Back To Basics TOC:: Throughput Accounting

2018 TOCICO Webinar
Back to Basics TOC:

Throughput Accounting
Presented by: Dr. Lisa Lang and Beau S. Ganas
Date: March 17, 2018
© 2018 TOCICO. All Rights Reserved.
2018 TOCICO Webinar
Cost Accounting History

• “Cost Accounting: The Number One Enemy of
Productivity”.
– Eli Goldratt at 1983 National Association of Accountants (now the
Institute of Management Accountants).
©2018 TOCICO. All Rights Reserved.
2018 TOCICO Webinar
Cost Accounting History

• Earlier Foundations (Pre‐1900):
– Pricing Rail Movements
– Pricing Textile Products
• Major developments in the use of cost
accounting are attributed to General Motors.
– Result of increasing product diversity.
– What are the products with the highest cost (i.e.
where do I focus my cost‐cutting efforts?)
2018 TOCICO Webinar
Many Uses of “Cost”

• Product Cost
– The operating expense of a product, based on an allocation.
• Cost to Operate
– The expense required to operate (a company, machine, etc.).
• Cost to Purchase
– The amount we need to pay in order to acquire the item.
• Cost when Selling
– The price our will customers will need to pay to acquire the
item from us.
2018 TOCICO Webinar
Cost per Unit

• Development of cost accounting led to the
concept of a “cost‐per‐unit”.
• Cost‐per‐unit (CPU) has three main components:
– Direct Materials
– Direct Labor
– Manufacturing Overhead
• Most commonly the cost‐per‐unit concept is
applied to products.
2018 TOCICO Webinar
Arguments Against CPU

• Cost per unit (CPU) is developed and utilized
as if though it represents the true “costs” the
organization incurs to produce a unit.
• Managers then take this false notion and
make decisions with it.
• This simply is not true.
2018 TOCICO Webinar
CPU – Direct Materials

• Materials are variable with production on a 1
for 1 basis.
• Materials are directly traceable to products.
• We MUST have a unit of materials to produce
a unit of a product or service.
• Direct Materials SHOULD be associated with
the cost to produce a product.
2018 TOCICO Webinar
CPU – Direct Labor

• CPU assumes Direct Labor is variable with the
unit of production.
• Direct Labor is in fact arbitrarily allocated to
products.
• Why arbitrarily? The reality is that Direct Labor is
not directly tied to unit production in the same
way materials are.
• Direct Labor SHOULD NOT be associated with the
cost to produce a product for these reasons.
2018 TOCICO Webinar
CPU – Overheads
• Again, CPU allocates Overheads to products or
services and treats the Overheads as variable.
• Overheads are fixed in the short‐term.
• Overheads may change, but in a step‐function
fashion; overheads are not continuously
variable as materials are.
• Overheads SHOULD NOT be associated with
the cost to produce a product for these
reasons.
2018 TOCICO Webinar
Cost per Unit Distortion

• The allocation process leads managers to
believe “bigger is better.”
– More units = lower unit costs.
• Despite “unit costs” decreasing, costs in total
do not.
• How can this be? It is due to a mathematical
illusion, not as a result of our operating
effectiveness.
2018 TOCICO Webinar
Cost per Unit Distortion Example

• Assume company Cost‐A‐Lot pays $500,000 of
direct labor expenses each month.
• In Month 1 the company produces 10,000
units.
• In Month 2, it produces 20,000 units.
• Calculate the labor cost per unit and total
labor costs each month.
2018 TOCICO Webinar
Cost per Unit Distortion Example
Month 1 Month 2
Total Labor $500,000 $500,000
Units 10,000 20,000
Cost Labor Per Unit $50.00 $25.00

Total Labor Expenses $500,000 $500,000
2018 TOCICO Webinar
Cost per Unit Distortion

