Take it to the limit

Just in case you needed proof that accounting can tell you most things you need to know about your business, today we're having a look at a management accounting concept which - slightly adapted - can be a tremendous help in accelerating your growth as a business.

But before we get into the exciting management accounting concepts...I know you can hardly wait...let me ask you a question.

All things being equal, which would you rather have: 10 jobs, each of which was 10% complete, or 1 job 100% complete and 9 jobs 0% complete?

In most organisations, the answer is the first one.

Or at least if you look at what they actually do, rather than what they say, it's the first one.

In every organisation there are people pootling away on activities of one sort or another which might not be entirely without merit, but which, at that point in time, make very little difference to the future of the organisation.

Let me illustrate: if I spend my time today writing up a revised expense claim policy, I might be busy enough. But when did you last work in an organisation where the lack of an updated expense claim policy was the biggest problem that stopped the organisation reaching its goals?

Probably never. But I bet you've sat in lots of meetings about activities like this before now.

Time ebbs away regardless, but the truth is whether you update your expense claim policy today, tomorrow, or a year from now, your business is unlikely to succeed or fail purely based on the state of your expense claim policy.

However by the end of the day, you might have a 10% completed project. Alongside a range of other 10% completed projects.

The likelihood of all those projects being equally valuable to your business is pretty much zero.

Yet, by the end of the day, they're all 10% complete, with completion dates staggered out over the next few months depending on when the board gave you a deadline for.

The exciting bit of management accounting

Given that backdrop, management accounting has a helpful perspective to offer.

Fear not, I'm not going to go too deeply into the technicalities. I just need to introduce you to a concept called "the limiting factor of production".

This is a really important concept in management accounting because your costing system should be designed to maximise the output from whatever the limiting factor of production is. (By the way, exactly the same principles apply in the service sector, I’m just using a manufacturing example here because most people find that easier to visualise.)

Let me illustrate.

In a factory, there are three machines. To produce our products, we need to take the raw materials through each machine in sequence.

Machine A has the capacity of 10,000 units an hour. Machine B can handle 5,000 units an hour. And Machine C has an 8,000 units an hour capacity.

What this means for costing purposes is that you need to base your cost models and pricing on a maximum output of 5,000 units an hour, because that's the fastest that your limiting factor of production (Machine B in this case) can produce.

Put another way, given the nature of our production process, here we have one project (Machine A) running at 50% of capacity, Machine B is at 100% and Machine C is at 62.5%.

That's the optimum output, and the maximum machine utilisations, for your factory under those conditions.

Flipping that around

Important though that is for the accounting nerds among us, that's not what we're primarily concerned with today.

Once we identify our limiting factor of production (Machine B) we have a range of strategies open to us.

For example, if we bought an identical machine to Machine B, we would presumably increase our output from the "B" section to 10,000 units an hour (2 x 5,000 units per hour), so that it matched up with the production rate of Machine A.

In that scenario, Machine C is now our limiting factor of production, because that's not going to run faster than 8,000 units an hour, even though both Machine A and Machine B (x2) can now handle 10,000 units an hour.

If we forget about the excitement of management accounting for the moment, what does this tell us about the company's priorities?

Well, in this scenario, any time invested to improve the output of Machine A is completely wasted, as is any time spent doing the same to Machine C. No matter how much better those machines run, your factory will still never produce more than 5,000 units an hour because that's the maximum throughput of Machine B, your limiting factor of production.

Linking back to where this article started, by far your biggest business priority should be working out ways to improve the output of Machine B or, as in this case, just buying another identical machine to double the "B" section's throughput.

In fact, anyone doing anything other than fixing the "B" section problem is by definition incurring cost for the business without generating any upside.

Will rewriting the expense claim policy fix the Section B problem?

Or the all-staff, offsite awayday?

Or the digitising the paperwork archive in the finance department to save on external storage costs?

No, they won't. But those projects will rumble on in the background anyway, clocking up time and cost without actually fixing the biggest issue holding your business back at the moment.

It's not as simple as this

Of course, it's not quite as simple as this. I've just expressed the problem in fairly stark terms to make the point.

I don't suggest you pay your corporation tax six years late "because we were doing more important jobs". HMRC tend to take a dim view of that sort of thing.

But it does illustrate the way that most organisations are happier rumbling along with a jumble of 10% completed projects when they would nearly always be better concentrating all their efforts and resources on the biggest problem in the business instead, and doing their best to fix that.

The biggest problem in the example above is getting more throughput in Section B. Nothing else in your business even comes close at being able to generate better bottom line results.

Let's imagine the all-staff, offsite away day was organised months ago and is taking place next Tuesday.

Next, some insightful CFO (ahem...) explained the concept of limiting factors of production to you.

Then you hear that the suppliers of Machine B are in the country at the moment and could meet you next Tuesday afternoon to talk about selling you another Machine B. However, they need to get a flight home on Tuesday evening and won't be back in the UK for another month after next Tuesday.

