HowtoGrowProfitwith

ThroughputAccounting

HowtoGrowProfitwithThroughputAccountingAPinnacleStrategiesWhitePaper

Today,companiesarefocusedonincreasingthroughputtherateatwhichacompany
generatesmoneythroughsales.Theywanttoexpandproducts,customerbase,markets,andso
on.Theywanttogrowasmuchaspossible,asquicklyaspossible.Theydonotwanttofocuson
shrinkingtheircompanyorlaborforce.Yet,themostcommonlyusedfinancialtoolstell
companiestofocusoncuttingcostsinordertomaximizeprofits,makingexpensesthefocusof
companies,notsalesgeneration.Thisoftenleadsmanagementtomakedecisionsthatactually
harmacompany.
Companiesneedtousefinancialtoolsthatmovethemtowardtheirgoal.Throughput
Accountingprovidesmanagerswithatransparentandfocusedmethodtomakedecisionsthat
consistentlyleadthemintherightdirection.Throughbettermanagerialdecisionmaking,
ThroughputAccountingimprovesacompanysabilitytomakemoremoneynowandinthe
futurebecauseitapproachesaccountingfromacashmanagementbasis.Itmeetstheneedthat
companieshavetomeetmanagementchallenges,includingoutsourcingproducts,process
improvement,andpurchasingcapitalequipment.

IsTraditionalCostAccountingBadforDecisionMaking?
TheDecisionMakersDilemma
Itisoftendifficulttoseehowdecisionsmadeinalocalareaaffecttheorganizationasawhole.
Thisisparticularlytrueofmanagerswhoarenotabletoseeoraffecteveryareaofthe
organization.Theorganizationalviewofmostmanagersistypicallylimitedtotheirownareaof
responsibilityandthosenearby.
Forabusinessleaderinanenterprise,theissueismoretroublesome,becauseheorshemust
concernthemselveswiththedecisionmakingofmultiplemanagersinvolvedinmanyaspectsof
theenterprise.Weknowfromexperiencethatlocalmanagersoftenmakedecisionsthatare
countertothepurposeoftheenterprise.Asinglepersonperiodicallymakingabaddecisionis
usuallynotsignificant,butifthereisasystemicerrorinmanymanagersunderstandingofthe
enterprisesfunctioning,manypoordecisionswillbemade,whichcouldcreatesignificant,long
lastingdamage.
Larger,subdividedenterpriseslosetheirsystemwideperspective,andmanagersareforcedto
relyondecisionrulesthataretypicallybasedonTraditionalCostAccounting;thebiggerthe
enterprise,thebiggertheproblem.

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HowtoGrowBusinessProfitwithThroughputAccountingAPinnacleStrategiesWhitePaper
Thedecisionmakerisoftenforcedtochoosebetweendecisionsthatmakeintuitivesense,but
mustbejustifiedusingTraditionalCostAccountingmethods.

TheDecisionMakersChallenge
Managersandsystemownersmustfindawaytopredictandaccuratelymeasuretheeffectof
localdecisionsontheglobalgoal.Thechallengeistogetlocalmanagerstothinklikebusiness
peopleandmakegooddecisionsbasedontheglobalsystemmeasurements.

Revenues

Expenses

Profit

Returnoninvestment

Often,inanefforttomanagethedollarsinanorganization,thelocalmanagersmanage
budgets,which,whileimportant,donotmimicthedecisionsofthebusiness.Mostimportantly,
budgetmanagementassumesafixedrevenuesource,overwhichlocalmanagershaveno
control.Theresultisthatlocalmanagementdecisionsbecomeonedimensionalbasedon
expensesandlocaloptimization.Therealityisthateverylocalmanager,beingpartofthe
system,canhaveasignificantimpactontherevenuesofanenterprise.Everymanagershould
beusingthesamemethodstoevaluatethequalityoftheirdecisions;basedontheimpacton
netprofitandreturnoninvestment(shortandlongterm).

