Throughput accounting (Dialogue part 4)19.09.2018
Q: In the previous Dialogue, we started talk on the financial side of decision-making. You told paradoxical things, for example, about the case when you increased the company’s profit by reducing employee productivity.
G: Yes, and I promised to tell you more about the principles of Throughput accounting. Of course, I can’t tell you more about this topic than, for example, Thomas Corbett’s “Throughput accounting“. Better read this book with all the examples and calculations in it. However, for our reader, who does not have time for books because he has to devote all his time to save his business, we will show a small example, which I call the “Ideal Factory”. But first, let me ask you one question: You have already said that many problems prevent you from running your business the way you would like. What are they?
Q: Yes, but you already call it the “External Reasons Page” and say that this list blocks the driver from finding the right problem for your business!
G: You are right – that is what I have said, but now I offer to check whether this is really the case because I saw that you still have doubts. We will create a list of all possible improvements that would allow your business to grow quickly and profitably. Don’t limit yourself – let your imagination run wild!
Q: OK, my business would “fly” forward if;
– I would always have more orders than I can produce.
– I would have no problem with money and all customers would pay on time and in full. No, everyone should pay 100% prepayment!
– Suppliers always provide me with the best quality materials on time. Yes, and so that I can pay for them within 90 days (better -180!).
– All employees would be highly motivated, always on-site, and working with a good conscience. Let none of them get sick, drink, or smoke.
– All equipment should be in perfect technical condition and never break.
Well, I don’t know what else – so that all internal processes would be perfectly organized (according to Lean), someone would clean everything, arrange it, and put it on the shelves!
G: Good fantasy flight! You know, it’s almost identical to the list I get when I run this exercise for professionals and business leaders. Sometimes I also hear something more exotic, such as the government abolishing all taxes. In general, you have a good wish list, which is basically a “Manager External Reasons Sheet”, why he doesn’t succeed the way he would like.
And now let’s say that you run a very small company that fulfills all your wishes and its name is “Ideal Factory”.
It is a company that is harder to imagine – the factory has only two machines (cutting and painting) and the company produces only two products – A and B. Each product undergoes a cutting operation from the beginning and then painting. The system flow looks like this:
Cutting -> Painting
For information on products, costs, and demand, see Table no. 5.
|Product A||Product B|
|Material costs, EUR||90||100|
|Cutting time, min||4||20|
|Painting time, min||30||20|
|Total process time, min||34||40|
To simplify the situation, let’s say you only have to run this factory for one week (five working days in one shift, which is a total of 2400 minutes (5 days x 8 hours x 60 minutes = 2400 minutes). – 2400 minutes each.
Table no. 6.
|Operation||Time required Product A||Time required Product B||Total, min||Required/Available|
All your wishes have been fulfilled and, as you can see in Table no. 6, the demand is higher than you can produce, because you cannot skip all the products through painting! The total operation expenses (OE) of the company, which is all costs except the cost of purchasing materials, is 10 900 euros per week. Please take into account these two figures – time 2400 minutes and OE 10 900 euros!
Attention: Reader, try to figure out this example, despite the answer! And now, please calculate what profit you can get from the ideal factory in a week?
Q: Well, the situation is not complicated here – product A has higher profitability (higher selling price, lower material costs, moreover, the operation time is shorter). So we will produce 60 products A (all demand) and product B as long as there is enough time for painting. And it is:
Product A takes 1800 minutes to paint (60 pieces x 30 min = 1800 minutes)
We have 600 minutes left for painting (2400 min – 1800 min = 600 min).
During this time we can paint 60 B products (600 min: 20 min = 30 pcs.).
Thus, we can sell 60 products A and 30 products B. Let’s calculate the revenue from each (sales price minus the price of raw materials once the number), and it will be:
Revenue from product A is 7500 euros ((215 – 90 = 125) x 60 pieces = 7500)
Revenue from product B is 3150 euros ((205 -100 = 105) x 30 pieces = 3150)
The total revenue is 10 650 euros. However, since the company’s maintenance costs are 10 900 euros, we will have a loss of 250 euros (10650 – 10900 = -250).
G: What are your conclusions from this calculation?
Q: This factory seems to have too high operation expenses. They should be reduced.
G: So if you fail to make a profit, you have to save somewhere, right? That is, should wages be reduced for workers, should the costs of repairs and maintenance of equipment be reduced, or should the costs be reduced for social purposes and the like?
Q: What else should I do? Of course, prices can be further increased if customers are willing to pay more or buy cheaper materials, but this can only be done if the customer has no complaints about quality. This seems a risky path for me.
G: It’s good that because you can’t make a profit, you don’t offer to immediately destroy customer relationships, which can lead to a company’s bankruptcy even faster than reducing “costs” by producing a low-quality product or at the expense of employee motivation.
However, the conclusions are still unsatisfactory – both solutions offered to you lead to the same end.
