Throughput accounting
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Throughput accounting (TA) is an alternative to cost accounting proposed by Eliyahu M. Goldratt. It is not based on Standard Costing or Activity Based Costing (ABC). Throughput Accounting is not costing and it does not allocate costs to products and services. It can be viewed as business intelligence for profit maximization. Conceptually throughput accounting seeks to increase the velocity at which products move through an organization by eliminiating bottlenecks within the organization.
Cost (or Management) accounting is an organization's internal method used to measure efficiency. Since no one outside the organization uses such internal accounts for investment or other decisions, any methods that an organization finds helpful can be used. Outside parties to a business depend on accounting reports prepared by financial (public) accountants who apply Generally Accepted Accounting Practices (GAAP) issued by the Financial Accounting Standards Board (FASB) and enforced by the U.S. Securities and Exchange Commission (SEC) and other regulatory agencies.
Throughput accounting improves profit performance with better management decisions by using measurements that more closely reflect the effect of decisions on three critical monetary variables (throughput, inventory, and operating expense — defined below).
[edit] History
When cost accounting was developed in the 1890's, labor was the largest fraction of product cost and workers might not know how many hours they would work in a week when they reported on Monday morning. Cost accountants, therefore, concentrated on how efficiently managers used labor since it was their most important variable resource. Now, however, workers who come to work on Monday morning almost always work 40 hours or more; their cost is fixed rather than variable. Many managers are still evaluated on their labor efficiencies, though, and many "downsizing," "rightsizing," and other labor reduction campaigns are based on them.
Goldratt argues that, under current conditions, labor efficiencies lead to decisions that harm rather than help organizations. Throughput accounting, therefore, removes standard cost accounting's reliance on efficiencies in general and labor efficiency in particular from management practice. Many cost and financial accountants agree with Goldratt's critique, but they have not agreed on a replacement of their own and there is enormous inertia in the installed base of people trained to work with existing practices.
The recent development of TA is constraints accounting, which focuses more strongly on the role of the constraint in decision making. (See Caspari & Caspari for details).
[edit] The concept of throughput accounting
Goldratt's alternative begins with the idea that each organization has a goal and that better decisions increase its value. The goal for a profit maximizing firm is easily stated, to increase profit, now and in the future. Throughput accounting applies to not-for-profit organizations too, but they have to develop a goal that makes sense in their individual cases.
Throughput Accounting also pays particular attention to the concept of bottlenecks in the manufacturing or servicing processes.
Throughput accounting uses three measures of income and expense:
- Throughput (T) is the rate at which the system produces "goal units." When the goal units are money (in for-profit businesses), throughput is sales revenues less the cost of the raw materials (T = S - RM). Note that T only exists when there is a sale of the product or service. Producing materials that sit in a warehouse does not count. ("Throughput" is sometimes referred to as "Throughput Contribution" and has similarities to the concept of "Contribution" in Marginal Costing which is sales revenues less "variable" costs - "variable" being defined according to the Marginal Costing philosophy.)
- Investment (I) is the money tied up in the system. This is money associated with inventory, machinery, buildings, and other assets and liabilities. In earlier theory of constraints (TOC) documentation, the "I" was interchanged between "Inventory" and "Investment." The preferred term is now only "investment." Note that TOC recommends inventory be valued strictly on totally variable cost associated with creating the inventory, not with additional cost allocations from overhead.
- Operating expense (OE) is the money the system spends in generating "goal units." For physical products, OE is all expenses except the cost of the raw materials. OE includes maintenance, utilities, rent, taxes, payroll, etc.
Organizations that wish to increase their attainment of The Goal should therefore require managers to test proposed decisions against three questions. Will the proposed change:
- Increase Throughput? How?
- Reduce Investment (Inventory) (money that cannot be used)? How?
- Reduce Operating expense? How?
The answers to these questions determine the effect of proposed changes on system wide measurements:
- Net profit (NP) = Throughput - Operating Expense = T-OE
- Return on investment (ROI) = Net profit / Investment = NP/I
- Productivity (P) = Throughput / Operating expense = T/OE
- Investment turns (IT) = Throughput / Investment = T/I
These relationships between financial ratios as illustrated by Goldratt are very similar to a set of relationships defined by DuPont and General Motors financial executive Donaldson Brown about 1920. Brown did not advocate changes in management accounting methods, but instead used the ratios to evaluate traditional financial accounting data.
Throughput Accounting is an important development in modern accounting that allows managers to understand the contribution of constrained resources to the overall profitability of the enterprise. See Cost Accounting for practical examples and a detailed description of the evolution of throughput accounting.