• The reality is that it is not somehow “cheaper”
to produce our products.
• We are more profitable because we are
generating more margin by selling more units.
• At most times, changes in production do NOT
affect our non‐variable costs of Direct Labor or
Overheads, thus they are not relevant in most
decisions.
2018 TOCICO Webinar
CPU Summary
• Cost accounting systems distort reality and
decisions made with cost‐per‐unit information.
• Cost accounting systems are easily manipulated.
• Where the time goes, so to do the costs.
• So if cost accounting is wrong, how do we fix it?
2018 TOCICO Webinar
CPU Summary
• Unfortunately, there is no fix.
• It is not a matter of more precise allocation,
various methods of allocation, activities vs
products.
• None of that is in the direction of the solution.
• Allocation = Distortion, thus we know the
solution must not allocate.
• TOC’s approach is new from the ground up.
2018 TOCICO Webinar
Throughput Accounting
• Throughput Accounting was developed in the early
1990s by Eli Goldratt to address the issues of cost
accounting.
• Explained in The Haystack Syndrome and
incorporated into later versions of The Goal.
• Experiences of implementing TOC at companies
would create friction with the accounting systems,
thus the need to address the accounting systems.
• “Tell me how you measure me and I’ll tell you how I
behave.” – Eli Goldratt
2018 TOCICO Webinar
Basics of Throughput Accounting

• There are three main components to Throughput
Accounting:
– Throughput (T)
– Inventory or Investment (I)
– Operating Expenses (OE)
• All other aspects of basic financial accounting
concepts remain the same.
• It is not the mechanics that are as important so
much as the insights drawn from the different
presentation of the accounting information.
2018 TOCICO Webinar

Throughput
• The rate at which the system produces goal units.
• In business, this is the rate our system produces net,
new dollars (euros, pesos, money essentially).
• Throughput can also be viewed as the value our
organizations generate.
• Throughput can be mathematically defined as:
Revenue‐Totally Variable Costs(TVCs) = Throughput
2018 TOCICO Webinar

TVC ‐ Totally or Truly Variable Costs
• These are costs that vary totally, on a 1‐for‐1
basis with production.
– Also can be thought of as the costs that would be
saved if we did not make any products.
• Examples:
– Material, Outside Processing, Freight In/Out,
Commissions
2018 TOCICO Webinar

Inventory (or Investment)
• The money the system invests in purchasing things
the system intends to sell.
• Throughput Accounting defines inventory in the
same basic categories of Raw Materials, Work‐in‐
Process, and Finished Goods.
• The distinction is the value given to inventories.
• In Throughput Accounting, inventories are carried
at their TVC value…typically just material cost and
freight in.
2018 TOCICO Webinar

Investment (or Inventory)
• Originally the definition of I was just Inventory.
– Expanded over time to be Investment as well.
• Suppose a new sales strategy required a
company to support more credit sales.
– Thus the company will invest working capital into
Accounts Receivable to capture the Throughput
from the initiative.
• Can be used to calculate ROI for a project or
initiative.
2018 TOCICO Webinar

Operating Expenses
• All the money the system spends in turning
inventory into Throughput.
– Operating Expenses are the total expenses other than
TVCs a company has in any period.
• This includes, wages, salaries, depreciation,
interest, overheads, etc.
– Labor is included here unless it is paid on a piece‐rate
basis.
• Essentially, Throughput Accounting treats all costs
other than TVCs as a period cost.
2018 TOCICO Webinar

• With just T, I, and OE decisions gain a
tremendous amount of clarity.
– How much investment is required for X initiative?
– How much OE will we really save.
• For example, to save labor, we must actually have fewer
people working at the company.
• We realize substantially all of our products will
generate positive Throughput.
– The question becomes which product mix
generates the highest level of Throughput?
2018 TOCICO Webinar

• The paradigm shift with Throughput
Accounting occurs when we understand the
reprioritization of T, I, and OE.
– Historically prioritized as: OE, I and then T.
– Throughput Accounting flips the priorities:
• T, then I, and lastly OE
– If this is true, where do managers focus today?
– What story are our financial statements telling us?
2018 TOCICO Webinar
Making Decisions with T, I, & OE

