Inventory: asset or liability? Let's judge it with Throughput Accounting

Theory of Constraints and Throughput Accounting

In this blog we will try to explain in a simple way and with practical examples how a modern management approach, such as the "Theory of Constraints" and its accounting legacy, the "Throughput Accounting", is an innovative tool to help companies and entrepreneurs creating value.

Throughput Accounting: maximize value creation with the Theory of Constraints

Let's start with a frequent and very common problem. How many times, compared to certain operating results, are the CFOs, CSOs and COOs discussing the numbers of economic results with immense surprise?

Why, for example, despite an exceptional year in which above-average sales led to a reduction in inventories, do we find ourselves discussing an economic result that is "surprisingly" below expectations, if not even negative in the worst case? And with the company’s controller that, supported by complicated Excel sheets full of numbers, trying to climb a glass-tower in an attempt - often in vain - to explain what might have happened and with other frustrated interlocutors who will not really understand what has been done wrong in the end.

We will explain how the root-cause of this confusion is caused by the wrong assumptions of traditional accounting systems, with their complex cost allocation mechanisms and why suspending conversion costs in inventory accounts (although required by GAAP), creates conflicts with good practices aiming to reduce inventory.

Let's start with a brief excursus to introduce the cornerstones of the Theory of Constraints, to help understand the logic behind the accounting approach of Throughput Accounting.

The principles of TOC - Theory of Constraints

First published in 1984 in the best-selling "The Goal" by Dr. Eliyahu M. Goldratt, the Theory of Constraints is based on a simple assumption:

"any system or organization, even the most complex, are actually - at a given time - influenced by a limited number of variables, even one, which limit the ability to achieve higher levels of the organization’s goals. These variables are the Constraints".

Unlike traditional additive approaches, that assume that any improvement in any area of the organization strengthens the system as a whole, the Theory of Constraint assumes that it is the Constraint, the weakest link in the chain, that dictates the overall strength of the organization's system, and that only improvements at the Constraint can significantly strengthen the capacity of the whole organization to increase its goals.

From this assumption, descend several principles:

Strongest resources shall be subordinated to support the constraint.
Protective capacity shall be kept at non-constrained resources to support the entire system performance.
Improving an already strong link will not improve much, and perhaps not at all, the performance of the entire system.

Let's take a sports discipline as a simple example: the cycling time trial for teams (very similar to the hiking example used by Dr. Goldratt).

This type of cycling performance requires that the time performance of the team is frozen when the fifth athlete to the finish line.

It is intuitive how a team composed of 4 high performing athletes and an honest rider as the fifth of the team, to improve their performance, should focus on enhancing the performance of the latter, i.e. the weakest link or the constraint.

for instance never using the weakest athlete at the front of the row to break the wind
avoiding to create gaps for the fifth athlete

It is also useless to replace any of the high-performing athletes with an even more performing ones if you do not improve the performance guaranteed by the fifth athlete, replacing him (replacement technology) or increasing his performance (continuous improvement). I think we don't need further explanations.

Several management models have been developed to optimize and improve constraint management to maximize the production of the system's goals, i.e. Throughput. One of these techniques is the production scheduling with the Drum-Buffer-Rope model, according to a logic that foresees the maximization of the constraint productivity. The technique consists in defining the following concepts:

The constraint dictates the beat of the entire system, hence being the "Drum"
The objective is to keep the constraint always productive at its maximum capacity, placing inventory buffers in a strategic way in front of the constraint to ensure that it never goes "idle" for lack of input, and in other strategic points to cover any risks downstream of the constraint.
The planning information flow is seen as a "Rope" pulled by the constraint: in other words, the constraint dictates the planning and the information flow related to the entire system that suboridnates entirely to the constraint's pace.

Similarly, in the team time trial, the team acts to protect the weakest rider, trying not to "squeeze him out" and supporting him if he shows signs of fatigue to prevent him from lagging at the finish line.

