Does traditional analytical accounting no longer meet your current needs? How to maximize the profit now and in the future? Throughput accounting is the solution for you!
Throughput accounting lays the foundations for a simplified approach to operational accounting, but beyond that is more of an analytical and systemic approach to clarify decisions using the precepts of the Theory of Constraints.
In this article, you will learn more about the definition of throughput accounting and the theory of constraints, how to calculate and measure throughput performance in accounting, how to deal with bottlenecks, and some tips to improve throughput accounting ratios.
What is throughput accounting?
Throughput accounting appeared in the 1980s, with the Theory of Constraints, initiated by Eliyahu M. GOLDRATT and democratized by his famous book “The Goal” and many others.
Management by constraints starts from the principle that the flow of money generated by an industrial or commercial structure is limited by a single factor: the main constraint, generally identified by a bottleneck near or squarely at the entrance of the constrained resource.
It exists a very strong opposition between traditional management accounting and throughput accounting. The first makes no distinction between the resources of the system, while the second focuses all its attention on them and this is precisely what allows the change of scale profitability without financing and without layoffs, on the contrary.
Another criticism of classic analytical accounting is the use of management indicators whose nature, periodicity, or frequency of publication is not compatible with the management of activities, which must also be more responsive.
Furthermore, traditional management indicators are not easily understood by non-specialists. Most operational staff, often with technical training, do not know how to make the connection between these very theoretical and abstract indicators that are familiar to them.
The research for maximum throughput leads to the search for new growth paths to increase sales, a theoretically limitless approach.
How do you calculate throughput accounting ratios?
It is calculated by subtracting from receipts or proceeds of sales the totally varying costs in accounting terms. Totally variable costs can be simplified to material cost because labor is now remunerated by a (relatively) fixed amount over the period of time, usually the month, hence a constant cost independent of the activity, and can be considered as part of business costs.
All you need to do is follow this formula:
Throughput accounting = Total of sales revenues – Direct material costs
Operating Expenses (OE)
Operating expenses are all costs, except the fully varying costs previously mentioned in the throughput calculation, necessary to operate and maintain the production system. Operational costs are considered fixed costs, although they may have changing characteristics
Investments or Inventory
It’s the amount of money invested in the system in order to transform it into throughput. This encompasses stored raw materials awaiting processing into salable products, as well as holding in capacity/capability to produce more units.
Net Profit is defined as Throughput - OE, or Sales Revenue - Total Variable Costs - OE
Return on investment (ROI)
ROI is the ratio of net profit (NP) to investments.
ROI = Net Profit / Investment
What is the theory of constraints?
The theory of constraints is a business philosophy first proposed in 1984 by Dr. Eliyahu M. Goldratt. In his novel The Goal, Goldratt suggests that the productivity of any system is hampered by limitations or bottlenecks that slow down a few key processes.
His Theory of Constraints offers a five-step procedure designed to improve efficiency, productivity, and profitability by managing or circumventing these constraints, thereby increasing the capacity of the entire system.
Goldratt's Theory of Constraints takes a logical approach to problem-solving and relies on measurable financial data to determine goals. The three metrics that catch his eye are:
- throughput, usually defined in terms of sales,
- operational costs,
- and inventory.
He suggests that by following his five-step process, throughput can increase while operating expenses and inventory decrease, making the whole operation more profitable.
Step 1: Identify the constraint (the bottleneck)
A constraint necessarily exists, which limits the performance of the system, without which this system would be able to operate with infinite performance. What prevents the system, the organization, the process, or the company from achieving its ends, its goal? What is the weak link in this chain?
The notion of bottleneck/constraint is fundamental because this particular resource limits the throughput of the entire system and determines its turnover and stock level. The objective of the first stage is to identify the bottleneck resource in order to better exploit it. Do you want to know how to deal with this bottleneck? Just keep reading!
Step 2: Exploit the constraint; improve the use of its capacity
The constraint determines the performance, throughput, sales, and revenue of the entire system. Exploiting the constraint means using the full capacity of this resource to achieve the goal, which is generally "to make a profit now and in the future” ("The Goal", Goldratt).
An hour lost on a bottleneck is an hour wasted on the entire system. The bottleneck is therefore valuable and the quality of its operation is paramount. Anything that interferes with maximizing the throughput of the bottleneck must be improved.
Step 3: Subordinate all processes to coercion
The constraint determines the throughput of the whole process. Producing more upstream than the bottleneck can absorb only inflates the outstanding amount in front of the bottleneck. The resources downstream of the bottleneck have excess capacity compared to the bottleneck and are most often found on standby.
Not using the bottleneck's full capacity is a senseless waste. Given reality and the precepts of the Theory of Constraints, the optimal flow is the one that flows smoothly through the process, whose resources are synchronized to the slowest rhythm, that of the bottleneck.
However, the temptation is great to make non-bottleneck resources work at their maximum capacity, so as not to "leave operators or machines unoccupied". To force synchronization, ensure optimal use of the bottleneck, and regulate the activity of other resources, the Drum - Buffer - Rope principle (DBR) is used.
Step 4: Increase the capacity of the constraint if relevant
Once all the initiatives to better exploit the bottleneck without investments are exhausted and if the recovered capacity is still not sufficient, it is necessary to consider the increase in capacity. The different possible levers are:
- Recruit staff if this increases throughput,
- Invest in an additional capacity: machines, equipment, workstations…,
- Replace machines, equipment, etc. with more recent, more powerful generations, other technology…,
- Subcontract the missing capacity,
- Complete the capacity with older, simpler means...
