Strategic Cost Management

THROUGHPUT Throughput is the quantity or amount of raw material processed within a given time, especially the work done by an electronic computer in a given period of time. It is also known as the Productivity of a machine, procedure, process, or system over a unit period, expressed in a figure-of-merit or a term meaningful in the given context, such as output per hour, cash turnover, number of orders shipped. In the business management theory of constraints, throughput is the rate at which a system achieves its goal. Often this is monetary revenue and is in contrast to output, which is inventory that may be sold or stored in a warehouse. In this case throughput is measured by revenue received (or not) at the point of sale exactly the right time. Output that becomes part of the inventory in a warehouse may mislead investors or others about the organizations condition by inflating the apparent value of its assets. The Theory of Constraints and throughput accounting explicitly av oid that trap. Throughput can be best described as the rate at which a system generates its products / services per unit of time. The ultimate goal of a business is to keep their customer satisfied. Businesses often measure their throughput using a mathematical equation known as Little's Law, which is related to inventories and process time: time to fully process a single product. Using Little's Law, one can calculate throughput with the equation: I = R * T, where I is the number of units contained within the system, Inventory; T is the time it takes for a unit to go through the process, Flow Time; and R is the rate at which the process is delivering throughput, Flow Rate or Throughput. If you solve for R, you will get: R=I/T

THROUGHPUT ACCOUNTING Throughput Accounting is a dynamic, integrated, principle-based, and comprehensive management accounting approach that provides managers with decision support information for enterprise optimization. TA is relatively new in management

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accounting. It is an approach that identifies factors that limit an organization from reaching its goal, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting. As such, Throughput Accounting is neither cost accounting nor costing because it is cash focused and does not allocate all costs (variable and fixed expenses, including overheads) to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. Throughput Accounting is a management accounting technique used as the performance measures in the Theory of Constraints (TOC). It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the velocity or speed at which throughput is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations. Management accounting is an organization's internal set of techniques and methods used to maximize shareholder wealth. Throughput Accounting is thus part of the management accountants' toolkit, ensuring efficiency where it matters as well as the overall effectiveness of the whole organization. It is an internal reporting tool. Outside or external parties to a business depend on accounting reports prepared by financial (public) accountants who apply Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB) and enforced by the U.S. Securities and Exchange Commission (SEC) and other local and international regulatory agencies and bodies.

BOTTLENECK IN WORKFLOW Throughput Accounting also pays particular attention to the concept of bottleneck in workflow in the manufacturing or servicing processes. A workflow consists of a sequence of connected steps. It is a depiction of a sequence of operations, declared as work of a person, a group of persons, an organization of staff, or one or more simple or complex mechanisms. Workflow may be seen as any abstraction of real work. For control purposes, workflow may be a view on real work under a chosen aspect, thus serving as a virtual representation of actual work. The flow being described may refer to a document or product that is being transferred from one step to another. From a list of workflow activities, a manager needs to identify the constraint or bottleneck. According to Garrison, a constraint is "determined by the step that has the

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smallest capacity." As such, when you look at the workflow analysis, the bottleneck is the step that processes the least amount of service or product per unit of time. Many times, this is not a surprise; in production environments this is often the place where work tends to stack up, or the step before a step that has an excess of workers standing idle. Elimination of the constraint is essential to improving the efficiency of the process. When determining how to address the constraint, the manager is faced with two decisions. The bottleneck can be eliminated by adding capacity at the constraint, or by reducing capacity at other points in the process. If possible, and demand for your product or service warrants it, it is preferable to increase capacity at the bottleneck. This could involve purchasing additional machinery, deploying more workers at the station, or providing coaching to current employees. However, if there is not additional demand to warrant increasing production, or if it is not possible to increase capacity at the constraint, it can be useful to reduce capacity at other points in the process to conserve resources. For example, if the bottling station is the constraint in a soda manufacturer, then having extra employees at the labeling station could be a waste of resources.

INFLUENCES ON THROUGHPUT 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, investment and operating expense. Throughput is calculated from Sales - Totally Variable Cost. Totally Variable Cost usually considers the cost of raw materials that go into creating the item sold. Investment 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 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 and payroll.