• To begin make decisions utilizing Throughput
Accounting, you only need to know the T, I, &
OE between the alternatives.
• Delta T, I, & OE is an extremely powerful,
easily understood, and quickly implemented
tool to make good decisions.
2018 TOCICO Webinar
Five Major Financial Decisions

• Company‐wide Decisions
• Business‐unit Decisions
• Product‐level Decisions
• Investment Decisions
• Make vs Buy Decisions
2018 TOCICO Webinar
Company-wide Decisions
• Company‐wide decisions are monitored and
measured on the financial statements.
– Are we achieving our goals?
• If so, why? If not, why not?
– Where should we focus our efforts?
– What are the weak areas to be improved?
• …There’s only one problem: the financials do
not answer these questions!
2018 TOCICO Webinar
• The cost allocation process creates distortion
of the actual results of the company.
• It does this by allocating costs to inventories.
• In doing so, the allocation process essentially
defers expenses from one period to the next.
• The allocation process behind cost accounting
methods takes expenses off of the income
statement and parks them on the balance
sheet until later.
2018 TOCICO Webinar
Example 1
• These two companies have the same revenues.
• They also have the same expenses.
• Their results are identical in reality.
• But they report drastically different results.
• Why?
2018 TOCICO Webinar
Example 1 – P&L
Inventories‐R‐US, Inc. TA, INC.
Year 1 Year 2 Year 1 Year 2
Revenues 500,000 750,000 500,000 750,000
Cost of Sales – DM (100,000) (150,000) (100,000) (150,000)
Cost of Sales – CC (50,000) (50,000) 0 0
Gross Margin 350,000 550,000 400,000 600,000
SG&A Expenses (200,000) (200,000) (400,000) (500,000)
Net Profit 150,000 350,000 0 100,000
DM = Direct Materials, aka Raw Materials
CC = Conversion Costs, which is allocated Direct Labor and Overheads
SG&A = Selling, General, and Administrative expenses
2018 TOCICO Webinar
Example 1 – Balance Sheet

Cash 100,000 100,000 100,000 100,000
Inventory (in total)
Raw Materials 75,000 150,000 75,000 150,000
Conversion Costs 150,000 400,000 0 0
Total Assets 425,000 750,000 175,000 250,000
Total Equity 425,000 750,000 175,000 250,000
DM = Direct Materials, aka Raw Materials
2018 TOCICO Webinar
Example 2 – P&L
Revenues 750,000 900,000 750,000 900,000
Cost of Sales – DM (150,000) (180,000) (150,000) (180,000)
Cost of Sales – CC (50,000) (650,000) 0 0
Margin*** 550,000 70,000 600,000 720,000
Operating Expenses (200,000) (250,000) (500,000) (600,000)
Net Profit 350,000 (180,000) 100,000 120,000
DM = Direct Materials
SG&A = Selling, General, and Administrative expenses
2018 TOCICO Webinar
Example 2 – Balance Sheet

