Throughput Analysis

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Throughput Analysis at the System Level

A key concept of throughput accounting is the use of profitability analysis at the system level instead of gross margin analysis at the product level. In a traditional cost accounting system, costs from all parts of the production process are compiled and allocated by various means to specific products. When subtracted from product prices, this yields a gross margin that is used to determine whether a product is sufficiently profitable to be produced. Throughput accounting almost entirely ignores gross margin analysis at the product level. Instead, it considers the production process to be a single system whose overall profitability must be maximized.

The key reason for this difference in perspective is that most production costs do not vary directly with the incremental production of a single unit of a product. Instead, most production costs are required to maintain a system of production, irrespective of the number of product units created by it. For example, a traditional cost accounting system will assign the depreciation cost of a production machine to an overhead account, from which it is allocated by various means to each unit of a product manufactured. However, if one unit were not produced, would this result in a proportionate drop in the amount of overhead cost? Probably not. Instead, the same amount of overhead would now be assigned to the fewer remaining units produced, which raises their costs and lowers their gross profits.

The Throughput Analysis Approach

To avoid this costing conundrum, throughput accounting uses an entirely different methodology, which is comprised of three elements: throughput, operating expenses, and investment. The key element of the three is throughput. To arrive at throughput, we subtract all totally variable costs from revenue. In reality, the only cost that varies totally with a product is the cost of its direct material. Even the cost of direct labor does not usually vary with the number of units produced. In how many companies can you find a situation where the staff immediately goes home when the last product is completed, or where employees are paid solely based on the number of units of production they create? Instead, the staff is employed on various projects during downtime periods, to ensure that the same experienced staff is available for work the next day. The result of the throughput calculation is a very high level of throughput – much higher than a product’s gross margin, which includes both labor and overhead costs.

The result of using throughput instead of gross margin is that hardly any products will not be produced due to a negative margin. This will only occur in a throughput accounting environment if a product’s revenue is matched or exceeded by its raw material cost, which is rarely the case. Instead, products with a low throughput will still be included in the product mix, since they contribute to some degree to the total throughput of a company’s production system.

The next element of throughput accounting is the concept of operating expenses. This is all other expenses besides the totally variable ones used to calculate throughput. Operating expenses are essentially all costs required to operate the production system. In throughput accounting, there is no distinction between totally fixed or partially fixed costs – instead, they are either totally variable costs or part of operating expenses. By avoiding the considerable level of analysis required to deduce the variable elements of most largely fixed costs, financial analysis is greatly simplified.

Throughput accounting also places considerable emphasis upon investment, which is the amount of money added to a system to improve its capacity. When combined with throughput, totally variable costs, and operating expenses, throughput accounting uses the following formulas for a wide array of accounting decisions:

Revenue – totally variable expenses = throughput

Throughput – operating expenses = net profit

Net profit / investment = return on investment

Questions to Answer in Throughput Analysis

When making a decision involving changes to revenue, expenses, or investments, the above three formulas can be used to arrive at the correct decision, which must yield a positive answer to one of the following three questions:

Does it increase throughput?
Does it reduce operating expenses?
Does it improve the return on investment?

If a localized decision yields a positive answer to any one of these questions, then it will also improve the company-wide system, and so should be implemented.

When answering the above three questions, it is best to favor decisions resulting in increased throughput, since there is potentially no upper limit to the amount of throughput that a company can generate. Decisions resulting in reduced operating expenses should be given the lowest action priority, since there is a limited amount of operating expense that can be reduced; also, a reduction of operating expenses may limit the production capacity of the system, which in turn may yield less throughput.

Podcast

A discussion of throughput concepts is available on Episodes 43 through 47 of the Accounting Best Practices podcast.