Don’t Let Accounting Mislead Decision Making!

Don’t Let Accounting Mislead Decision Making!

Mark Blackwell, Arkaro

The solution is Throughput Accounting, but let’s understand why cost accounting approaches can distort understanding.

The right tool for the right job

It is important to know when to use a hammer and when to use a screwdriver. A screwdriver will have little impact on a nail. A hammer could be used on a screw, but unlikely to deliver the desired outcome! And so, it is with accounting systems… 

GAAP Cost Accounting standards, such as standard cost accounting, are fit for the purpose of informing investors and helping to file taxes but can be poor for managerial decision making. With GAAP style accounting entrenched in business for 100 years, how can this possibly be?

An alternative to GAAP for analysis and decision making is throughput accounting.

Core to managerial decision making is understanding whether alternative options may be better or worse than the current baseline, including understanding what revenues and costs might change.  Familiar decisions include,

GAAP accounting systems, and especially Activity Based Costing (ABC) accounting, aim for precision by carefully allocating costs down to low levels, as far as products or SKUs. The hope is that this detail will reveal profitability insights for better decision making. Sadly, the analysis is often inaccurate because of this detailed allocation.

Allocated costs may seduce decision-makers into dangerous conclusions like “Hey, if we move manufacturing of this product from our Texas facility to the Florida plant our gross margin goes up from 30% to 40%!” If this difference is due to a truly variable cost like shipping the margin will increase 10%: However, if the margin change is due to an allocation, or depreciation, the gross margin may not change at all, and the decision to move production could be wrong.

Deleting “low-profitability” products will not necessarily cause allocated costs to go away – the costs are simply transferred elsewhere. The effect can be a tail-chasing activity as previously “profitable” products now look less attractive as costs are shifted on to them! 

A key problem with allocating cost - Capacity growth is not linear

Why do allocations work this way? A key principle to appreciate is that capacity, whether it be production assets, or monthly salaries of individuals comes in larger chunks of cost than the decisions being affected. Reducing the workload of a key laboratory technician by reducing the product line will likely have no impact on the monthly salary! The costs do not go away – even though they have been carefully allocated down to SKU level. Likewise, the number of production lines does not grow linearly with volume produced, but in steps.

Capacity growth is not linear - Product Management

When optimising a product portfolio, but with no intent to close a production line, the costs of running the production line must be considered a fixed operating expense. However, a higher-level decision to close or replicate the production line may change these same costs to become variable costs. It all depends upon the level of decision making.  GAAP accounting does not distinguish these cases.

Going back to the plants in Texas and Florida. A move would be rational if it caused the total operating expense to fall. For example, the move decision would allow lower labour costs at the Texas plant, without changing labour costs in Florida.

Throughput accounting,

  • Focuses on what really changes as a result of the decision.
  • Does not allow artificial allocations
  • Does not artificially reduce production cost by booking it to inventory!

Focus on maximising throughput at the constraint

Which is the most profitable product in the table below?

Focus on maximising throughput at the constraint - Product Management

The roots of Throughput Accounting rest with Dr. Eli Goldratt, author of the classic business book “The Goal” which led to the Theory of Constraints (ToC). Recognising constraints and improving throughput (the bottleneck in the Emergent Approach to Strategy) at the constraint is another focus area in this approach.

For many manufacturing organisations, especially with large-scale investments, driving return on fixed assets is key to maximising financial returns. If the organisation were to rent these assets, then it would be clear why a measure of profitability of throughput per unit of time at the constraint would be so important.

So why do we still use gross margin profitability of $ per kg of finished product, and why is so much attention given to $ per kg profitability when investors are also looking at time in quarterly earnings reports??

Throughput Accounting brings emphasis to rate (kg/hour) to show to speed at which money is made on the constraint, hence this approach is also known as Profit Velocity. Another term used is Assignable Contribution Rate (ACR).

Assignable Contribution Rate (ACR)

In Goldratt’s ToC, the constraint may not be on the production line. Other constraints could be availability of working capital, a key raw material, or even the availability of sales representatives’ time. Once identified, similar approach to maximising Throughput rate at the constraint may be made.

Angelica Horst – CEO PGP International, ABFI
Angelica Horst - CEO
PGP International, ABFI

“We hired Arkaro to help us think through some important
business decisions. I was very pleased with the collaboration
between Mark and the PGP Team. I can now see a brighter
future for our business!” 

The shift in thinking needed to move to throughput accounting is not always easy.  This is where an experienced consultant can help embed understanding in an organisation with the help of powerful visualisation tools. Arkaro has seen Throughput Accounting deliver impressive benefits to businesses. Building on years of experience,  Arkaro can work with your teams to exposing insights and accelerate the generation of results whilst leaving lasting capability improvement. 

Mark Blackwell - independent consultant Arkaro

Mark Blackwell

With over 25 years of experience Mark has global line management and consultancy experience across innovation, product management, marketing, sales and supply chain built on strong analytical capabilities and business acumen.   
A 6 Sigma Black Belt, Mark was internal business consultant and productivity business leader in DuPont covering a range of industries including advanced materials, agriculture & speciality chemicals and nutrition & health. 

Mark is based in the Geneva, Switzerland area.