Cash 100,000 100,000 100,000 100,000
Inventory
Raw Materials 150,000 50,000 150,000 50,000
Conversion Costs 400,000 100,000 0 0
Total Assets 750,000 250,000 250,000 150,000
Total Equity 750,000 250,000 250,000 150,000
DM = Direct Materials
2018 TOCICO Webinar
• The allocation of expenses to the balance sheet
each period distorts results.
• Whether or not cost accounting or Throughput
Accounting reports higher or lower earnings
depends on changes in inventory levels.
– Inventories rise, cost accounting reports higher profits
– Inventories drop, cost accounting reports lower profits
• This distortion through allocation means managers
cannot determine the real results of actions.
2018 TOCICO Webinar
Business-unit Decisions
• As companies grow in scope and complexity
different lines of operation may develop.
• The question of how business units are
performing then arises.
• Often to assess this, corporate overheads are
allocated to the business units.
– Revenue or Gross Margin allocation
– Time‐based allocation
– Other methods (evenly, activity‐based, etc.)
2018 TOCICO Webinar
• This allocation of corporate overheads distorts
reported performance of the business units.
– These are not costs controlled by the business
units and they have no authority to cut the costs.
– The allocation methods are arbitrary and
subjective.
– Leads to massive infighting among the heads of
the business units.
2018 TOCICO Webinar
• A second way cost accounting allocations
affect business units is through transfer prices.
• The cost accountants develop product costs of
products made in “Business Unit 1 (BU1)” that
are used by “Business Unit 2 (BU2)”.
• After this calculation, the fighting begins.
2018 TOCICO Webinar
• Should BU1 or BU2 manager decide the profit
margin on the product?
• If BU1’s price is too high for BU2, should BU2 be
allowed to buy from cheaper outside suppliers?
• If BU2 is not willing to “pay” for BU1’s product at
the transfer price, can BU1’s manager sell to
external parties?
• Thus the efforts are directed to optimizing each
BU, not the company as a whole.
2018 TOCICO Webinar
Product-level Decisions
• Cost accounting’s predominant driver in
product‐level decisions is cost‐per‐unit (CPU).
• As discussed, there are numerous, significant
flaws in the concept of CPU.
• In Throughput Accounting, the focus is on
generating Throughput, not saving costs.
• The priority system is rearranged and the focus
and nature of decisions is greatly changed.
2018 TOCICO Webinar
Product-level Decisions
• The allocation process creates the flawed CPU
concept, which distorts product profit margin.
• Thus our product mixes are wrong.
– Need to reevaluate product mixes.
• All products generate Throughput (a positive
value).
• Product mix changes can have significant, short‐
term positive impacts on profitability.
2018 TOCICO Webinar
Product-Level Example
• A company has two products P and Q.
• The following is a summary of the products:
Product P Product Q
Selling Price $90.00 $100.00
Raw Materials (45.00) (40.00)
Direct Labor (10.00) (8.33)
Manufacturing Overhead (27.50) (22.92)
Product Profit $7.50 $28.75
• Obviously from above, we see that cost accounting
would say Product Q is the most profitable to produce.
2018 TOCICO Webinar
• Below is the production capability for one week.
• You can only produce one of the following
product mixes in a week:
Maximize P Maximize Q
Product P 100 60
Product Q 30 50
• We must calculate the difference between the
alternatives by using Delta T, I, and OE.
2018 TOCICO Webinar
Before we proceed, let’s ask ourselves the
following question:
• What would cost accounting suggest our
product mix be?
• Cost accounting would suggest maximizing
production of Product Q, since it has the
highest product profit.
2018 TOCICO Webinar
Maximize
Product Q
Units Price Revenue
Product P 60 $90 5,400
Product Q 50 100 5,000
Total Revenue $10,400
Product P 60 45 $(2,700)
Product Q 50 40 (2,000)
Total Materials $(4,700)
Throughput $5,700
2018 TOCICO Webinar
Maximize
Product P
Units Price Revenue
Product P 100 $90 $9,000
Product Q 30 100 3,000
Total Revenue $12,000
Product P 100 $45 $(4,500)

Product Q 30 40 (1,200)
Total Materials $(5,700)
Throughput $6,300
2018 TOCICO Webinar
Maximize P Maximize Q Delta
Delta T $6,300 $5,700 +600
Delta OE ‐ ‐ ‐
Delta Net Profit (NP) $6,300 $5,700 +600
Delta Investment ‐ ‐ ‐
ROI N/A N/A N/A
The answer is obvious:
Maximize Production of Product P!
2018 TOCICO Webinar
Inventory or Investment Decisions

