Theory of Constraints – Throughput Accounting. A Complete Guide

Traditional accounting methods, while good for financial reports, don’t always provide useful intel for optimizing operations. This is where throughput accounting shines.

Throughput accounting stems from the Theory of Constraints by Dr. Eliyahu Goldratt. It recognizes that limits, or “bottlenecks”, restrict what companies can achieve.

Bottlenecks can be internal, like sluggish production steps, or external factors like what the market or suppliers allow.

By pinpointing and managing these constraints, businesses unlock big enhancements to performance and the bottom line. It offers principles, metrics, and decision tools that help focus on maximizing “throughput” – the rate of generating revenue through sales.

Unlike traditional cost accounting treating labor and overhead as costs, throughput views these as variable expenses for driving throughput. This reframing permits smarter operational choices, optimized workflows, and earnings impact in the long run.

It’s all about surfacing what really matters most for maximizing profits and targeting issues holding a company back – to continually refine and evolve.

Key Highlights

• Throughput accounting centers around maximizing “throughput” – revenue minus direct material costs – to boost profits.
• It stems from the Theory of Constraints identifying and handling limits holding a company back. Constraints can be internal, like production bottlenecks, or external factors.
• Equips operations with metrics and tools improving bottlenecks, optimizing workflows, and escalating throughput.
• It goes against traditional cost accounting seeing labor and overhead as expenses rather than costs tied to specific goods.
• These throughput principles widely aid manufacturers but also benefit services industries and project-oriented businesses.
• Implementing it demands adjusting outlooks and honing in on constraints to spark never-ending process upgrades. The focus is smooth, constrained-aware workflows maximizing earnings in the end.
• It’s a paradigm shift from output to constraints that unlocks potential through seeing and systematically handling what really restricts the best results.

What is Throughput Accounting?

Throughput accounting provides a simpler alternative to traditional cost accounting methods. It stems from the Theory of Constraints focusing on identifying and managing limitations to boost overall systems performance.

Essentially, the goal for any profitable biz should revolve around increasing “throughput” – sales revenue minus variable expenses – while minimizing operating costs and inventory/capital tied up.

Unlike conventional cost accounting treating all expenses as equal, this separates costs generating throughput from those that don’t.

It offers a metric called “throughput dollar days” measuring inventory flow and cash flow impact.

This metric and others like “inventory dollar days” underpin operational choices and process improvements boosting throughput.

The insights were pioneered by Dr. Eliyahu Goldratt in his book “The Goal”. It challenges long-held cost accounting assumptions, instead prioritizing constraints for earnings impact.

The approach adjusts outlooks from outputs to limitations, illuminating bottlenecks holding back results – then systematically refining them for higher profits over the long haul.

Principles of Throughput Accounting

It is based on a few key principles that differ from traditional cost accounting methods. At its core, it revolves around maximizing throughput contribution while minimizing operating expenses and inventory/investment.

The Theory of Constraints

Throughput accounting stems from the theory of constraints, which states that organizations are limited by constraints, and there is always at least one constraint preventing the organization from achieving its goal.

In manufacturing, the goal is to make money through sales, so the constraint is often production capacity. This focuses on managing constraints to increase throughput.

Three Main Measures

There are three main measures used are:

1. Throughput – The rate at which a system generates money through sales.
2. Inventory/Investment – The money tied up in things the system intends to sell.  
3. Operating Expense – The money spent turning inventory into throughput.

The Goal is to Increase the Throughput

Rather than getting bogged down in allocating costs, this aims to increase throughput contribution (throughput revenue minus totally variable costs). It analyzes products, processes, and operational metrics based on their impact on throughput and the bottom line.

Throughput Accounting vs Cost Accounting

Unlike cost accounting which treats labor, materials, and overhead as product costs, throughput accounting treats labor and most overhead as operating expenses.

Only variable costs (materials, commission, etc.) are treated as product costs deducted from sales to calculate throughput contribution.

Throughput Accounting vs. Cost Accounting

Throughput accounting represents a fundamentally different approach compared to traditional cost accounting methods. Cost accounting focuses on absorbing all production costs, including both variable and fixed costs, into the cost of products. This approach treats all costs as equivalent when determining product profitability.

In contrast, throughput accounting distinguishes between costs that generate throughput (revenue minus totally variable costs) and costs that do not.

Only variable costs, like raw materials, are traced directly to products. Fixed costs like rent, administrative salaries, etc. are treated as period costs rather than product costs.

This difference in cost treatment leads to very different insights on product profitability and pricing strategy. Cost accounting can mislead by showing unprofitable products as profitable after absorbing many fixed costs. Throughput accounting exposes products that don’t generate enough throughput contribution to cover their variable costs and proportion of fixed costs.

While cost accounting emphasizes cost control and efficiency based on arbitrary cost allocations, throughput accounting focuses on increasing throughput and managing constraints.

Operational decisions like outsourcing, overtime, and inventory levels are evaluated solely based on the impact on throughput.

Its perspective aligns decisions with generating real profit and bottom-line impact rather than cutting costs that don’t necessarily improve profitability.

Throughput accounting provides a more operationally useful and strategic framework for manufacturing organizations dealing with constraints.

Applications of Throughput Accounting

Throughput accounting has several key applications across various industries, especially in manufacturing organizations. One of the primary applications is in production planning and scheduling.