Solutions must be chosen carefully as some are relatively inflexible; financing or recruitment binds the company for a certain time, the addition of capacities only produces these effects after a certain period of time, subcontracting may entail risks, etc.
Step 5: Start over at step 1 if the constraint has changed
When the bottleneck "jumps", a new constraint will appear. It is generally the resource with the most limited capacity just after the bottleneck, which in turn becomes the bottleneck. It is, therefore, appropriate to resume the process from step 1.
By chaining the cycles, we maintain continuous improvement. In ToC jargon, continuous improvement is called POOGI (Process Of OnGoing Improvement).
How to measure throughput performance in accounting?
To measure throughput performance in accounting, we calculate the ratios and then interpret these results.
The greatest attention must be paid to maximizing the passage of the products generating the most profit. Decision-making is then based on the throughput generated per minute of constraint. The higher T/ min, the better.
The key to an analysis by throughput accounting is the turnover per bottleneck minute. The latter being the constrained resource that determines the throughput of the entire system and therefore the sale, the maximum exploitation of the limited capacity of the bottleneck is an obsession of Theory of Constraints. The important quantity is the passage time of a product through the bottleneck.
Let’s make an example of a factory that has 2 types of products A and B:
- Product A is sold for $100, it takes ten minutes to clear the bottleneck, which puts the turnover value of one minute of the bottleneck at 100/10 = $10.
- Product B is sold for $60 and requires 4 minutes of the bottleneck, i.e. $15 of turnover per minute.
As the bottleneck has a limited capacity, the company generates more profit by maximizing the production of product B at the cost of products A.
What do we do with bottlenecks in throughput accounting?
Faced with a big demand or a period of work of great intensity, productivity must be increased. However, if it is poorly managed, it can be the source of a bottleneck, i.e. a sharp slowdown or even a sudden stop of the entire production chain. Unsuitable means of work is often the cause. Don’t worry about the bottleneck in throughput accounting, our solution is to identify the bottleneck resource and then exploit it in an efficient way.
So, how to exploit it? If the performance of the constrained resource can be monitored through the TRS indicator, the techniques of analysis and improvement of productivity will find their use.
Among the inducers of waste we will find untimely changes of series/planning and/or scheduling, changes of series longer than necessary, unavailability of materials, tools or personnel, breakdowns, etc. Quality must be guaranteed or filtered before the bottleneck, to avoid wasting valuable capacity processing items that cannot be used downstream due to non-compliance.
Improve the production chain
When the production line begins to slow down, it is essential to pinpoint the area where this is happening in order to find the cause. Otherwise, no measures will be effective, including heavy investments in new machinery.
It is by analyzing the factors responsible for downtime (production time change, changes in production, etc.) and collecting data (breaks, machine maintenance, lack of raw materials, etc.) that you will be able to determine the problem, to know its frequency and its seriousness.
It will most often emerge that the cause comes from the manufacturing processes and not from the machines themselves. The most effective solution will then be to invest in training so that employees are more versatile.
Use planning tools
To avoid bottlenecks, the best method is to smooth the workloads by adapting them according to the available resources, i.e. human and material. Scheduling software is a tool that optimizes the synchronization of processes, resulting in better control of the production chain. With this tool, you will produce on time while avoiding overstocking and wasting time.
Simplify business management
A business management software that makes it possible to better coordinate the actions of the company, whatever its size and its sector of activity: inventory management, accounting system, HR, ... It is indeed able to manage all the sales processes, purchasing, stock, logistics, production, and accounting.
As a result, the transmission of information is more efficient between departments, especially since it is updated in real-time. You will thus have a transversal vision that will facilitate your decision-making.
Tips to improve your throughput accounting ratios (TAR)
Maintain tight control over your company's fixed and varying costs to increase your cash flow and profits.
Make a plan and ensure rigorous monitoring of expenses
You need to assess where your company is now and where you would like it to go. A good roadmap is essential to anticipate expenses and unforeseen events in the year. To plan for the future, you must first understand your historical costs – and therefore compile this data effectively and efficiently.
Compare yourself to the rest of the industry
Start with criteria that are meaningful to your company and comparable to those used by your competitors. If you find that you are spending more in certain categories, you need to examine the causes and take appropriate measures to bring these costs closer to the industry average.
Manage variable costs
Establish the history of your company's variable expenses and calculate what they represent in terms of percentage of sales. Historical percentages provide a good indication of potential future costs and serve as a benchmark to ensure these costs remain commensurate with sales.
Limit fixed costs
The company’s fixed costs may be subject to a certain tolerance, as they are generally recurring and often represent long-standing relationships with suppliers. However, you should periodically scan the market to see if you could get a better price elsewhere.
Invest in technology
Explore new technologies that could help your business improve efficiency and productivity and reduce costs. Many companies, for example, use cloud computing systems, rather than in-house equipment, which is often more expensive to purchase and maintain.
In conclusion, what is called throughput accounting analysis helps the company to make decisions based on the impact on the theory of constraints indicators. Thus, any increase in OE and/or Investment should lead to a proportional increase in throughput. Conversely, any decrease in OE and/or Investment should not lead to a decrease in throughput.