Whatever you think about the free enterprise system, making more money now and in the future is a cornerstone for those for-profit companies who participate in it. Let’s look at how TOC can fundamentally shift management thinking and achieve ever better returns on shareholder funds. By using the systems-based measurements of Constraint Accounting, you will be equipped with the means to make better decisions.
The reason we have financial measurements in the first place is to ensure that we make better financial judgements for our organisations. These judgements can fall into five basic categories:
[Listen to audio version, read by David Hodes]
Let’s get some definitions down. The basic financial measures of TOC can be articulated by the formula below:
ROI = return on investment
T = throughput, or sales less truly variable costs (referred to by cost accountants as contribution margin)
OE = operating expense, defined as labour plus overheads
I = investment
Throughput less operating expense equals profit, and hence (T – OE)/I is profit divided by investment (or ROI). The goal of a for-profit organisation is to maximise return on investment—both now and in the future. To do this, it must meet certain necessary conditions, such as satisfying shareholder investment criteria, engaging staff in the vision, mission and purpose of the organisation, and ensuring good, healthy relationships with suppliers and regulators.
The troubles begin with the unexamined assumptions we make about our existing accounting systems. Fundamentally, whether you are in the world of projects or production, the prevailing paradigm has us break up the whole into constituent parts to try and tame complexity. We use methods in our management accounting which call for earned value in projects and absorption costing in production. Both methods are fundamentally the same; they seek to ascribe value to activity, regardless of whether the activity is at the constraint or not.
All organisations have constraints,
or else their profits would be infinite.
No less an authority than the late Stanford professor and management accounting academic Charles T Horngren made the case that: ‘Relevant information is the predicted future costs and revenues that will differ among alternative actions. The existence of a limiting factor changes the basic assumptions underlying the cost and revenue opportunity of a particular action.’
Stated another way: An organisation will maximise profit when it sells the product or service with the highest contribution margin (throughput) per unit of the constraint.
This idea is self-evidently true. All organisations have constraints, or else their profits would be infinite. The corollary is that non-constraints must then, by definition, have ‘excess’ capacity available. But this is not the way the majority of finance departments look at the world. They generally ignore the contribution made by the scarce resource, and indeed wouldn’t know what the scarce resource was, nor what to do with it, if it were to jump up and announce itself with megaphone in hand.
Most finance folk obsess about cost drivers, firm in their belief that knowing and reducing the unit cost of a product or service will maximise profits. They struggle mightily to achieve what in the business is called the ‘matching principle’—that is to match the revenue in a given financial period with the costs incurred in that period. Revenue less costs is, after all, the definition of profit. But they’re looking at the wrong thing.
Whose rules are you playing by?
Because Finance sets the rules of the game, Operations ends up chasing down their local efficiencies, assuming that a penny saved here and another saved there will all add up to what the scorekeepers say is important. There is a nagging feeling, though, that something is amiss—are they not all trying to make money for the organisation and not merely save costs? Is the additive weight of the links in the value chain what’s important, or is it the strength of the weakest link which determines how much value can be pulled through?
Marketing and Sales are also caught in this dilemma, struggling to sell the product or service with the highest gross margin per unit (selling price less fully absorbed cost). Finance fears that Sales will give away all the margin they have just to get the deal. The finance folk, therefore, load the ‘cost’ of the product or service with as much labour and overhead burden as they can muster. When the product or service is eventually sold, Finance is confident that as a consequence of absorbing all the costs the accounting conventions and policies allow, the organisation will maximise its profits. But their comfort is misplaced.
Even worse, by absorbing the operating expense into the cost of a product or service, this accounting sleight of hand credits an operating expense to profit. This operating expense moves miraculously to the balance sheet as an asset, whether it’s Work in Process (WIP) trapped in the system, or finished goods no one wants to buy. It becomes very tempting to overproduce so that more and more operating expense can be converted into inventory, or ‘earned value’, meanwhile converting precious cash into warehouses full of product and taking focus off the critical paths of projects.
The dilemma about whether or not using product or service cost leads to maximising profit is articulated in the ‘evaporating cloud’ below:
If we can all agree on the idea that the organisation is looking to maximise profit, then in the entities B and C, we have the necessary conditions of ‘maximise throughput at the constraint’ and ‘maximise the difference between revenue and cost’. In the entities D and D’ we have the dilemma: ‘abandon absorbed product or service cost’ versus ‘use absorbed product or service cost’?
There’s no issue with profit maximisation coming from maximising the difference between revenue and cost. Indeed, that statement is not in conflict with the idea of maximising throughout at the constraint—they are mutually supportive necessary conditions for maximising profit.
Where the argument breaks down is in the assumption between C and D’. It says that in order to ‘maximise the difference between revenue and cost’, we must ‘use absorbed product or service cost’, because ‘according to the matching principle, I must absorb periodic fixed costs into the cost of my products or services so I can determine product or service profitability’.
If all of this sounds a bit technical, let’s look at a simple example. Let’s say Product A has a fully absorbed cost of $10—that is, all materials and absorbed operating expense comes in at $10, and it takes 1 hour to produce this product, which you sell for $20. Your gross profit is $10 per hour. Now, if product B only makes $1 of gross profit per unit—calculated on the same basis as for product A—but it takes only 5 minutes to produce, then, all other things being equal, we will end up making $12 profit per hour—a 20% improvement simply by selecting our sales choices according to the principle of maximising throughput.
The idea of being able to determine the cost of a product or service based on production volume, and the allocation in a given accounting period of an often arbitrary operating expense burden, is the accountants’ equivalent of Don Quixote tilting at windmills.
We often fail to examine our assumptions—no less so in business than in any other walk of life. The decisions we make, based on unexamined habits of thought, can have fateful consequences for organisational performance. We are handed a set of measures by the accountants and assume that in reading them we will have a good idea about how to go about making sound financial judgements. But reading the financials and thinking you know what’s really going on in your organisation is like going to your favourite restaurant and eating the menu to understand the taste of the meal.
If you want to learn more about how TOC can help you focus where it really counts, why not schedule a video call.
The Theory of Constraints offers a new operating system fit for our complex world of change. To learn what that operating system might look like, we invite you to download our Executive Guide to Critical Chain Project Management [PDF].
The change of mindset from standard thinking to Theory of Constraints (TOC) is both profound and exhilarating. To make it both fun and memorable, we use a business simulation. Just as astronauts need a few zero-gravity rides in a special aircraft before they experience the real thing in space, the game simulates the effects of TOC. We call it The Right Stuff workshop and we’d love to run it with you.
[Background photo: ‘Vintage cash register’
by Ramiro Mendes on Unsplash]
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