ThePitfallsofTraditionalCostAccounting
TraditionalCostAccountingfailstoprovidethisguidancetomanagers.Itsimplycant.Itis
basedonseveralassumptionsthatwhile,atonetime,werevalid,arenolongerareflectionof
therealitythatmanagersfindthemselvesin.
Traditionalcostaccountingsprimaryoperatingassumptionisthatlaborexpenseisdirectlyand
positivelycorrelatedtoprocessoutput.Ittreatseveryresourceasthingswithapproximately
thesamequality,ignoringtheexistenceofaprocessconstraint.However,theTheoryof
Constraintsclearlyshowstheimportanceofunderstandingconstraintsinmaximizing
throughput,andhowvitalitisforallpartsofacompanytomanagearoundandtothe
constraintresource.
Itisonlywhenallpartsofanorganizationworktogethertosupporttheconstraintfromsales
toR&Dtomanufacturingthatthroughputcanbeachieved.Ifanypartoftheorganization
ignorestheeffectsoftheconstraint,throughputwillbeaffected.Thus,itisnotanyrandom
partofthesystem,suchaslaborefficiency,thatdeterminestheentiresystemsthroughput,
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butwhatlimitsthesystemfromachievingmorethroughput.TraditionalCostAccounting
ignoresthispointoffocusandgivesequaltreatmenttoallareas.
Givingequaltreatmenttoallareasandignoringtheconstraintresultsinaninabilitytoconsider
thetrueimpactthateachareaofthecompanyhasonthroughput.Thiscancausemanagement
tomakedecisionsthatharmthehealthofcompany.Considerthefollowingexamples:

Ifanengineerfindsawaytoimproveprocessesatanonconstraint,willitincrease
throughputiftheconstraintisunaffected?

Ifproductsareoutsourcedtocutlaborcosts,willtheactualspenddeclineorreal
throughputincrease?

Ifpurchasingdiscoversacheapersupplierforapart,whatwilltheimpactbeon
throughputandtheconstraint?

Whilethesedecisionscanshowimprovementusingtraditionalcalculations,theymay
ultimatelyreducethroughput.Itisonlywhenmanagementconsiderstheconstraintinits
decisionsthatthroughputwillbeincreased.
TraditionalCostAccountingalsoleadsdecisionmakersastraybyallocatingfixedexpensesto
theproductionofanincrementalunitofproduction.Bytreatingmaterial,laborandoverhead
costsasvariablecosts,itignorestherealitythatlaborandoverheadexpensesareusuallyfixed
onincrementalvolume.Laborandoverheadarenotvariableproductioncosts,theyreperiod
costs.Whenacompanyreceivesaneworder,ittypicallydoesnothireadditionalemployees,
terminatecurrentemployees,opennewmanufacturingsites,orclosecurrentsites.The
numberofemployeesandplantsstaythesame,asdothecostsrelatedtothem.Yet,managers
aremakingdecisionsbasedonfaultynumbersthatstateotherwise.
AnotherproblemwithTraditionalCostAccountingisits(unintentional)encouragementof
inventorycreation.Theprimarypurposeofmanufacturingistoproduceproductstosell,but
theleadersofthisfunctioncanlosesightofthegoalwhenlaborandoverheadcostsare
absorbedintoinventory.Absorbingcostsintoinventoryactuallyencouragesthecreationof
inventoryanddiscouragesthereductionofinventory.Byproducingalargeinventoryinorder
todeferlaborandoverheadcostsuntilaproductsells,itmayappearthatacompanyismore
profitablethanitreallyis.Conversely,whenexcessinventoryisremovedfromthesystem,it
mayappearlessprofitable.Essentially,TraditionalCostAccountingencouragesthecreationof
excessinventoryevenifsalesarelow,consumingcashatatimewhenacompanymayleast
affordit.