• Traditional cost accounting systems rely upon cost
savings to determine ROI, payback period, and are
used as justification for investments.
– Acceptable payback periods can range from 5‐10 years.
– ROI above 10% are considered outstanding.
• Investing from a Throughput Accounting
perspective takes on an entirely different approach.
– A payback period of 2 years would likely be
unacceptable.
– ROI below 20% would likely be unacceptable as well.
2018 TOCICO Webinar
Inventories Example 1
• Our company could sell all Ps and Qs if we
hold $20,000 more in inventories.
• We also need to hire a worker for $19,200
annually to manage the new inventories.
• Our Company’s hurdle rate is 20% annual ROI.
• There are 48 working weeks in our year.
• Assuming we picked the Maximize P product
mix, should we hold the higher inventories?
2018 TOCICO Webinar
Maximize
Product P
Units Price Total
Product Q – Additional Weekly Revenue 20 $100 $2,000
Product Q – Additional Weekly TVCs 20 40 (800)
Product Q – Add’I Weekly Throughput $1,200
Working Weeks in Year 48
Annual Throughput Generated $57,600
Delta Operating Expense (OE) – Worker Exp. $19,200
2018 TOCICO Webinar
Make Don’t Make
Investment Investment
Delta T $57,600 ‐
Delta OE (19,200) ‐
Delta Net Profit (NP) $36,400 ‐
Delta Inventories (I) 20,000 ‐
ROI (NP/I) 182% N/A
Yes! We should hold higher inventories. It will increase our
bottom line by $36,000 and the project has a 182% ROI.
2018 TOCICO Webinar
Investment Example 1
• Our company could sell all Ps and Qs if we sold to
customers on credit.
• The Accounts Receivable balance would grow
$30,000.
• Our bad debts expense will increase $24,000.
• There are 48 working weeks in our year.
• Our Company’s hurdle rate is 20% annual ROI.
• Assuming we picked the Maximize P product mix,
should we sell on credit terms?
2018 TOCICO Webinar
Maximize
Product P
Units Price Total
Product Q – Additional Weekly Revenue 20 $100 $2,000
Product Q – Additional Weekly TVCs 20 40 (800)
Product Q – Add’I Weekly Throughput $1,200
Working Weeks in Year 48
Annual Throughput Generated $57,600
2018 TOCICO Webinar
Sell on Credit Don’t Sell on
Credit
Delta T $57,600 ‐
Delta OE (24,000) ‐
Delta Net Profit (NP) $23,600 ‐
Delta Investment (I) 20,000 ‐
ROI (NP/I) 118% N/A
Yes! We should sell on credit. It will increase our bottom
line by $23,600 and the project has a annual ROI of 118%.
2018 TOCICO Webinar
Make vs Buy Decisions

• The same impact transfer pricing has on
business units is felt in make vs buy decisions.
• The reason is that cost accounting allocations
create a “product cost” which is over‐inflated
and over burdens components or products
with costs that have been arbitrarily assigned.
2018 TOCICO Webinar
Make vs Buy Example

The following shows a comparison between a product
produced inside and a vendor’s quote for the product.
Should the company make or buy the product? The
company needs 10,000 units of Part #507.
Part#507 – Make Part#507 – Buy

Cost $150.00 $87.67
Materials $35.00 Unknown

Labor 60.00 Unknown
Overhead $55.00 Unknown
2018 TOCICO Webinar
Make vs Buy Example

Cost accounting would suggest we outsource and buy
the part from the vendor. Throughput Accounting
would suggest producing the product internally.
Part#507 – Make Part#507 – Buy

Cash outlay (TVCs) $35.00 $87.67
Units needed 10,000 10,000
Total cash outlay $350,000.00 $876,700.00
2018 TOCICO Webinar
Make vs Buy Example

Make Buy Product Delta
Product
Delta T $(350,000) $(876,700) 526,700
Delta OE ‐ ‐
Delta Net Profit (NP) (350,000) (876,700) 526,700
Delta Investment (I) ‐ ‐ ‐
ROI (NP/I) N/A N/A N/A
We should make the product internally. It will increase our
Throughput and our bottom line by $526,700 as compared
to purchasing the part from the vendor.
2018 TOCICO Webinar
Throughput Accounting Decisions

• Unique to Throughput Accounting decisions is the
fact that Global AND Local decisions are linked.
• Only Throughput Accounting has the ability to tie a
local decision to the global well being of the
company.
• By looking at T, I, & OE to make decisions, this
essentially recasts the financial statements.
• Alignment between the various levels can be
achieved by marrying local actions to global
outcomes (as measured on the financial statements).
2018 TOCICO Webinar