Q: Listen, you prepared this example with a non-profit company. No wonder it will lead to bankruptcy! I do not understand – where does it make sense?
G: Okay, but what if you run this business differently?
Q: What could be different here – two operations, two products!
G: Look at this option – let’s start producing product B, which you say is a less profitable product.
The time required for painting B is 1200 minutes (60 pieces x 20 min = 1200 min).
We have another 1200 minutes left for painting (2400 min – 1200 min = 1200 min).
In the meantime, we can paint 40 A products (1200 min: 30 min = 40 pcs.)
Thus, we can sell 40 A products and 60 B products. Let’s calculate the revenue from each (sales price minus the price of raw materials once the number) and it will be:
Revenue from product A is 5000 euros ((215 – 90 = 125) x 40 pieces = 5000)
Revenue from product B is 6300 euros ((205 -100 = 105) x 60 pieces = 6300)
In total, they are 11 300 euros. As the company’s operation expenses are 10 900 euros, we will have a profit of 400 euros (11300 – 10900 = 400).
The results for both your “high profitability” option and the TOC option can be seen in Table no. 7.
Table no. 7.
|Option with “high” profitability||TOC option|
|The selected set of products||60 gab. A + 30 gab. B||40 gab. A + 60 gab. B|
Q: Now I don’t understand anything! How can it be that we make a loss by producing a product with higher profitability, but make a profit with lower profitability?
G: You know what’s interesting – I’ve offered dozens or even hundreds of good entrepreneurs to do this exercise, and most of them can’t make a profit. In fact, in 2005, I myself caused serious losses when I first performed a similar TOC Accounting (Throughput accounting) task.
Now imagine a real business with hundreds of products and dozens of operations where not all business conditions are perfect as in our example. What is the probability that the manager can make the right management decision that will bring him more profit?
Q: It seems to me that the probability is close to zero!
G: The conclusion from this can be that our managers who run profitable companies (except those who “know-how”) are, on the one hand, heroes who do the impossible with their intuition and hard work, and, on the other hand, wastes, who stand on big money and don’t even see how it can be lifted!
There are other conclusions:
– Even if you run an “Ideal Company”, it does not mean that you can do it successfully if you do not know how and are guided by existing paradigms of decision-making, cost, profitability.
– In all likelihood, the reason why your business isn’t doing as well as it could is not something from the “External Reasons page”, but simply because you don’t know how to do it right.
Q: Now I have started to better understand your thesis from the first “Dialogue” about the fact that each system (business) has an internal simplicity and that you can find the point at which you can immediately achieve the maximum result. Is there a method that allows you to immediately figure out which of several products should be produced first to get the maximum profit?
G: Of course! Besides, solving such an exercise with two products usually takes 30-40 minutes and the result in 80% of cases the audience is negative or erroneous. After demonstrating the two basic TOC accounting formulas, all participants in the exercise can make the right decision on which product combination of the 6-10 products to offer should be produced, in one to two minutes!
Q: It all looks fictional, but in practical life, our companies are not perfect. Often we do not have the number of orders we cannot produce, and often we lack the money to pay all bills without delay.
G: Exactly. It is in this situation that the power of TOC becomes even more pronounced! Look at what you have just said, on the other hand, the company lacks money but has a lot of spare capacity. In my view, this means that the narrowing of the system is no longer in production but in sales. Why can’t the sales share sell more?
And please, now we will not talk about the fact that they do not know, do not know the customer’s wishes, do not talk to customers, we do not have sales specialists at all, there is huge competition, and so on. This is a separate topic of conversation called TOC sales and marketing.
Q: Okay, but how to solve this problem?
G: First look at this situation through 5FS, or the Five Focusing Steps we talked about in our second dialogue, and take steps that can expand system throughput through the new bottleneck. However, as we talked today about TOC accounting, I offer to look at the situation solely through the financial aspect. Why doesn’t the company usually have enough orders.
Q: Because customers are not satisfied with the price at which a company sells its product.
G: Exactly, from a financial point of view, price is the most important aspect, although it is always a combination of the best price, quality, and service. Have you ever heard anything from a sales specialist that at the current price you can sell no more than 50 units, but if there was a 15% discount, 100, and if the production could produce products at 30% lower price, we could export to country X and sell 1000 and more units there?
Q: Of course, but we can’t sell the product below cost!
G: Just like in your exercise you wanted to produce a “profitable” product A instead of a product B “at a higher cost”? And what is the result?
Q: Are you saying that TOC can also be used to define pricing and sales policies?
G: Of course! And it is a must!
In this case, TOC allows you to quickly decide on the optimal price and sales balance for all products sold with maximum profit. Really, and how much discount can you give in exchange for increasing the volume of the order, so that as a result it would bring the company the maximum possible profit at this stage? In case the market situation changes (your sales and marketing have worked well) – how can you increase your profits and what is the new price and volume balance?