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CONSTRAINTS ON THROUGHPUT Caspari and Caspari are practitioners who are aware that throughput accounting is not perfect, essentially we are trying to evaluate a global-throughput paradigm with an existing local efficiency costing paradigm and calling it throughput accounting. Caspari and Caspari borrow a term from computing jargon to describe the situation, throughput accounting is a legacy system firmly lodged in the cost world. It appears that we must eventually replace it with something more systemic constraints accounting. We need throughput accounting to transit from absorption accounting to constraints accounting. This doesn t mean that constraints accounting is derived from throughput accounting, it is not, but we needed to go there first before we completely understood what was missing. Let s view this by analogy. In organic evolution, when a new need or opportunity arises, organisms must make do with whatever is on hand because there is nothing else. A pre-existing part is co-opted to a new function, thus we have the panda s thumb which isn t a thumb at all and a multitude of similar examples. In business revolution then, when a new need or opportunity arises, firms also must make do with whatever is on hand because, at first, there is nothing else. When drum-buffer-rope first appeared there was a need for a consistent accounting approach. Variable costing was at hand and pressed into service. Of course, organic evolution is an entirely passive process whereas business revolution is decidedly active. In business we can invent totally new solutions, but first, we need to understand the problem. Throughput accounting limitations allowed us to better understand the problem that we wanted to solve. Variable costing also developed from cost accounting, but out of the recognition that some costs are incurred irrespective of the fixed cost component and thus better management decisions about product cost could be made by identifying these variable or differential costs. Throughput accounting develops this concept further to the point where direct labor is no longer considered variable. Although product cost is avoided by instead considering throughput, t he concept isn t very far away. Constraints accounting is the only methodology that is truly a systemic/global optimum approach. For instance we lose sight of the constraints as soon as we get above a product level in our accounts. In throughput accounti ng we make investment on the basis of a significant increase in output or throughput then have to depreciate the investment at some glacial rate over many years as operating expense. When the constraint moves out into the market we don t really know what contribution to expect from any new product, we know that anything above material cost is a positive contribution, but that knowledge alone isn t sufficient. Constraints accounting is a global throughput accounting paradigm with which we can evaluate our global-throughput decisions/operations in an internally consistent

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manner. It brings the effect of identified constraints to the profit and loss statement and therefore effectively subordinates the management accounting function of the firm to the goal of the organization in a true process of on-going improvement. It provides a bridge for building new product contribution expectations. It allows us to recover investment in breaking constraints as operating expense at rates commensurate with the new rate of throughput. And it provides a means of goal congruence via financial incentives to bust constraints, thus generating alignment for both short-term and longterm results. In broad principle the incentive system is not dissimilar to those suggested for kaizen in Japan.

THE THEORY OF CONSTRAINTS Every now and then, a completely new idea comes along that can be described as either refreshing, disturbing, or both. Within the accounting profession, the theory of constraints is that change. It originated in the 1980s through the writings of Eliyahu Goldratt. His training as a physicist, rather than as an accountant, appears to have given him a sufficiently different mind-set to derive several startling changes to the concepts of operational enhancement and cost accounting. The theory of constraints is based on the concept that a company must determine its overriding goal, and then create a system that clearly defines the main capacity constraint that will allow it to maximize that goal. The title Theory of Constraints adopts the common idiom "A chain is no stronger than its weakest link" as a new management paradigm. This means that processes, organizations, etc, are vulnerable because the weakest person or part can always damage or break them or at least reduce the outcome. The analytic approach with theory of constraints comes from the contention that any manageable system is limited in achieving more of its goals by a very small number of constraints, and that there is always at least one constraint. Hence the theory of constraints process seeks to identify the constraint and restructure the rest of the organization around it, through the use of Five Focusing Steps. 1. Identify the constraint (the resource or policy that prevents the organization from obtaining more of the goal) 2. Decide how to exploit the constraint (get the most capacity out of the constrained process) 3. Subordinate all other processes to above decision (align the whole system or organization to support the decision made above) 4. Elevate the constraint (make other major changes needed to break the constraint)

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5. If, as a result of these steps, the constraint has moved, return to Step 1. Don't let inertia become the constraint.

