Throughput Accounting - The Concepts of Throughput Accounting

The Concepts 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 'bottleneck' (referred to as constraint in the Theory of Constraints) 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 net sales (S) less totally variable cost (TVC), generally the cost of the raw materials (T = S - TVC). Note that T only exists when there is a sale of the product or service. Producing materials that sit in a warehouse does not form part of throughput but rather investment. ("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 and payroll.

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:

1. Increase throughput? How?
2. Reduce investment (inventory) (money that cannot be used)? How?
3. Reduce operating expense? How?

The answers to these questions determine the effect of proposed changes on system wide measurements:

1. Net profit (NP) = throughput - operating expense = T-OE
2. Return on investment (ROI) = net profit / investment = NP/I
3. TA Productivity = throughput / operating expense = T/OE
4. 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.