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ProductOutsourcingACaseStudy
MalteseFinders,Inc.producesgolddetectors1.Managersusethecostofproducingpartsin
house(standardlaborrates)toevaluateproductivityandmakethedecisiontooutsourceparts
ifitischeapertobuythantoproduceitinhouse.Ifsomeonecansellthemacomponentfor$5
thatcosts$10internally,outsourcingwillincreaseprofit.
Thisdecisionresultedinrigorousenforcementofapolicytooutsourceallpartsthatwere
cheaperfromoutsidevendors.Partsthatcouldbepurchasedcheaperwerenolongerproduced
inhouse,butpurchasedfromacompetitivesupplier.Asaresult,60%ofitspartswere
outsourced.
Despitereducingcapacityandworkforce,thepolicyandactionsdidnotincreaseprofit.
Managementexaminedthecostsofpartsagain,discoveringthatevenmorepartswerenow
cheapertooutsource.Theadditionaloutsourcingofpartsfailedtoincreaseprofit.Instead,
profitdeclinedfurther.
Managementclosedoneplant,increasedproductionhoursintheremainingplants,and
purchasedadditionalinventorytokeepproductionrunning.Thecompanywasabletoproduce
moreproductsthanever.Eventhoughsaleswerenotincreasing,inventorywasincreasing,and
theyshowedalargeprofit.
Butthecompanyhadalotofinventoryandnoonewasbuyingit.Itwasstillspendingmoneyto
createproducts,butdespitetheprofitontheledgersheet,moneywasnotcomingintomeet
expenses.MalteseFindershadtofileforbankruptcyandchangethenameoftheircompany.

PurchasingCapitalEquipmentACaseStudy
SimpleStrategiesproducespartsforradios.PriortoshiftingtoThroughputAccounting,Simple
Strategiesundertookastrategytoreducecostsbyreducingtheprocesstime.Oneofthese
decisionswasthepurchaseofnewmanufacturingprocessequipmenttoreduceprocesstime
by8%.Unfortunately,thiswasforanonconstraintresource.
Thedecisionwasfocusedonalocalarea,viewinglaborandoverheadasequals,without
considerationofconstraints.Thenumberofemployeeswasnotreduced,andthepricepaidto
vendorsforrawmaterialswasnotreduced,sothecostsavingsdidnotmaterialize.Infact,the
onlyeffectwasthecashpaidoutforthenewprocessequipmentreducedthecashonhand.

Atruestory,butthenameshavebeenchangedtoprotecttheguilty.

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HowtoGrowBusinessProfitwithThroughputAccountingAPinnacleStrategiesWhitePaper
SwitchingtoThroughputAccounting,managementchangeditsfocusfromspeedingupthe
processtimeinindividualareastoreducingthetimeontheconstraint.Byinvesting$3,000in
theconstraint,thetimeontheconstraintwasreducedfrom15minutesto10minutesperunit.
Outputincreased80%andthecompanyadded$10milliontoitsbottomline.

HowCanThroughputAccountingHelp?
ThroughputAccountingfocusesonincreasingrevenue(throughput),improvingcashflow
(investment)andprovidingcapacity(operatingexpense).Everymanagementdecisionismade
basedonexpectedchangesinthroughput,investmentandoperatingexpense.Throughput
Accountingallowsmanagerstotakeamorebalancedapproachtodecisionmaking,givingan
accuratepictureoftheresultsofdecisions.ThroughputAccountingalsodemonstrateswaysto
makemoreprofitablepricingandmarketingdecisions.
ThroughputAccountingshiftstheemphasisindecisionmakingfrommanagingcostsand
budgetstomaximizingthroughputandprofitability.Itemphasizestheimprovementofflow
throughthesystem,providingfeedbackonthefinancialimpactoftheconstraint.Itdrives
managementdecisionstoimprovetheconstraintsefficiency;ensuringallcompanyresources
supporttheconstraint,sothatprofitcanbemaximized.
ThisapproachdifferssubstantiallyfromTraditionalCostAccountingbecausethecompanyis
notfocusedoneverymachineandemployeeworkingatoptimalefficiency.Instead,itsbasisis
thatifacompanyoptimizesanynonconstraint,itwilloverloadtheconstraintandcreateexcess
inventory.
ThroughputAccountingprovidesawaytomeasureproductivityimprovementeffortsbasedon
howtheyaffectcostandthroughput.Itcanbeappliedtodecisionsthataffectallaspectsofa
companyincludingproductprice,processimprovement,rewardstructures,investment
justification,transferpricing,andperformancemanagement.Theresultisathorough
understandingofhowacompanyisfunctioningasawholeandtheabilitytoanalyzethetrue
impactofmanagementdecisionsbeforetheyaremade.

