One of the most perplexing observations of modern business is the disconnect between accounting and business decisions. Before the torches are lit and the pitchforks are brought out, let us review some key points that lead to this conclusion.
1. Most modern businesses desire growth. Financial accounting and cost accounting are geared, or at least tend, to focus on cost, not growth in throughput.
2. Allocation of costs presupposes that volume is fixed and costs are variable. We spread the cost over the units that “cause” the cost. Activity based costing emphasizes this by assuming that the units (activity) is the basis for cost, not the existence of the capacity that allowed the activity.
3. The cost types we call variable rarely are. We pay employees by the hour, not the unit in most cases. The cost for labor is generally driven by the hours the employee is at work, not the amount of work they complete.
4. Top-line growth requires selling units, not putting them in inventory. Yet, we hang up expenses on the balance sheet for units we produce but do not sell.
5. Costing of inventory rarely accurately portrays the cost of capacity consumption. If we only produce one unit in a month, we do not allocate the entire cost of operating the facility to it. We now must break out period cost versus standard cost. However, there is still a hidden motivation to build inventories to keep period costs in check.
6. Formulaically assigning costs to inventory based on most allocation methods hides the real impact of decisions, or at least smooths the results of those decisions across many transactions making them less visible.
This is not an indictment of general accounting, cost accounting, Activity Based Accounting or accountants. Between banks, investors, advisory boards and senior management groups, the need for general accounting is undeniable.
But to help understand the impact of a transformative project, throughput accounting is a better tool. There are many resources that cover the details of T Accounting, so only the basics will be covered here.
The basics are simple. Throughput accounting focuses on the generation of cash through sales. In its simplest form, Throughput = Sales – Material Cost. Think of throughput as the amount a customer pays to convert raw materials to finished goods and deliver them. Operating Expense is all the costs required to convert those materials. If throughput is greater than operating expense, we make money. If the costs to convert (OE) is greater than T, we lose money.
Now that we have that basic understanding, we can dissect operating expenses. First, we must accept the nature of most costs. Variable costs are rarely linear, or perfectly variable. Most of what we call variable costs are tied more closely to time than output, a fact often missed when we have small crews work over to finish an order. Utilities are more closely related to someone being in the building than to how many people are there. Labor has an artificial floor that is close to full-time, meaning we cannot keep our workforce if they are only working 25 hours per week, so we generally make up work to keep them busy.
So cost is associated with different bands of capacity. We know that at a certain production level, we need enough folks to fill all the operator spots. If we produce fewer units than expected, we still pay a mostly fixed cost per hour to operate.
That, in essence, is the cost of capacity. A facility configured to produce 100 units per hour costs $1000 per hour. If we only get 50 units per hour, it costs $20 per unit OE. If we can optimize the operation to get 125 units per hour without adding cost, each unit costs $8 OE.
Traditional accounting would focus on how to reduce the cost per unit. We would look at “rightsizing” the work force, reducing material cost or reducing other spending. Throughput accounting would have us first look at how we get more units per hour. Then we would look at reconfiguring to a capacity level more in-line with demand. Traditional accounting would focus on reducing the individual costs per unit while T accounting would have us focus on generating more T with the same OE.
Or we can skip the entire accounting discussion and think of it this way:
· Operating costs are more fixed than variable for a given level of capacity
· Labor is usually required to support a system of dependent manufacturing or processing events and is adjustable only through reconfiguration of the process (think of a key employee absence and the resultant drop in labor efficiency)
· Throughput is generated by executing against that capacity
· For companies that are capable of selling more, a 10% increase in sales volume is more valuable than a 10% reduction in labor cost. 10% of top line should always be more than 10% of direct labor.
By knowing the total operating cost per hour at a facility, we can easily determine the cost per unit by dividing the cost per hour by the units per hour. An hour of downtime costs an hour of OE. Unutilized capacity costs the same. We can even go so far as to compare product line profitability by costing products based on their capacity cost. More aggressive pricing can be offered if we are selling excess capacity versus adding capacity on oversold lines.
Traditional accounting is not going to go away. It is the standard language of business and is required for almost any transaction. But understanding the basics of T accounting can make better decisions easier, especially in cost-savings project prioritization. That is a topic for a future posting.