Then the Theory of Constraints focuses on Buffers Management as a management tools to execute control of the production flow. But this is not our focus today.

What is important to know here, is that in order to protect the constraint and to maximize the system productivity, it is necessary to make decisions conflicting with common accepted principles of traditional accounting model:

Apart the constraint, other resources shall not be activated at 100% of their availability. Pushing at 100% other resources will only generate excess inventory and WIP, deteriorating the performance of the system.
In order to increase the system throughput, the system flow must be improved. To improve the flow it is recommended to plan for small lots instead of big batches, as this will help reducing lead times and variability.

Principles of Throughput Accounting

In addition to the various management models mentioned above, the Theory of Constraints has also developed an alternative accounting approach - Throughput Accounting - which revolutionizes the concepts imposed by traditional accounting models adopted by the majority of companies, making them more linear and easier to understand and implement, and removing the above conflicts.

Let's start with few definitions.

Throughput, the organization's goal, is identified by the difference between Revenues (R) and Totally Variable Costs (TVC), also known as Truly Variable Costs

The main differences with traditional accounting systems lie in the following areas:

a different treatment of Transformation Costs, and therefore in the evaluation of Inventories (I) and Operating Expenses (OE).
a different priority given to each component.

Looking at the treatment of costs, the founding principle of Throughput Accounting lies in considering transformation costs as derivatives of the decisions taken on the level of Capacity the Company has decided to equip itself with. Therefore, they are not variable in function of the volumes of output, but rather they are fixed costs depending on the capacity levels.

How can someone disagree: just look at the employment contracts. Workers (thanks God) are not paid according to the number of pieces produced, but are paid hourly wages, regardless of the number of units produced. The same applies to heating costs for example: the production areas will be heated regardless of whether 100 or 150 units of a given product are produced. In other words, most of the costs of production resources are linked to their availability rather than their outcome.

Also traditional accounting, when analyzing cost for their nature and behaviors, considers capacity costs as fixed. But then it tries to force those principles with cost allocations, trying to force them as variables using absorption costing.

From a priority point of view also, Throughput Accounting differs greatly from traditional accounting models.

Traditional accounting has a "cost focus" and historically pushed companies to set as primary objective the reduction of operating expenses, relegating the realization and increase of throughput as a secondary objective. This happened (and is happening) simply because:

Operating Expenses are fully controllable and can be uniquely attributed to a cost centre and therefore to a manager. They are the result of a functional vision of the company.
On the other hand, it is more complex to manage Throughput, as it depends on cross-functional processes and it also depends on external variables that are not completely controllable and cannot be assigned to a single manager. Throughput rewards a cross-functional company. But how many companies are really operating in a cross-functional way?

For TOC and Throughput Accounting instead, maximization of Throughput is the primary goal because:

The increase in throughput, through internal improvement actions, has no potential limits, except the market, the latest of the constraints.
The reduction in expenses, on the other hand, has objective limits, since beyond certain levels the reduction in operating expenses leads to deterioration in performance and quality. And because once reached the "zero level", operating expense cannot be further reduced.

Ranked second in term of importance (in the sense of management focus) Throughput Accounting puts Inventory because, in addition to not creating value, it unnecessarily absorbs business resources: without entering in details, all modern management theories (TQM, Lean Manufacturing, Six Sigma and of course also Theory of Constraints) agree in considering excessive levels of inventory a waste.

Throughput Accounting eliminates Bias of Traditional Methods

To fully understand the differences between the two accounting models, let's try to analyze the data over three years for two fictitious manufacturing firm each producing the same 3 products (A, B and C) and each achieving the same production and sales volumes with the same capacity and cost structure.

TR Company runs Traditional Accounting logic, while TA Company adopts Throughput Accounting.

Let's see how the same operational results are differently reported according to the accounting model on the Income Statements and Balance Sheets of the two companies.