ProcessImprovementACaseStudy
TalentedEnterprisesproducespartsforcameras.Itsprimarymeasureofproductivityislabor
absorptionundertheassumptionthatifmoreworkisbeingdonetocreateinventory,profits

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HowtoGrowBusinessProfitwithThroughputAccountingAPinnacleStrategiesWhitePaper
willincrease.However,usingthismeasureresultedinactionstoincreaseinventoryandbuild
stockproductsratherthanfillactualcustomerorders.
Processimprovementswereimplementedtoreducecosts.Effortsweremadetodecreasethe
laborinvolvedinproducingparts.Thiswasdoneforalloperations.Manynonconstraints
becamefaster,producingevenmoreworkthantheconstraintscouldhandle.Eventhough
laborwentdown,inventoryincreasedanditbecamemoredifficulttofulfillordersontimeand
toproperlyprioritizemanufacturingjobs.
Whenmanagementlearnedaboutthroughput,itshifteditsfocusfromabsorbingcostsinto
inventorytoincreasinghowquicklyworkcouldbecompleted.Emphasiswasgiventoimproving
constraints.Byinvesting$25,000inthefacilityandaddingtwoadditionalemployeestotheday
shift,outputincreased73%.UnderTraditionalCostAccounting,theseexpenseswouldnot
havebeenjustifiedbecauselocaloutputefficiencywouldhavedeclinedonaperlaborhour
basis.However,thecostwasminimalcomparedtotheincreaseinthroughput.

HowtoUseThroughputAccountingtoMakeDecisions
Whendeterminingwhataffectadecisionwillhave,managementneedstoconsiderthe
following:
1. Willthedecisionincreasethroughput?How?
a. Willthechangeincreaseordecreasesales?
b. Willthechangeaffectyourrawmaterialcosts?
c. Willthechangeaffectyourprices?
2. Willthedecisionreduceinvestment?How?
a. Willthechangeincreaseordecreaseyourinventories?
b. Willthechangeincreaseordecreaseyourreceivables/payables?
3. Willthedecisionreduceoperatingexpense?How?
a. Willactualcashoutlaysbereduced?
b. Willthechangeincreaseordecreaseyourstafflevels?Whoisleavingthe
company?
c. Willthechangeincreaseordecreasethenumberofoutsidecontractorsyou
need?Willyousendmoreorlessdollarstooutsideentities?
Thechangeinthroughputlessthechangeinoperatingexpenseisthechangeinprofit(TOE=
PROFIT).Ifthechangeinprofitispositive,youcanbeassuredthatthedecisionwillleadthe
organizationtowardsmakingmoreprofit.
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HowtoGrowBusinessProfitwithThroughputAccountingAPinnacleStrategiesWhitePaper
Ifprofitdividedbyinvestment[(TOE)/I]isgreaterthan1,thereturnoninvestment(ROI)will
bepositiveandyoucanbeassuredthatthedecisionisafavorableinvestment(notaloss).

ThroughputOperatingExpense=PROFIT;Ifprofitis
positive,thedecisionwillincreaseprofit.

If(ThroughputOperatingExpense) Investmentis>1,ROI

willbepositive.

HowtoUseThroughputAccountingforProductProfitability
ThroughputiscreatedwhenaproductissoldandisexpressedasaRATE.Theamountof
throughputisthesellingpricelesstotalvariableexpense(TVE).TVEisdefinedasmoneythatis
onlyspentwhenthereisasale.Therateatwhichproductsgenerateprofitisdeterminedby
thethroughputperunit,dividedbytimeontheconstraint.

Throughput=SellingPrice TVE

RateofProfit=Throughputperunittimeonconstraint

Knowingwheretheconstraintisnowandwhereitwillbeinthefuturehelpsqualifydecisions
thatimpactprofit.Timeonconstrainttellsmanagementtherateatwhichaproductis
contributingtoprofit,thushelpingmanagementjudgethebenefitofchangesinthe
manufacturingprocess.

ProfitabilityAnalysisACaseStudy
DynamicSolutions,Inc.sellsthreemajorproducts.Productionofeachoftheseproducts
requiresdifferentvariableexpensesanddifferentratesofresourceconsumption.
Product

SellingPrice

MonthlyDemand

ContributionMargin(CM)

$200

100

$150

$175

50

$40

$100

75

$45

Operatingexpensesare$16,000permonth.TheconstraintistheQResource.
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ProfitabilityAnalysisUsingTraditionalCostAccountingDynamicSolutions,
Inc.

