Theory of Constraints: “Throughput Accounting” Gives Company Their First Profitable Year Since 2008!

Changes to Decisions About “Customer Pruning” Quickly Yield a Turn-Around

The founder and owner of this specialty foods company, created the company in her kitchen in 1984, out of her passion for great tastes and the seafood traditions of Virginia’s Chesapeake Bay region. In 2007, she had a challenging, but profitable $2.5 M retail, wholesale and internet sales business, when the Great Recession of 2008 hit. Over the next five years, she operated at a slight annual loss, keeping the business afloat through bank loans and personal credit cards to buy supplies and make payroll.

The Problem: In 2014, the owner of this company asked Steve Holcomb, a local performance excellence consultant, if there was a way to return to profitability, without “spending a fortune”. In recent years she had tried applying “Lean” techniques to her order fulfillment operations. It improved organization and safety, but failed to restore profitability.

During the period beginning in ’08, she and her Sales and Finance leaders made several important operational decisions, based on traditional GAAP accounting analysis, to try to return to profitability. Those decisions included “pruning” two wholesale distribution channels that GAAP cost-benefit analysis found to be high-cost, low-profit. Five years later, by mid-2013, profitability still eluded them.

What they needed was an effective way to judge the impact of operational decisions on profitability (e.g. decisions about purchasing, inventory, pricing, staffing, production methods, promotions, sales channels, etc.), and then a way to monitor the actual daily effect of those decisions using available operations data.

The Solution: Steve introduced company leaders to a little known operational accounting method[1]. “Throughput Accounting” (TA) helps leaders evaluate impact of operational decisions on profitability before they are made. TA then helps leaders monitor actual impact of each decision on profitability, so adjustments can be made. TA uses three key metrics to evaluate each decision, calculated from existing data: Throughput (T), Investment (I) and Operating Expense (OE), as shown in the following figure. From these, it’s possible to estimate other traditional financial metrics for day-to-day decision-support. TA is not intended to replace GAAP accounting, required for audit and tax purposes. It is simply a way to help leaders make the best daily operational decisions for greatest business performance.

Steve taught TA to the company leaders from the book Throughput Accounting[2]. Other excellent references include those by Du Plooy[3], Caspari[4] and others.

After training, Steve helped company leaders build a simple TA Excel file to analyze the effect of possible decisions on Throughput, ROI and Net Profit, using existing data about their ~100 product SKU’s. The Sales, Marketing and Finance leaders then identified and evaluated several possible operational decisions for return to profitability:

• Offer tiered freight discounts for wholesale distributors *
• Restore two distribution channels “pruned” under GAAP *
• Negotiate better terms with a prospective wholesaler *
• Raise prices selectively on some items with low “T”
• Aggressively resolve delinquent accounts, to quickly generate “T”
• Implement capabilities for self-packing of several key products
• Change the way products are sold through the internet

The Results: This TA analysis encouraged the company leaders to quickly implementing four low-cost decisions, out of nine considered (* shown above, and four of the yellow boxes shown on the “2013 & 2014 THROUGHPUT / WEEK (actual)” scorecard at the top of this article). Two of implemented changes were to reverse past decisions to “prune” two important distribution channels. GAAP analysis had shown these to be high-cost, low-profit, but TA analysis confirmed them to be highly profitable. The scorecard (top figure) shows a comparison of the results in 2013 and '14.

Perhaps the greatest change was a shift in thinking that affected every aspect of the business. A shift away from focus on Revenue, to focus on the Throughput “margin” contributed by Revenue to "overcome the enemy" of Operating Expense. The Sales & Marketing VP characterized this as a shift from “It’s all about Revenue!” to “It’s all about Throughput!” Eli Goldratt, inventor of TA, expressed this idea in another way; “. . . doing work and profiting from that work are two very different things.”

[1] Theory of Constraints Throughput Accounting (TOC TA)

[2] Thomas Corbett, North River Press, 1998

[3]Throughput Accounting Techniques Etienne Du Plooy, General Media Press, 2016

[4]Management Dynamics: Merging Constraints Accounting to Drive Improvement John & Pamela Caspari, Wiley, 2004

Other References:

Dr. Lisa Lang also offers helpful TOCTA resources and training on her “Science of Business” website, including this ~1 minute silent video titled "The Top Financial 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 about Velocity Scheduling System for custom job shops and machine shop? Visit www.ScienceofBusiness.com.

Another excellent resource is the chapter on “Evaluating Change” on Dr. Kelvyn Youngman’s excellent website at www.dbrmfg.co.nz (linked to the picture below).