Throughput Accounting: Basics (#43)
/In this podcast, we cover the basic concepts of constraint management, including the bottleneck, inventory buffer, sprint capacity, and throughput. Key points made are noted below.
This is the start of a five-part series on throughput accounting. This is a nifty topic that’s rarely covered in school. Partially, I think, because it goes against the grain of a lot of the other accounting methodologies. One bad rap it gets is that it only applies to manufacturing, which is absolutely not the case. So, if you were about to delete this podcast because you don’t do manufacturing, you might want to wait a little bit longer.
First, I’ll give an overview of the main throughput concepts, and then in later episodes, I’ll describe how you apply it.
The Theory of Constraints
Throughput accounting is based on the theory of constraints, which says that one percent of all events causes 99 percent of the results. That one percent is the bottleneck operation, which controls the profits of the entire company. The bottleneck is also called the drum, because it sets the pace for the entire company. If the bottleneck is well managed, then profits are high. If not, then profits drop. If you focus all of your resources on making the bottleneck as absolutely efficient as possible, then you will make more money. On the other hand, if you invest dollars anywhere else in the company but leave the bottleneck alone, then you’ve essentially just burned all of those invested dollars.
For example, if you implement a massive company-wide efficiency improvement campaign, only the portion that impacted the bottleneck will actually improve the company’s total output, even if the entire company became more efficient.
Let’s continue with the example. Let’s say that the efficiency campaign was extremely effective in improving the processing speed of a machine located ahead of the bottleneck operation, so that it can now produce twice as many parts. That’s just great. The trouble is that the bottleneck cannot handle all of the extra parts, so the new production just piles up in front of the bottleneck. The net result is that you’ve now invested in more inventory than you had before. Or, to look at it another way, you would have been better off not to have improved that upstream operation.
Now, I already mentioned that throughput does not just apply to manufacturing, so let’s look at it from the perspective of the sales department. The CEO wants more sales, so he authorizes the hiring of more sales people. The new employees are very effective in obtaining customer interest in the product, but now the sales technician who conducts the demos is completely swamped. And customers won’t buy the product until they’ve been through the demo. So once again, we have a bottleneck – it does not allow sales to be completed, and it’s not even in the manufacturing area.
The Buffer
That was the drum, or bottleneck, and it’s the central part of throughput accounting. However, you also need to know about the buffer. There needs to be a buffer in front of the bottleneck operation, because you maximize profits if the bottleneck is always running, and you need on-hand inventory to ensure that it always runs. If there’s no buffer, then the bottleneck may sometimes run out of work, and that loss in productivity drops straight to the bottom line. So, this is the one place in the company where inventory is good. Most accountants are trying to eliminate inventory from their companies, because it’s a waste of working capital. But if you do that to the inventory in front of the bottleneck, you’ve just cost the company a pile of money.
The same concept applies in my earlier example with the sales technician. If someone cancels a demo, then someone should immediately reschedule a demo into that time slot. Otherwise, the sales technician’s time has been permanently wasted.
The Rope
There’s one more concept to address, which is the rope. The rope is the method used to release inventory into the production processes ahead of the bottleneck. The trick is release inventory just in time to ensure that the bottleneck and its buffer are fully supplied with the correct amounts of work-in-process inventory.
If the rope releases inventory into the system too late, then the bottleneck will be starved of work, and the company loses money. Conversely, if it releases too soon, then you choke the system with too much inventory. The rope has a lot of similarities to a just-in-time manufacturing system.
Once again, you can use the rope concept outside of the manufacturing area. Getting back to the sales demo scenario, it’s the job of the sales personnel to keep a steady stream of fully qualified customers lined up, ready and waiting for their product demos.
Taken together, these three concepts are called the drum-buffer-rope system in the theory of constraint management.
Sprint Capacity
In addition, there are two more terms to be aware of. The first is called sprint capacity. This is the ability of upstream work centers to generate a lot of output fast when the buffer in front of the bottleneck is used up. This happens when you have a machine failure or a labor shortage that reduces the flow of inventory to the bottleneck. If you have enough resources to scramble and rapidly fill that pipeline before the bottleneck operation runs dry, that you have excellent sprint capacity.
Once again, the accountant is usually trained to screw up the sprint capacity system. To the accountant, there appears to be too much production or labor capacity sitting around, which – they think – is costing the company too much money. In reality, you have to look at where the capacity is located. If it’s ahead of the bottleneck, you may very well want to keep it, whereas if it’s after the bottleneck, it might be a good idea to sell it.
Throughput
And the final term – you may have noticed that this podcast is about throughput accounting, but I never defined throughput. Throughput is the margin that’s left after you subtract the totally variable cost of a product from its selling price. This usually means that the variable cost is strictly the cost of materials that go into a product, and nothing else. It does not include overhead, it does not include direct labor.
In a throughput costing environment, our job is to maximize throughput dollars. Since the bottleneck drives the amount of product that we can produce, the key factor is the minutes of time required to get a product through the bottleneck operation, in relation to the amount of throughput dollars you earn from the product.
That sounded a little too theoretical, so here’s an example. You can earn $100 of throughput from the sale of one unit of Product A. That product requires 10 minutes of processing time at the bottleneck operation, so you can earn $10 per minute of bottleneck time used. On the other hand, you can earn $60 of throughput from the sale of Product B, which requires 4 minutes of bottleneck processing time. So for Product B, you can earn $15 per minute of bottleneck time used. This means that the company will earn more money in total if it can push more of Product B through the bottleneck, even though Product A appears to make more money per unit.
This last concept is the whole key to throughput accounting – you have to identify the bottleneck, which is not always an easy thing to do, and then make sure that the right product flows through it. Pretty obviously bottleneck management is key, and that’s why it’ll be the topic of the next episode.