THROUGHPUT ACCOUNTING PERFORMANCE MEASUREMENTS Throughput Accounting is a management accounting technique used as the performance measures in the Theory of Constraints. It is the business intelligence used for maximizing profits. Unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughputs. Conceptually, Throughput Accounting seeks to increase the velocity or speed at which throughput is generated by products and services with respect to an organization s constraint, whether the constraint is internal or external to the organisation. A traditional set of performance metrics causes managers to focus their attention in a multitude of areas, rather than on the constrained resource, and so should be largely avoided. The proper use of a constraint-based management system requires the use of an entirely different set of supporting performance measurement. Here, we mentioned 16 measurements that will contribute to the proper monitoring of a company that uses constraint management as its guiding principle. 1. 2. 3. 4. 5. 6. 7. 8. 9. Ratio of throughput to constraint time consumption Total throughput dollars quoted in the period Ratio of throughput dollars quoted to throughput firm orders received Sales productivity Ratio of throughput booked to sh ipped Trend line of sales backlog dollars Ratio of maintenance downtime to operating time on constrained resource Throughput of post-constraint scrap Constraint utilization

10. Constraint schedule attainment 11. Manufacturing productivity 12. Manufacturing effectiveness 13. Order cycle time

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14. Throughput shipping delay 15. Inventory turnover 16. Return on investment

TARGET COSTING Target costing describes the costs that are expected to be incurred, to create a new product and how this will impact product profitability levels. By describing costs in a proactive and future-oriented manner, managers can determine how they should alter product designs before they enter the manufacturing process in order to ensure that the company earns a reasonable profit on all new products. Under the target costing methodology, a cost accountant is assigned to a new product design team, and asked to continually compile the projected cost of a product as it moves through the design process. Managers will use this information not only to make product alterations, but also to drop a product design if it cannot meet its cost targets. There are four basic steps involved in target costing, which are: 1. Price and value research: Conduct market research to determine the price points that a company is most likely to achieve if it creates a product with a certain set of features. The research should include information about the perceived value of certain features on a product, so that the design team can add or subtract features from the design with a full knowledge of what these changes will probably do to the final price at which the product will be sold. 2. Maximum allowable cost calculation: Subtract from the prospective product price a gross margin that must be earned on the product. By subtracting the required margin from the expected price, we arrive at the maximum amount that the product can cost. 3. Value engineering: Use value engineering to drive down the cost of the product until it meets its overall cost target. Value engineering requires considerable attention to the elimination of production functions, a product design that is cheaper to manufacture, a planned reduction of product durability in order to cut costs, a reduced number of product features, less expensive component parts, and so on in short, any activity that will lead to a reduced product cost. A standard procedure is to force the team to come within a set percentage of its cost target at various milestones (such as being within 12% of the target after three months of design work, 6% after four months, and on target after five months); if the team cannot meet increasingly tighter costing targets, then the project is cancelled.

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4. Follow-on activities: Once these design steps have been completed and a product has met its targeted cost level, the target costing effort is shifted into a different activity, which is follow-on activities that will reduce costs even further after the product has entered its production phase. This final step is used to create some excess gross margin over time, which allows the company to reduce the price of the product to respond to presumed increases in the level of competition. The sources of these cost reductions can be either through planned supplier cost reductions or through waste reductions in the production process (known as kaizen costing).

LIFE CYCLE COSTING Life cycle costing includes all costs expected during the life of an item over some finite study period. This means costs associated with acquisition and ownership of a system over its full life must be estimated and timed for the year of the expenditure. The summation of all costs from project inception to disposal of assets must be described in terms of the time value of money, which is the driver, for knowing how much money will be spent in each time slot. Life cycle costs are affected by three important issues in addition to the obvious capital costs: 1. Installation and use practices are influenced by engineering and operations. Practices define loads, equipment defines strengths, and usage determines life of the components. Equipment life/death must be converted into money decisions. 2. Component life and death are influenced by the grade of equipment carrying the loads. Equipment grades have finite load carrying capability which defines when/how components live and die. Death of equipment defines maintenance demands and equipment outages which denies use of the equipment for productive use. 3. Load profiles during various segments of the use cycle are very important considerations. The simple use of average loads and average strengths are perilous decisions which generate inaccurate cost profiles and significantly influence life cycle costs.

