, WIP, or in Finished Goods.

—Money blocked in plant and machinery.

—Receivables are also part of “I”.

Copyright @ 2013 Avenir Management Services Pvt Limited - India

—All the expenses are clubbed together as “OE” and are

—All employee expenses are part of “OE”.

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—What happens to P, ROI & cash flow when we improve

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—If we decrease I, keeping T & OE constant, P improves due

—When we reduce OE keeping T, and I constant, P, ROI, and

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Direct Labor $18/hr / 60 minutes / hour $ 0.30

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Raw Materials $ 80.00

Overhead (55 minutes @ $ 1.8029) $ 99.16

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Workstation Original Proposed

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Raw Materials $ 80.00

Original standard unit cost $195.66

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Cost savings per unit $ 6.31

Less: Cost of fixture 5,000

IRR = 400%, Payback Period < 3 Months

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1. What prevents the firm from increasing throughput?

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2. Will the total amount of Throughput change?

3. Will the Operating Expenses of the firm change?

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6. What is the real economic effect of the proposal?

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Copyright @ 2013 Avenir Management Services Pvt Limited - India

Cost savings per unit $ 6.31

Less: Cost of fixture 5,000

IRR = 630%, Payback Period about 2 Months

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2. Will the total amount of throughput change?

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— 4. Will the amount of investment of the firm

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Global First Year Subsequent Years

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• The plant engineer makes a similar suggestion, but this

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101 15 minutes 20 minutes

102 25 minutes 23 minutes

103 10 minutes 10 minutes

104 5 minutes 5 minutes

Total Time 55 minutes 58 minutes

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