• How do T, I, & OE compare to other methods?
• There truly is no comparison.
• All the other methods are tinkering with
“product costs”, which we now know simply
do not exist.
• The other methods create a distortion of
reality as they are built on some form of cost
allocation.
2018 TOCICO Webinar

• Other methods are focused on more precision
or simply rearranging the allocation calculation.
• It’s not a matter of what’s being allocated or
how its done. It’s simply a matter of common
sense.
• If making a product doesn’t cause us to incur the
cost, then we can’t say it’s that product’s cost.
• Allocation always creates distortion.
2018 TOCICO Webinar
Additional Applications
• New Categories of Decisions
– Strategic
– Tactical
– Financing
• Budgeting and Projections
• External Financial Reporting
– GAAP or IFRS vs Throughput Accounting
• Throughput‐based ERP Solutions
Bios & Contact Information
2018 TOCICO Webinar
https://www.scienceofbusiness.com/throughput-accounting/
• “Dr. Lisa” Lang
– President, Science of Business
– Renowned TOC Expert and foremost expert for applying TOC to
Marketing
– Author: The Theory of Constraints Approach to Cash Velocity,
Maximizing Profitability, Achieving a Viable Vision, Mafia Offers,
and Velocity Manufacturing.
– DrLisa@ScienceofBusiness.com
• Beau S. Ganas
– Former cost accountant
– Throughput Accounting Guru
– Expert at Accounting and Technology
– CPA, CMA, CFE, CIA, CISA
– Beau@ScienceofBusiness.com
2018 TOCICO Webinar
The Mafia Offer Boot Camp is a full day workshop
during the pre‐conference on April 29.
Register for the Conference & Workshop or just a full day workshop!
https://www.scienceofbusiness.com/2018‐tocico/
2-Day Conference April 30 - May 1, 2018
Pre-Conference Workshops April 29, 2018
See you at the Luxor Hotel in Las Vegas, NV
in Vegas!

Back To Basics TOC:: Throughput Accounting

Uploaded by

Copyright:

Available Formats

Back To Basics TOC:: Throughput Accounting

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Back To Basics TOC:: Throughput Accounting

Uploaded by

Copyright:

Available Formats

2018 TOCICO Webinar

Back to Basics TOC:

Cost Accounting History

Cost Accounting History

Many Uses of “Cost”

Cost per Unit

Arguments Against CPU

CPU – Direct Materials

CPU – Direct Labor

Cost per Unit Distortion

Cost per Unit Distortion Example

Cost per Unit Distortion Example

Cost Labor Per Unit $50.00 $25.00

Cost per Unit Distortion

Basics of Throughput Accounting

Basics of Throughput Accounting

Basics of Throughput Accounting

Basics of Throughput Accounting

Basics of Throughput Accounting

Basics of Throughput Accounting

Basics of Throughput Accounting

Basics of Throughput Accounting

Making Decisions with T, I, & OE

Five Major Financial Decisions

Example 1 – Balance Sheet

Total Equity 425,000 750,000 175,000 250,000

Example 2 – Balance Sheet

Total Equity 750,000 250,000 250,000 150,000

Product P 100 $45 $(4,500)

ROI N/A N/A N/A

Inventory or Investment Decisions

Delta Operating Expense (OE) – Worker Exp. $19,200

Delta Inventories (I) 20,000 ‐

ROI (NP/I) 182% N/A

Delta Investment (I) 20,000 ‐

ROI (NP/I) 118% N/A

Make vs Buy Decisions

Make vs Buy Example

Part#507 – Make Part#507 – Buy

Materials $35.00 Unknown

Make vs Buy Example

Part#507 – Make Part#507 – Buy

Make vs Buy Example

ROI (NP/I) N/A N/A N/A

Throughput Accounting Decisions

Making Decisions with T, I, & OE

Making Decisions with T, I, & OE

You might also like