SUCCESS STORY; Virginia Technology Company Achieves a 4th Quarter Financial Turn Around with "Throughput Accounting"
A Simple Question, Asked of Company Leaders Each Week, Turned A Projected 8% Loss Into a 18% Net Profit in the Last 90 Days of 2020:
“How Can We Be Better Than Before?”[1]
The Problem:?In the final quarter of 2020, the founder of an image capture and processing company in Hampton Roads, Va. asked Steve Holcomb for help in addressing poor financial performance.?Steve began by asking them to estimate their current financial condition (indicated by the yellow arrow on Figure 1). It did not look good.?Company senior leaders estimated they were between level 2 and 3 on this chart; Usually meeting all financial commitments, not always profitable, but not always losing money.
In September 2020, the impossible was needed; A quick financial turn-around in the remaining 90 days of the year.
In the past, senior leaders had always managed company finances according to traditional GAAP Cost Accounting (CA)[2] .?However, they felt that this once-a-month “Cost View” of company performance was leaving them in the dark and slow to act on important daily decisions. As a result, by September 2020 the financial projections for the year were not looking good.?Cash from sales was often not keeping up with variable costs required to “make and sell more product”, and fixed costs to “keep the doors open”.?Additionally, the 2020 COVID-19 pandemic was creating all kinds of new and unexpected business challenges. As is often the case, GAAP accounting was not showing a clear direction for a solution and improved financial performance.
What was needed is a way to judge the impact of day-to-day decisions on year end Net Profit (NP).?Decisions like material purchases, inventory levels, pricing, staffing, production, promotions, sales channels, etc.
The Solution:?Steve introduced the company leaders to a powerful, but little-known method for making better day-to-day business decisions; “Throughput Accounting” (TA) or “Throughput Economics”[3] (TE).?In their first meeting, Steve asked the leaders;
“What is your goal for this company, and how do you measure your weekly rate of goal accomplishment?”
Unfortunately, their answers were somewhat vague.
In the 1980’s, Dr. Eli Goldratt, inventor of the Theory of Constraints and author of The Goal introduced the idea of Throughput Accounting. He proposed that the rate of goal accomplishment in a for-profit company can best be measured as Throughput (T); the cash received for products and services, minus the “truly variable costs” spent to produce and deliver them. In a “for profit” company, the goal is for cash receipts to exceed costs, now and in the future, through the sale of high-quality products or services.?Throughput(T) then, is the weekly or daily accumulation of cash, above the variable costs of products or services sold each week, toward a positive Net Profit (NP) at year end.
Dr. Goldratt once said that a company using TA as their financial management strategy when their competitors do not, would be like someone “competing against blind kittens”.
Holcomb showed leaders how to construct a simple weekly graph of T, OE and NP for their company for 2020, as shown in Figure 2.?The Throughput (T) goal for the year is shown, as well as the timing of three change initiatives (A, B and C), undertaken by this company to try to improve financial performance.
The 2020 year-end goal in Figure 2 can also be represented as shown here in Table 1 (Note:?Values shown in figures and tables of this report are notional currency values, rather than actual company values, although they are proportionally correct.?They are shown without units such as dollars, pounds sterling, crore lakhs, rupees, etc. so they should work in any currency):
At this point, some simple definitions will be helpful.
T = R – TVC
NP = T – OE
After constructing the graph in Figure 2, the team estimated the actual weekly cumulative T (Throughput) for the first 41 weeks of 2020. This was added to the T graph as the dark blue vertical bars, shown in Figure 3. As of 10/4/21, shortly after Holcomb began working with this company, the predicted year-end result of this rate of weekly T accumulation was a negative NP, or a net loss. Accumulated T (Revenue - TVC) by year end was projected to be 8% below Operating Expenses (OE), as shown by the yellow arrow in Figure 3. A disastrous condition! Table 2 shows this same prediction using notional but proportionally accurate values.
At this point in the project, Holcomb began leading the team through weekly meetings for the remaining 12 weeks of 2020 to answer the Important Question;
"What Corrective Actions Shall We Take, to be “Better Than Before?”[1]
Initially, the team identified three simple improvement initiatives, D, E and F shown on Figure 3, to try to “steer” financial performance to a positive Net Profit by year end.
The Results:?Just two weeks later (10/18/20), a huge jump in T was observed because of initiatives D, E and F. This is shown in Figure 4 as the two dark blue vertical bars. Counting ALL cash received by the company each week, including COVID-19 loans and grants made a huge difference in the weekly T performance. This additional cash went straight to T, incurring no?additional TVC. But the act of minimizing material ordered through year-end for things not needed, and weekly review of T performance also played a large part in this quick success.?However, this jump in cumulative T was still not adequate for a profitable year, so more changes were needed. The team identified four more simple changes to try (G - J).