Year 1 - The Beginning

Here below the data for Year 1: to not overcomplicate the case, let's assume that there are no initial inventories.

The following are the remaining cost data related to the capacity that, to keep it simple, we will keep constant for all three years. Yearly data, for simplicity, have been calculated multiplying for 52 weeks the weekly data (to simplify we have assumed flat capacity over the year, without any closing / vacation period). We have also assumed that labor cost per worker is a flat rate common in every department to keep data simple.

TR Company, according to traditional accounting system the company would report these figures, with a profit of €45,782 at the end of Year 1.

Traditional accounting - TR Company PL year 1

Of a total of €858.000 Operating Expenses, €604.218 have been absorbed to product sold in the Cost of sales and €208.000 have been reported as SG&A.

Let's see what happens to TA Compamy with Throughput Accounting.

Throughput accounting - TA Company PL year 1

TA Company does not report any profit nor loss: it has reached breakeven. Why this difference? The reason is simple:

With traditional accounting TR Company is suspending the transformation costs of the inventory produced to the inventory accounts in the Balance Sheet. These transformation costs incurred during the year but suspended to the balance sheet amount exactly to 45,782€ of profit highlighted.

Traditional accounting - TR Company BS year 1

While TA Company, with throughput accounting, is reporting all its transformation costs into the Income Statement as Operating Expenses, while only the direct materials costs of the accumulated inventory have been suspended to the Balance Sheet.

Throughput accounting - TA Company BS year 1

Year 2 – Market Situation Is Worsening

Let's go ahead with year 2, keeping all the capacity and production data unchanged for simplicity for both companies, but modifying only the sales data.

With the same production plan and the same capacity, we find that the two Companies have worsened their sales performance on Product C due to a demand reduction, which compared to year 1 has moved from 5.000 to 4.000 units sold with a reduction of 20%

In other words:

each company is producing exactly the same mix and quantities of the year 1
the capacity and the level of operating expenses has remained exactly the same for both
the only difference is that both companies are selling less and thus producing more inventories.

Keeping prices unchanged, we should expect a worst economic performance for both companies. Let's look at the data again.

TR Company reports its result with Traditional Accounting….

Traditional accounting - TR Company PL Year 2

… while TA Company reports its result with Throughput Accounting

Throughput accounting - TA Company PL Year 2

The difference is stunning:

Although sales have worsened, TR Company shows an imporant improvement in its bottom line, which goes from a profit of €45,782 in year 1 to €70,653 for year 2 (a 55% of profit increase). It seems that it is worth to sell less and produce more inventory. Interesting theory, we could increase the capacity in the factory and grant more vacation to our sellers...
TA Company with its Throughput Accounting, on the other hand, shows a considerable worsening of the result, which goes from the break-even in the previous year to a dry loss of 50,000€ a year 2. This seems to be more coherent with the operational results.

Comparing the two different P&L, TR Company has achieved a bottom line results of €120,653 higher than TA Company. How did they make all this money? Let's look again at the respective Balance Sheets to figure it out.

Here below the Balance Sheet for TR Company at the end of year 2.

Traditional accounting - TR Company BS Year 2

Looking at the Balance Sheet we realize that the conversion costs suspended in the inventory now amount to €166,435. If we subtract the €45,782 suspended in the first year from this amount, we find exactly this difference of €120,653.

The Balance Sheet of TA Company continues exposing just the direct materials costs for a total of €145.500.

Throughput accounting - TA Company BS Year 2

Year 3 – An Exceptional Year

Despite the sales data for Product A and B are the same of the previous year, performance for Product C is exceptional: both Companies sold-out the current year production plus the entire inventory pooled in previous years. At this point, one might expect the results to improve for both companies. An exceptional year end business review is expected

Let's see what happened to TR Company. The controller just finished consolidating the numbers and…. surprise.

