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Cost accounting is an organization's internal method to measure efficiency. Since no one outside the organization uses such internal accounts for investment or other decisions, any methods that an organization finds helpful can be used. Outside parties in the U.S. depend on accounting reports prepared by financial (public) accounts under Generally Accepted Accounting Practices (GAAP) issued by the Financial Accounting Standards Board (FASB) and enforced by the Securities and Exchange Commission (SEC) and other regulatory agencies.
Throughput accounting claims to improve management decisions by using measurements that more closely reflect the effect of decisions on three critical monetary variables (throughput, inventory, and operating expense -- defined below).
When cost accounting was developed in the 1890's, labor was the largest fraction of product cost and workers might not know how many hours they would work in a week when they reported on Monday morning. Cost accountants, therefore, concentrated on how efficiently managers used labor since it was their most important variable resource. Now, however, workers who come to work on Monday morning almost always work 40 hours or more; their cost is fixed rather than variable. Many managers are still evaluated on their labor efficiencies, though, and many "downsizing," "rightsizing," and other labor reduction campaigns are based on them.
Goldratt argues that, under current conditions, labor efficiencies lead to decisions that harm rather than helping organizations. Throughput accounting, therefore, removes standard cost accounting's reliance on efficiencies in general and labor efficiency in particular from management practice. Many cost and financial accountants agree with Goldratt's critique, but they have not agreed on a replacement of their own and there is enormous inertia in the installed base of people trained to work with existing practices.
The concept of throughput accounting
Goldratt's alternative begins with the idea that each organization has a goal and that better decisions increase its achievement that 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 uses three measures of income and expense:
- Throughput (T) is the money the system receives for products that are sold. Throughput replaces output, a variable that can be manipulated to make financial accounting statements more attractive to investors. Output that is delivered to a warehouse rather than a customer does not count.
- Inventory (I) is the money the system has invested in things it intends to sell, money which it cannot use for another purpose until then. In addition to conventional fixed costs like buildings and machinery, electricity, labor, adhesives, lubricants, and many other items that usually count as variable costs are part of Inventory.
- Operating expense (OE) is the money the system spends to convert inventory into throughput. OE is variable cost in the strictest sense; raw materials and components that go into a product is the best example.
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 (money coming in)? How?
2. Reduce Inventory (money that cannot be used)? How?
3. Reduce Operating expense (money going out)? How?
The answers to these questions determine the effect of proposed changes on system wide measurements:
4. Net profit (NP) = Throughput - Operating Expense = T-OE,
5. Return on investment (ROI) = Net profit / Inventory = NP/I,
6. Productivity (P) = Net Profit / Operating expense = NP/OE, and
7. Inventory turns (IT) = Throughput / Inventory = 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.
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