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 4Sight Technologies - Newsroom


Leaning Toward Better Managerial Decision-Making

Published on: 12/10/2014

May's column on BI and cost accounting focused on how BI systems can help you establish accurate product costs and perform impact analysis to establish the right mix of products to maximize profit.

But there's another approach, which is closely related to Lean Manufacturing and applies a lot of the same principles.  It's called Throughput Accounting (TA) or the Theory of Constraints (TOC), and some companies have found that it leads to better decisions -- and better bottom-line results -- than traditional cost accounting. 

In a 2009 paper entitled, "The Theory of Constraints: Productivity Metrics in Software Development," author Derick Bailey describes TA (or TOC) as examining "the entire cost structure of a system, from concept to cash."  But TA does not focus on the costs of individual processes that go on in an organization.  Instead, the focus is on maximizing overall "throughput," which TA theorists generally define as revenue minus direct materials and sales commissions.

All assets are not created equal

TA is all about maximizing the flow of goods or services and reducing inventory.  TA theorist Eli Goldratt, in a pioneering 1984 book called The Goal: A Process of Ongoing Improvement, defines inventory extremely broadly: "All the money that the system has invested in purchasing things which it intends to sell."  This means everything -- raw materials, work in process, finished goods, and also things like fixed assets and other items not normally included in a company's "inventory" figure.  The idea is that every dollar you invest should be looked at in terms of how it helps get product out the door and money in the bank.

In TA, inventory is not treated as an asset -- instead, it's treated more like an expense, or a sunk cost, as Peter Drucker describes it in a Harvard Business Review article entitled, "The Emerging Theory of Manufacturing."  In financial reporting, inventory shows up on the balance sheet, right up there with cash, under Current Assets.  But carrying inventory costs a bundle, in warehousing, transportation, insurance, tangibles taxes, obsolescence, and shrinkage.  Drucker says, "Stuff that sits in inventory does not earn anything. In fact, it ties down expensive money and absorbs time." This is because you're buying materials and labor now, but not getting any revenue until later (if ever).  If you have more inventory than you can sell quickly, you're better off operating a plant at less than capacity for the time being, even though conventional cost accounting says your cost per unit of output is higher that way.

Goldratt and other TA theorists focus on identifying "bottlenecks" or points of constraint in any process or system of flow. Classic examples would include a punch press that processes every unit of production that comes out of a manufacturing plant, or a printing press that produces every copy of a newspaper. 

When the amount of stuff you can sell is limited by the amount of stuff a certain machine can crank out, that machine is a bottleneck.  In terms of maximizing throughput, the bottlenecks are the only things that matter -- improving the efficiency of some part of the plant that is not a bottleneck doesn't allow you to move more product out the door, because every unit of finished goods still has to go through the bottleneck.  It therefore makes no sense to release raw materials into production beyond what the bottleneck can process.  Anything that's stacked up as work-in-process ahead of the bottleneck is inventory -- and, therefore, a cost.  The Theory of Constraints does entail keeping a certain work-in-process "buffer" ahead of the bottleneck,  so that if there's breakdown at some point upstream in the production process, the bottleneck can keep operating.  Other than that, however, inventory should be kept to a minimum.

The high cost of efficiency

Suppose you're a brass instrument manufacturer and make trumpet bells by hand-hammering and spinning them on a lathe.  This is a time-consuming process, and it may be that the technician who makes bells can only make 10 a day.  If the CNC milling machine you use to make valves can produce, say, 50 a day, traditional cost accounting would tell you to run the machine at full capacity and make a large number at a time, to minimize the variable cost per valve. But if you do that, you're not increasing the number of trumpets you can make per day -- because the constraint is the bell-spinning process, so the extra valves just pile up as work-in-process inventory.

Throughput Accounting suggests that it's better to make 30 valves a day, just keeping up with the bell-spinner by providing three valves for each trumpet -- this reduces the amount of raw material you have to release into the production process, as well as the storage cost for valves while they wait to be installed.  This is true even though it means running the valve machine less efficiently.

Not just for manufacturing

Every industry has constraints or bottlenecks -- for example, a software development group with only one QA engineer or a marketing group with an editor who can only review so many articles per day. These constraints limit how many sales you can make -- if you can't produce or deliver the goods, you can't sell them, or at best, your customers can buy them but can't take delivery right away.

Resource Optimization (RO) and Business Intelligence systems are powerful ways of evaluating how these principles work in your company and whether Throughput Accounting can help you make better decisions, when used along with traditional cost accounting.

Throughput Accounting (or the Theory of Constraints) can also be applied to other business decisions such as capital budgeting, using the same principle.  Next month, we'll take a look at some more applications of this theory, and we'll also look more closely at constraints in the software industry. 

By John Kafalas

4Sight Technologies

This monthly column covers Business Intelligence and data analytics issues. If you have questions, comments, or topic suggestions, please contact the author.

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