By 10/25/20 the nine initiatives taken so far had moved the company from an “inevitable net loss” to a certain net profit. This is shown in Figure 5 as the five dark blue vertical bars for weeks 10/25/20 – 11/22/20. Leaders had discovered that financial performance did not have to be a “spectator sport”, where everyone helplessly waited for the inevitable fiery crash. They had learned that, even where there was little time left in the accounting year, their quick actions could “steer” T performance and create the possibility of a positive NP. They began to get a bit excited in their hunt for ways to be “Better than Before” in T and NP performance, adding two final improvement initiatives, K and L. These were added in the last five weeks of 2020 but were designed to have a positive impact on T at the start of accounting year 2021.
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Figure 6 shows them ending 2020 with a Net Profit that exceeded Operating Expenses by 18%! This was instead of the 8% loss predicted just three months earlier.?This turn-around was due entirely to the 11 simple actions the leadership undertook in the last 90 days of 2020. It is worth noting that one of the change initiatives, J - "Apply for Rebuild Va. CARES act funds. . . " was not successfully accomplished. Even without this large infusion of cash, which would have gone straight to T, the company still achieved a profitable year. The summary performance values are shown here in Table 3.
Another way to characterize this success story is by looking at their weekly Free Cash Flow (FCF). The formula and calculation of FCF can be complex. But a simple approximation is to take your bank balance this week, minus your bank balance last week. The difference is approximately your FCF for the week. FCF tells you if you are burning through cash or adding to your cash balance.
When this company started work with Holcomb on this effort, their average weekly FCF was negative (burning through cash) and was about equal to their weekly Revenue. In other words, they were burning through cash at about the same rate as weekly cash from sales was coming in. For every 10,000 in sales they earned, they were withdrawing and spending about 10,000 from their cash accounts.
However, by the end of this project in 2020, and continuing into 2021, their FCF has completely turned around and is now positive instead of negative. Today, for every 10,000 they receive in sales, they are adding about 1,000 to their cash accounts; a 110% turn around.
Eli Goldratt, inventor of TA, once expressed it this way; In business, putting people to work, and making money from that work are two very different things. (paraphrase)
After the successful conclusion of the 2020 effort described above, company leaders began 2021 with a new understanding and focus on T, and deployed the performance graph, shown in Figure 7. This graph is updated, reviewed, and discussed regularly by company leaders. Figure 7 shows 10 new initiatives designed by the team to “steer” performance toward a 2021 Net Profit.
2021 Improvement Initiatives:
By the end of June 2021, the “Projected T” for the year in Figure 7 shows a huge “cushion” of safety against the year-end T Goal. This will likely be reduced as material purchases (TVC’s) increase to support production. But since they meet regularly to review this graph, leaders will be able to monitor and react early to unacceptable erosion of this “safety buffer”. Table 4 shows the values associated with the situation as of 5/30/21.
Perhaps the greatest change from this effort was not in the financial performance over two years. The greatest change was the shift in thinking by company leaders, that now affects all aspects of the business.
There is no reason you couldn’t try this for your own business immediately, as described below.
Best Regards for Great Success!
If you want to quickly give it a try, watch this 1.5-minute “how to” video from Dr. Lisa Lang, then try it for yourself.?Don’t worry that her example is about manufacturing job shops.?The principles apply to any business that offers products or services for profit. (If the video link below has problems, browse to https://youtu.be/gBrJF6CcqlA ).
Dr. Lisa Lang also offers helpful Throughput Accounting resources and training on her “Science of Business” website, including this 1.5-minute silent video titled "The Key Financial Dashboard Metric for Job Shops".
? June 11, 2015, Science of Business, Inc. This work is reproduced and distributed with the permission of Science of Business, Inc. Want to learn more? Visit www.ScienceofBusiness.com .
Additional Information:?
Throughput Accounting (TA) or Throughput Economics (TE) help leaders judge the impact of day-to-day business decisions on future Net Profit (NP), through the metrics of THROUGHPUT (T) and OPERATING EXPENSE (OE).?TE then helps leaders monitor actual outcomes in real time, so adjustments can be made.?TE is not intended to replace GAAP Cost Accounting, required by banks and tax authorities.?TE is simply a way to connect leaders at all levels of the business, with the financial impacts of their daily decisions.?TE uses financial metrics that companies already have available in their existing financial data, to evaluate the impact of each operational decision on T and NP and answer the question “How can we be better than before?”.