Revenues

ProductA

ProductB

(100x$200)

$20,000

$8,750

(75x$100)
TotalRevenues

TotalCosts

$7,500

$36,250

(100x$50)

$5,000

(50x$35)

(75x$55)

TotalRMCosts

Wages

Total

(50x$75)

MaterialCosts

ProductC

$1,750
$4,125
$9,750

$3,221

$425

$1,729

$4,975

Overhead

4,319

928

1,721

$6,668

TotalCosts

$12,540

$3,103

$7,575

GrossProfit

$7,460

$5,647

($75)

GrossMargin/Unit

[$7,460100]

$74.60

[$5,64750]

[($75)75]

ProductPreference

#2

$112.94
($1)
#1

#3

AccordingtoTraditionalCostAccounting,ProductCshouldbedroppedandProductBisthe
companysbestprofitgeneratingproduct.
DynamicSolutionsdiscoversthatitcannotdeliveralloftheunitsforProductAandB
demandedbycustomers.Itdoesnothaveenoughcapacity.So,itdecidestodeliverwhatitcan
whilelookingforahighergrossmarginproductandexploringitsoptionsforrestructuring.

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MaximumProfitAvailableUsingTraditionalCostAccounting
DynamicSolutions,Inc.

UnitsSold

TotalCM

CMperUnit

ProductB

50

$40

$2,000

ProductA

100

$150

15,000

ProductC

$45

____0

TotalCM

$17,000

Operatingexpense

16,000

Operatingincome
beforetaxes

$1,000

ButwhatifDynamicSolutionshadusedThroughputAccounting?

ProfitabilityAnalysisUsingThroughputAccountingDynamicSolutions,Inc.

Averagesellingprice/unit
Variablecosts/unit
Throughput(CM)/unit
Constraintmin.required
Qresource
Throughputtimeon
constraint(Qresource)
ProductPreference

ProductA

ProductB

ProductC

$200

$75

$100

50

35

55

$150

$40

$45

30

30

10

$5.00/min.

$1.33/min.

$4.50/min.

#1

#3

#2

ThroughputAccountingshowsthatProductCisthebetterprofitmakingproductinthelong
termthanProductBbecauseithashigherthroughput(contributionmargin)andagreaterrate
ofprofit.

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MaximumProfitAvailableUsingThroughputAccounting
DynamicSolutions,Inc.

UnitsSold

CMperUnit

TotalCM

ProductC

75

$45

$3,375

QResourceTime
Used
750 min

ProductA

100

$150

15,000

3000

ProductB

15

$40

__600

_450

TotalCM

$18,975

Operating

16,000

$2,975

4,200min

expense
Operating
incomebefore
taxes

WhileTraditionalCostAccountingsfocusongrossmarginsofindividualproductswouldhave
DynamicSolutionsincreaseproductionofProductBanddropProductC,Throughput
Accountingshowsthatbymaximizingtherateofthroughputusingtheconstraint,Dynamic
Solutionscanrealizenearlythreetimestheamountofprofit.

Conclusion
Cuttingcostsisimportant,butitisnotthemostimportantfactorinmaximizingprofit.
Intodaysworldofglobalcapitalismandshareholderexpectations,companiesareseekingways
toexpandineveryareaprofit,quality,andsoon.Focusingsolelyoncuttingcostsdoesnot
producethebestresult.Youcanonlycutcostsforsolongbeforethereisnothinglefttocut.
Todaysmarketplacerequirescompaniestofocusonthroughput.Thisrequiresan
understandingofacompanysconstraintandhowchangeswillaffecttheconstraint.
ThroughputAccountingenablesmanagerstoexaminethelinkbetweenprocessconstraintsand
financialperformanceindecisionmaking.Thismakesitpossibletodeterminetherealimpactof
theirdecisions.Beforeadecisionismade,acompanycanlookattheimpactonthroughputand
compareittotheeffectonoperatingexpenseandtherequiredinvestment,solvingthe
decisionmakingproblemformanagers.

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