1st QUARTER 2014
45
Goldratt believed, as do many in manufac-
turing, that the cost of the business, exclusive
of strictly variable costs, is the cost of capac-
ity, and all the assets devoted to manufactur-
ing are part of it. He detailed his concept
(which will soon sound familiar to financial
executives) as the management of T, I, and
OE. The concept subsequently morphed into
“Throughput Accounting.”
T, I, and OE
“T” stands for “throughput” in Goldratt’s for-
mulation. For many manufacturing managers,
throughput is a proxy for volume, whether that
volume is sold or banked in inventory. The
Goldratt formulation considers throughput as
the net value of revenue less the money spent
in obtaining that revenue. The money spent on
obtaining revenue represents only those costs
that bear a direct relationship to production of
goods that are sold
. Therefore, only such costs
as direct materials, subcontract services, utili-
ties, commissions, and freight are included.
Those of us who are financial executives will
recognize these as truly variable costs, with
curve of production and “throughput” as vari-
able gross margin.
“I” stands for all the net assets of the manu-
facturing enterprise. It is further defined as all
the money invested in the things the “system”
intends to sell. Goldratt saw the enterprise as a
system designed to add value to the company.
TheThroughput Accounting definition of
assets has a wrinkle that financial managers
should be aware of: Inventory contains no
capitalization of non-materials costs because
this practice adds no value to the company.
“OE” stands for operating expense. Oper-
ating expense in the lexicon of Throughput
Accounting means all the expenses of the
enterprise except those deemed to be vari-
able (those included in the calculation of
throughput). We might think of these as the
infrastructure cost necessary to running the
business and producing goods for sale.
Though termed “accounting,” Throughput
Accounting flouts the conventional GAAP
model of capitalizing labor and overhead into
inventory. It is, in fact, contribution margin
accounting on steroids.
What Do We Sell?
The temptation of manufacturing people
(whether employed in the factory or elsewhere
in the company) is to answer the question of
“what do we sell?” in terms simply of products
andmarkets when, in fact, we are selling the
capacity tomanufacture. In this sense, OE
becomes the operative problem to be managed,
for it represents “capacity.” It therefore behooves
one to optimize the generation of throughput
over the capacity. While it may seem simplis-
tic to say that we merely sell capacity when it
requires product development andmarketing
to do so, it is vitally important to coordinate
the company’s offerings with optimal use of the
capacity. It is also essential that manufacturing
managers recognize that management of the
capacity is equally vital.
There are numerous examples of “sell-
ing the capacity.” Airlines are selling the
capacity to transport passengers in which
airplanes represents capacity. Before de-
regulation, airlines optimized “throughput”
by charging high prices on flights that were
rarely full. In the deregulation environment,
they obtain throughput by restricting capac-
ity (i.e., the air fleet) and getting all the seats
filled using variable pricing to do so.
Similarly, a paper manufacturer will seek
to keep the capacity utilized by structuring
products that keep the mills running and
taking incremental business only slightly
related to their main product lines. Airlines
and paper companies are highly capital-
intensive businesses, but service companies
and light-manufacturing shops face the
same problem of utilization. For example,
the professional services firm establishes
a capacity infrastructure of high-quality
professionals to meet the needs of its clients
and then needs to generate throughput to
utilize that capacity.
What Do We Make?
The temptation is to define what we make in
terms of parts, subassemblies, and finished
products. To return to
The Goal
, what we are
supposed to make is money. The question of
how we sell the capacity to do so in a coherent
and consistent fashion is one often asked, with
emphasis on the coherent and consistent part
of the question.
The answer is strategic and requires that
manufacturing and marketing tactics are
fashioned to support a “sell the capacity/make
the money” strategy. Also needed are simple
metrics to present the results in a manner that
supports and reinforces the strategy. Such a
strategy designates capacity as the relevant
resource to be managed, and all sub-strategies
and tactics flow from this “goal.”
The strategic goal of capital-intensive
industries, such as paper manufacturing, is to
insure that the mills never go down, not only
because the cost of starting and stopping
them is excessive, but because of the financial
need to amortize the large fixed investment
in capital assets that they represent. Such
companies often structure their product
offerings to insure a very high rate of utiliza-
tion of the producing assets. The modern
manufacturing company is, in fact, a large
fixed investment. Perhaps not all of them
have capital tied up in fixed assets to the same
extent as paper companies, but certainly
21st-century manufacturing companies are
investments in the infrastructure of human
resources, systems, buildings, and machinery.
Almost the entirety of this infrastructure is
a “cost of being in business,” or what Goldratt
would call OE. What remains in the money-
making equation is to maximize throughput
(T in the Goldratt construct). In conven-
tional accounting terms, financial executives
would simply say: Maximize incremental
gross margin to cover the factory overhead
and the SG&A to make the money. However,
in Throughput Accounting, there is a little bit
more to it than that.
THE COST OF
BUSINESS, EXCLUDING
VARIABLE COSTS, IS
THE COST OF CAPACITY,
continued on page 46