Traditional accounting - TR Company PL Year 3

The discussion meeting opens with great chaos:

“we maintained the same production efficiency and volumes as in the previous year without spending a euro more”

shouts the COO of TR Company.....

“....we also improved overall revenues by 16% with an additional €182,000 in revenue compared to the previous year, absorbing the entire inventory on Product C, and we find ourselves discussing a reduction in pre-tax income of €64,000. Something is definitely wrong.”

Says the Chief Sales Officer of TR Company, that leaves the meeting blaming against the controller that surely shall have done wrong with the maths.

What about TA Company with its Throughput Accounting? The Company reported a positive profit of €80,000, with total satisfaction of the management and bonuses award for the whole team.

Throughput accounting - TA Company PL Year 3

Now we have learned how to explain this difference:

The increase in sales of Product C has not been sustained by an increase in production, but with the inventory accumulated in previous years.
Therefore, the Profit and Loss statement of TR Company has been flooded with the costs incurred in previous years but that had been suspended as Inventories in the Balance Sheet.

Traditional accounting - TR Company BS Year 3

Looking at the Balance Sheet, it is clear that suspended transformation costs have changed from €166,435 in year 2 to €94,425 in year 3, with a difference of €74,010, which is equal to the difference between the profit of €80.000 shown by TA Company and the profit of €5.990 reported by TR Company.

Throughput accounting - TA Company BS Year 3

TA Company, with its Throughput Accounting model has continued suspending just the cost of direct materials, that for Product C reached 0 at the end of the year as the company has depleted all its inventory accumulated in the previous years.

Let's draw the conclusions

Drawing the sums on the three years of operations it is clear that:

the Traditional Accounting model adopted by TR Company has rewarded inventory accumulation: the Company has enjoyed its higher profits in year 1 and 2, when it has build-up its inventory.
the Throughput Accounting model adopted by TA Company, on the other hand, has rewarded the maximization of throughput and the minimization of inventory: this is evident since TA Company has enjoyed its highest profit in year 3.

One might argue that it is only the effect of different accounting principles, while in fact the results are the same. But the real question we should ask ourselves is: if all theories of modern management, from TQM (Total Quality Management), to Lean Manufacturing, to the Theory of Constraints, agree in considering the production of inventory a waste, an evil to avoid / limit to a minimum, then why are we using an accounting method that:

clearly favors inventory accumulation rather than penalizing it
creates much more complications in the interpretation of data
does not facilitate business decisions, precisely for reasons of complexity and distortions it causes.

Without ignoring moreover that the cost of the inventory is not only an opportunity costs, but it involves huge carrying costs (warehouse spaces, handling costs, insurance, deterioration, obsolescence, pilferage, etc.)

The paradoxes that traditional accounting brings with it are not only many but are also risky. As seen, a company that is accumulating inventory, and with few sales is likely to find itself not only in the paradox of generating a profit, but also:

presumably negative cash flows from operations which must be offset by borrowing third-party capital (to fund such inventory)
to pay financial charges on the borrowed capital
to pay taxes on profits, which are likely to be funded as well generating additional financial charges

And lastly, if for some reason the following years a new technology appears making obsolete the accumulated inventory, the devaluation of that inventory will make the situation even heavier, and maybe the company will be forced to try to place the inventory at a heavy-discounted price if not to scrap it.

Next steps

For now let our controller check all the data again for the next review meeting.

In the next blog we will analyze how profitability analyses are different and we will demonstrate again how Throughput Accounting is superior to Traditional Accounting profitability analyses based on product transformation costs.

An important note: Throughput Accounting does not aim to replace the traditional US GAAP or IFRS accounting standards that must be complied with for public disclosure of information.

Throughput Accounting is a useful Management Accounting Tool, therefore for internal purposes and management business decisions.

At WeeonD, we are experts in Theory of Constraints and we help companies quickly implement Throughput Accounting models. To learn more, please contact us via our website (www.weeond.com/contacts) or by email at info@weeond.com