Now what do you do - cancel the awayday and meet with the supplier, or have the awayday and catch the supplier in a month's time when they're next passing through?

Put in those terms, the obvious answer is to cancel the awayday, even if you have to pay some cancellation charges to the venue, because the upside to your bottom line of getting a second Machine B at least a month earlier, based on the hypothetical numbers above, is almost certainly greater than the cost of another day's room hire for your offsite.

That's the obvious answer in terms of your bottom line, but I haven't worked at many places where that's the decision they would have taken.

Because the away day has been in everyone's diaries for months, and finding another day the whole board can all be together again will be tricky, and because no-one wants to upset the team who had put all the away day activities together...that's what gets prioritised.

None of those reasons are completely without merit, of course.

It's just that compared to increasing your factory's output from 5,000 units an hour to 8,000 units an hour (i.e. the maximum capacity of Machine C, which has now become your limiting factor of production), nothing else you can do is likely to have anywhere near the level of bottom line impact as meeting the Machine B suppliers next Tuesday.

Knowing me, knowing you

Knowing this dynamic is in play, let's go back to the original question.

Which would you rather have: 10 jobs, each 10% complete. Or 1 job 100% complete and 9 jobs 0% complete?

If the job you had focused on to the exclusion of everything else was sorting out another Machine B in our factory example above, then you'd much rather have that than ending the day with 10% of the Machine B sorted out, alongside 10% of the new expense claim policy and 10% of the agenda for the all-staff away day.

Equally, if your business had sorted out 100% of the away day agenda, but hadn't even made a start on buying a new Machine B yet, I'd seriously question the wisdom of that decision.

In most organisations, though, the acceptable way forward is to have 10% of 10 jobs done, rather than 1 job 100% complete.

All sorts of tasks - each of them worthwhile in their own way, and championed by people who mean well - take time, energy and effort away from what should be your organisation's number one objective.

Because they don't understand how limiting factors of production work, most organisations would give their HR Manager a bonus for organising a wonderful away day, but they would fire the HR Manager if, at their appraisal, they said they hadn't done any of the objectives set in their last appraisal because they'd spent 100% of their time helping Bob in Production buy a new Machine B instead.

In reality, if you cared about your bottom line, you'd give your HR Manager a bonus for pitching in to help deliver the single most bottom-line enhancing project your company needed delivering this year, and fire them if, while a huge opportunity went unattended to, they were fiddling around organising the menu for the away day.

A life of their own

This is a problem with organisational structures. While they are helpful to an extent...necessary even...they often get in the way of what really needs doing.

That's because, once you set up a Marketing Department, or an HR Department, or a Finance Department they will find things to do in order to keep the people in that department busy.

So someone will be organising the away day, someone will be rewriting the expense claim policy, and so on. That's the way organisations are set up to operate.

Set up a Department X and inertia takes over. In no time, Department X will be taking up time and energy in your management infrastructure and further reduce the focus on the Machine B project.

Department X will take up airtime and energy in management meetings, which will tie up people for longer than they were before. Time that could have been spent on Machine B.

And that's because the Head of Department X only has the objective of doing "Department X stuff". Whether or not Machine B ever gets sorted out isn't their problem - it won't interfere with their promotion prospects or pay package in the slightest.

For that reason, while it's not a perfect model, when you think about bringing in more people to your organisation, or get persuaded that "you really need a Department X here because all our competitors have one", you should ask yourself one simple question.

"Will doing this help us reduce the impact on our business of our limiting factor of production?"

Now, that presupposes that you know what your limiting factor of production is, which many organisations don't. Or to the extent that they think they do, it's something that might be superficially true but isn't actually the real issue.

During my time in the education sector, an organisation I worked with put a lot of store in making sure that student behaviour was clamped down on to "stop troublemakers" as that was seen to be the biggest issue for their bottom line. The amount of reporting and staff appraisal energy which went into this was considerable.

And although, in isolated instances, poor behaviour was an issue, it had nothing close to the bottom-line impact of running courses which were impossible to make money on - if we needed 30 students to take a course at the level of income we received from the government, but our biggest classroom only held 20 students, that's a guaranteed sea of red ink on the bottom line no matter how good or bad any student's behaviour might be.

Because the limiting factors of production weren't used in this organisation as a basis for making management decisions, much more effort was put into selling these guaranteed loss-making courses than was put into selling courses we could make a profit on.

The question to ask

For that reason, every time you are presented with a request to spend money or hire a new staff member, there are only two things you need to do before making your decision.

Firstly, refresh yourself on what the limiting factor of production really is inside your organisation.

Then, ask yourself whether the proposed action takes you closer to eliminating, or at least minimising, the impact on your bottom line of whatever your limiting factor of production.

If it doesn't, think twice about spending the money. However well-intentioned the request is, you're almost certainly going to generate sub-optimal returns on your investment.

I don't use AI to write my articles, so if you see a spelling mistake, or think I'm barking up completely the wrong tree, it's all my own work, not the hallucinations of a third-rate algorithm.