Figure 8 shows an analogy for how one can think about the flow of cash being monitored in Throughput Accounting / Throughput Economics on a weekly basis.
Average total cash velocity for each weekly period is represented as liquid flowing into and out of a series of tanks, from Cash Receipts at the top, to Net Profit at the bottom.?Figure 8 shows the average notional financial figures for the technology company in this study over the full 52-week period of 2020.?After the 12 improvement initiatives of 2020, average cash receipts of 90,997 per week were being received.??22,736 per week was spent on TRULY VARIABLE COSTS (TVC) such as raw material, components, packing, shipping, and sales commissions.?This leaves a respectable average weekly Throughput (T) of 68,261.?Once again, Throughput (T) is all the money left over from CASH RECEIPTS, after paying weekly TVC’s, where (T = Receipts - TVC).??Accumulated cash from T is then used to “defeat the enemy” of operating expenses (OE), in this case an average of 58,086 per week.?Net Profit (NP) then is the cash left over when OE is paid from T.?NP = T – OE.?In this case, weekly average NP = 10,175 = 68,261 – 58,086.
Perhaps the greatest change from this effort was a shift in company thinking affecting all aspects of the business. A shift away from focus primarily on Sales, to a focus on improving Throughput “margin” contributed by Sales to "overcome the enemy" of Operating Expense.
Excellent resources on the topic include Throughput Accounting[4] by Corbet and those by Du Plooy[5] , Caspari[6] and others.
[1] - Ravi Gilani, Founder – Goldratt India, www.goldrattindia.com , Time and Cash Training Course
[2] - Generally Accepted Accounting Principles – see www.businessdictionary.com
[3] - Throughput Economics: Making Good Management Decisions, by Eli Schragenheim, Henry Fitzhugh Camp, and Rocco Surace, 2019, Productivity Press
[4] -Thomas Corbett, North River Press, 1998
[5] - Throughput Accounting Techniques Etienne Du Plooy, General Media Press, 2016
[6] - Management Dynamics: Merging Constraints Accounting to Drive Improvement John & Pamela Caspari, Wiley, 2004
Enterprise Business Agility Coach
3 年Great article, Steve! You solved my conundrum of how to talk about TA with a technology company without explicitly using inventory as a TA term. A great coupling with TA is the concept of exponential return (https://rich-sevawise.medium.com/exponential-return-the-principles-of-agile-organization-5540b7ec29d5), a concept I learned from Peter Merel while becoming an XSCALE Business Agility coach. The tie in to TA is the key concept of pouring most net profits back into developing new products (or new product feature delighters), instead of using those profits to pay dividends. Amazon and Tesla are great examples of companies with exponential or super-exponential growth in throughput because they've historically poured most available cash into increasing operating expense to create exponential return instead of paying dividends. We need companies to stop thinking of OE as evil!!!
Principal Electrical I&C Designer
3 年Good work Steve! The results demonstrate and bear witness of well through out plan. Your plan has answers all the important defining questions of how, how much, what, when, where, and why... Continued success in the future. Stay positive and test negative! Joseph A. Covington
Championing Technology Delivery with 2 decades of Delivery Excellence | Delivery acceleration with Agile |Driving Continuous Improvement |Global project management
3 年Very well explained . Eager to learn how this can be mapped for service industry like IT
Project Manager at GENEDGE
3 年I received a question in a message from Anil Dosi. I will repeat it here as others might be interested: Anil's Question: Dear Steve, I got little bit confused while going through your article at one place (Figure 3). Vertical blue lines showing some wavy structure. How cumulative T can go down at any moment of time? As I understood it should be up continuously. Kindly clarify on my doubt. Thanks. My Answer: Anil - Thanks for the great question about how it is possible for cumulative T to decline over time.?This happens in any weekly period where T is negative, making the cumulative T decline.?Since T = R - TVC, where R = weekly revenue & TVC = weekly truly variable costs),?T "goes negative" in any week when R is less than TVC.?For example, we might receive 0 revenue one week, but spend 1,000 on materials and 500 on shipping to continue to make and sell product.?In that week T = 0 - (1,000+500) = -1,500.?Hope this helps. - Steve
Digital printing & packaging consultant and advocate for practical sustainability initiatives. Chartered Engineer, M.I.E.T.
3 年Thanks - this a powerful example of the benefits of TA and associated thinking, but it would have been more powerful if it included details of at least some of the 9+ initiatives that turned the situation around. Apart from better cash management (accelerating collections, delaying payables etc), what else helped?