PROBLEMS & SOLUTIONS There is a danger in using throughput accounting to prioritize customer orders after they have already arrived in house. If company management is knowledgeable in throughput analysis, it may use this knowledge to delay low-throughput customer

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orders in order to achieve higher short-term profitability. The obvious problem is that some orders could be delayed well beyond their original promise dates, which may result in customers shifting their future orders to more reliable suppliers. Taken to an extreme, this approach can result in orders being continually driven to the bottom of the production priority list until such time as the mix of existing orders creates an opening at the constrained resource that allows it to be produced (which may result in some orders never being shipped). In addition, this action merely shifts low-throughput orders into a later reporting period, where the company will now be more likely to experience even lower throughput due to the presence of an increasing volume of lowthroughput orders in its production backlog. The obvious solution is to completely separate throughput analysis from the production scheduling function. The scheduling staff should be confined to the already-complex task of scheduling the production of all customer orders that have been received, without even knowing what the throughput of various orders may be. This will result in a reasonable mix of orders being delivered that have a full range of throughput dollars associated with each one. Thus, throughput analysis should not be used at the tactical level of scheduling production. A better level of planning using throughput analysis is at the strategic level, where the company decides whether it will produce low-throughput products at all, before they are even offered for sale to customers. Once they are offered for sale, it is now too late to use throughput analysis, unless it involves changes in pricing. It is also useful to use throughput analysis as part of the target costing system. Under target costing, a product design team determines the price point at which a prospective new product can be sold, and then designs a product to have a cost that will generate a sufficient profit at the predetermined price point. Throughput analysis can yield valuable information by eliminating any nonvariable costs assigned to a new product, so that management can determine the true throughput contribution of the product. In short, throughput analysis is most useful for creating a mix of products that creates the highest possible level of throughput, but should not be used to prioritize product deliveries once the company has committed itself to shipping them.

CONCLUSION Many companies are quietly accumulating their failure data and building models of their operations. They are doing the fundamental efforts to build more reliable plants that deliver the lowest long term cost of ownership for their investors. These improved plants are showing cost reductions and more stable operations without fanfare as the leading edge of a new wave of improvements becomes based on technology.

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An ancient Chinese warlord summarized the same type of issue succinctly 2000 years ago when he said All men see the battles I win, but no man knows the strategy for my success. In other words, don t look for your competitors to advertise how they re making more money with improved plants. They will not volunteer to tell you the secrets of their hard work in making better and more effective life cycle cost decisions though the use of reliability and maintainability technology. We have got to make a technology change to get a change in your performance.

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REFERENCES:

Eliyahu M. Goldratt and Jeff Cox, The Goal, 2nd Revised Edition, North River Press, Croton-on-Hudson, N.Y. Jay S. Holmen, ABC vs. TOC: it's a matter of time, Management Accounting (USA), Jan 1995 v76 n7 p37(4) John B. MacArthur, From activity-based costing to throughput accounting, Management Accounting (USA), April 1996 v77 n10 p30(5) John H. Sheridan, Throughput with a Capital 'T', Indust ry Week, March 4, 1991 Richard V. C., Eugene J. C., and Gerald E. C., Beware the New Accounting Myths, Management Accounting, December 1989, pp.41-45. Robin Cooper, Regine Slagmulder, Integrating activity-based costing and the theory of constraints, Management Accounting (USA), Feb 1999 v80 i8 p20(2) Robin Cooper, Robert Kaplan, Activity-Based Systems: Measuring the Costs of Resource Usage, Accounting Horizons, September 1992, pp. 1-13.Goldratt, Eliyahu and Jeff Cox. The Goal. Croton-on-Hudson: North River Press, 2004. Garrison, Norren and Brewer - Managerial Accounting: 12th Edition (2007)

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