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Throughput Capital Budgeting
A solid knowledge of throughput accounting concepts can go a long ways toward the avoidance of unnecessary investments, because it focuses attention on what investments will improve total company throughput or reduce operating expenses. As we will see, most other capital purchase requests not impacting these areas should be declined.
Traditional Capital Budgeting
The traditional capital budgeting approach involves having the management team review a series of unrelated requests from throughout the company, each one asking for funding for various projects. Management decides whether to fund each request based on the discounted cash flows projected for each one. If there are not sufficient funds available for all requests having positive discounted cash flows, then those with the largest cash flows or highest percentage returns are usually accepted first, until the funds run out.
There are several problems with this type of capital budgeting. First and most important, there is no consideration of how each requested project fits into the entire system of production – instead, most requests involve the local optimization of specific work centers that may not contribute to the total throughput of the company. Second, there is no consideration of the constrained resource, so managers cannot tell which funding requests will result in an improvement to the efficiency of that operation. Third, managers tend to engage in a great deal of speculation regarding the budgeted cash flows resulting from their requests, resulting in inaccurate discounted cash flow projections. Since many requests involve unverifiable cash flow estimates, it is impossible to discern which projects are better than others.
Throughput Capital Budgeting
A greater reliance on throughput accounting concepts eliminates most of these problems. First, the priority for funding should be placed squarely on any projects that can improve the capacity of the constrained resource, based on a comparison of the incremental additional throughput created to the incremental operating expenses and investment incurred.
Second, any investment requests not involving the constrained resource should be subject to an intensive critical review, likely resulting in their rejection. Since they do not impact the constrained resource, these investments cannot impact system throughput in any way, so their sole remaining justification must be the reduction of operating expenses or the mitigation of some type of risk.
The one exception to investing in non-constraint resources is when there is so little excess capacity in a work center that it has difficulty recovering from downtime. This can be a major problem if the lack of capacity constantly causes holes in the inventory buffer, and places the constrained resource in danger of running out of work. In this case, a good investment alternative is to invest in a sufficient amount of additional sprint capacity to ensure that the system can rapidly recover from a reasonable level of downtime. If a manager is applying for a capital investment based on this reasoning, he should attach to the proposal a chart showing the capacity level at which the targeted resource has been operating over the past few months, as well as the severity of holes in the buffer caused by that operation.
At what point should a company invest in more of the constrained resource? In many cases, the company has specifically designated a resource to be its constraint, because it is so expensive to add additional capacity, so this decision is not to be taken lightly. The decision process is to review the impact on the incremental change in throughput caused by the added investment, less any changes in operating expenses. Because this type of investment represents a considerable step cost (where costs and/or the investment will jump considerably as a result of the decision), management must usually make its decision based on the perceived level of long-term throughput changes, rather than smaller expected short-term throughput increases.
Podcast
A discussion of throughput concepts is available on Episodes 43 through 47 of the Accounting Best Practices podcast.
Related Topics
Theory of constraints
Throughput analysis
Throughput price setting
Types of capacity
Types of constraints