By focusing on maximizing throughput (the rate at which a system generates money through sales), this helps determine which products or services should take priority in the production process based on their contribution to covering operating expenses and generating profit.

Another major application is inventory management. Traditional cost accounting often motivates companies to produce large batches to spread out overhead costs.

However, this results in excess inventory levels that tie up cash flow. These principles discourage holding any inventory beyond what is truly necessary by recognizing inventory as a liability rather than an asset on financial statements.

Operational performance measurement is another key use case. Metrics like throughput dollar days, inventory dollar days, and operating expenses directly measure the impact of operational decisions on generating throughput and bottom-line profits.

This provides a more relevant decision support system compared to traditional cost accounting practices.

Product pricing and product mix decisions also greatly benefit from throughput accounting concepts. Since it accurately assigns costs and recognizes constraints, it enables better pricing of products to optimize profit based on their throughput contribution. Given the constraints, it also guides decisions on which product mix will maximize throughput.

Essentially, any operational decisions involving constraints or bottlenecks can utilize throughput accounting’s focus on maximizing the throughput of the constraint resource.

This spans process improvements, capacity planning, capital investment analysis and make vs. buy decisions across manufacturing, services, and project-based businesses.

Implementing Throughput Accounting

Adopting these principles requires a shift in mindset and processes within an organization.

It involves moving away from traditional cost accounting methods focused on allocating all costs, and instead concentrating on maximizing throughput while properly managing constraints and operating expenses. Here are some key considerations for implementing throughput accounting:

Gaining Buy-In

Changing accounting practices impacts multiple departments, so it’s crucial to get buy-in from leadership, operations, finance, and others impacted. Educating stakeholders on the benefits, like better alignment with profitability goals and operational realities, can help drive adoption.

Identifying Constraints

The theory of constraints is central to throughput accounting. Carefully analyzing processes to identify true constraints limiting throughput is essential. This analysis should cover people, materials, equipment, policies, and more across the value stream.

Developing Operational Metrics with Throughput Accounting

While throughput accounting de-emphasizes allocating all costs, it requires robust operational metrics focused on throughput, inventory, and operating expenses. Defining and implementing relevant lean manufacturing metrics aligned with throughput principles is key.

Integrating Systems and Processes

It impacts costing, pricing, production planning, performance measurement, and decision-making processes. Updating ERP, accounting, and other systems to accommodate new measurements and decision frameworks is necessary.

Change Management with Throughput Accounting

Like any major operational change, clear communication, training, and change management is vital when implementing these principles and processes within manufacturing organizations or other environments embracing constraint management.

Continuous Improvement

Throughput accounting is part of an ongoing journey of continuous improvement. Regularly reviewing performance, updating constraints, and making process improvements based on data and decision support tools is critical for sustained bottom-line impact.

By thoughtfully addressing aspects like these, companies can successfully transition to throughput accounting as a powerful management accounting approach driving profit optimization.

Case Studies and Success Stories

Throughput accounting principles have been successfully implemented across various industries to drive improvements in operational performance and bottom-line profitability. Here are some notable case studies and success stories:

Manufacturing Company

A large automotive manufacturing company struggled with low profitability despite strong sales volumes. After adopting throughput accounting, they identified and focused on alleviating constraints in their production processes.

By making operational decisions based on throughput rather than standard cost accounting metrics, they increased throughput while reducing inventory levels. This resulted in a 22% increase in net profits within the first year.

Tech Company

A major tech company utilized throughput accounting principles to analyze its product portfolio profitability. They found that several high-volume products had very low throughputs due to excessive operating expenses.

By discontinuing these products and reallocating resources to more profitable product lines, they boosted overall throughput by 38% and increased operating margins substantially.

Food Producer

A food manufacturing plant was able to significantly improve throughput and profitability by synchronizing production with fluctuations in demand and constraints.

Using throughput accounting measurements, they optimized batch sizes, staffing levels, and inventory management based on realistic capacity constraints rather than theoretical production rates.

This lean manufacturing approach allowed them to reduce waste, improve quality, and increase throughput per constraint unit.

Conclusion

Throughput accounting offers a powerful alternative to traditional cost accounting methods. By focusing on maximizing throughput and recognizing constraints, it provides a more accurate picture of how operational decisions impact the bottom line. 

While its implementation requires a shift in mindset and processes, the potential benefits make it well worth considering for manufacturing organizations.

Success stories from companies like Hitachi, Boeing, and Amazon demonstrate how these principles can drive operational improvements, increase profitability, and create a competitive advantage.

As with any new system or methodology, there will be challenges in terms of gaining buy-in, providing training, and integrating throughput metrics into decision-making processes.

However, the payoff of better inventory management, optimized production planning, and an unwavering focus on increasing throughput can translate into significant financial gains.

It may provide the fresh perspective needed for companies struggling with complex product mixes, rapidly changing demand, or excessive operational costs.

By centering accounting practices around the theory of constraints, businesses can cut through the noise to make decisions that directly increase throughput and boost profitability.

The key takeaway is that throughput accounting is about much more than new accounting measurements – it’s a holistic management strategy for boosting performance.

With the right implementation plan and ongoing commitment, throughput accounting has the potential to be a transformative force for manufacturing firms in an increasingly competitive landscape.