This is the eighth conversation in our Maximizing Profitability the Theory of Constraints (TOC) Way series.  To read number 7, go here:  https://www.scienceofbusiness.com/maxprofit7/

Brad:  “Theory of Constraints (TOC) is unique with its emphasis on Throughput, the additional margin the company gains when it sells one more product or service.”

Dr. Lisa:  “Yes; this ‘Throughput Margin’ includes no allocated costs – not even direct labor costs (which TOC considers a period cost).”

Brad:  “Each product or service sold has a Throughput Margin.  The Sales Revenue minus the Truly Variable Costs (material, outsourcing, freight, and sales commission) equals Throughput.”

Brad:  “Now for the really cool, counterintuitive part.  Add up the Throughput of all the products and/or services sold for the period (for example, a month, or a quarter, or a year), and you get the total Throughput.  Throughput is cumulative.”

Dr Lisa:  “And by this you mean that the cumulative Throughput of all the products/services sold in a period are equal to the Throughput of the company in that period.”

Brad:  “Exactly!  When allocation methods are being used, this is not the case.”

Dr. Lisa:  “And this is totally separate from the period costs – the fixed costs or overhead costs.  Overhead costs or fixed costs for a period are typically known with the exception of how much overtime might be needed.  But if you work overtime, then this just increases these overhead costs in the period.”

Brad:  “The overhead cost ‘bucket’ is what we in TOC call Operating Expense (OE) and in this bucket are all the costs that are not considered Truly Variable Costs.”

Brad: “ With these 2 simple buckets that account for all our costs – Throughput and Operating Expense – it is clear that we have to generate enough total Throughput for the period to equal Operating Expense to breakeven, and enough more to meet the profit objective for the period.”

Max Profit pic #8 Profit-equals-T-minus-OE

Dr Lisa:  “Yes and because there are no cost allocations based on volume assumptions, it really is that simple.”

Brad:  “ERP systems normally muck this up.  It is hard to isolate Throughput because of all the incorrect cost allocation assumptions build into these systems.  Special reports usually have to be written to provide the correct information.”

Brad:  “To better manage a company to higher levels of consistent profitability, this information is crucial.  For someone used to cost accounting, it will give them a headache – or a migraine if he or she realizes the utter and complete fallacy of analyzing service or product profitability.”

Dr. Lisa:  “When you work with a company to analyze their financials from a TOC Throughput Margin perspective, where do you start?”

Brad:  “Throughput Margin varies, in most cases because it has not been visible and managed.  So I start working with a company to understand the total Throughput Margin and Throughput Margin percentage they have had annually over the last few years, usually back to 2008 before the downturn.  That’s usually pretty quick and easy to do, and provides the business owner with a new and valuable insight into how money is really made in the company.  It is also a good starting point for further analysis and decision-making based on what we find.”

Brad:  “But we need to quickly get to management of the Throughput Margin of individual products and services.  We dig into the heart of the pricing process at the customer-part level of detail.”

Dr. Lisa:  “What is the objective?”

Brad:  “It is helping the company quickly achieve a much higher Return on Sales, of course.”

Dr Lisa:  “And for many of the custom job shops we work with, the target is a 20% Return on Sales up from 0 to 5%.  Not bad!”

To be continued.

Best Wishes,

<a href=”https://plus.google.com/112099441389008525257?rel=author“>Dr Lisa Lang </a> and Brad Stillahn

P.S.  To ask questions or leave a comment, click visit:  https://www.scienceofbusiness.com/maxprofit8/

P.P.S.  Custom job shops should check out www.VelocitySchedulingSystem.com (This is NOT software.)

Frequently Asked Questions

How do you calculate Throughput-margin?

To calculate Throughput-margin, Totally Variable Costs are subtracted from Revenue. Totally Variable Costs are those costs that vary totally with an activity, meaning if the activity is engaged in, the costs will be incurred, if the activity is not engaged in, the costs will be saved. Examples of Totally Variable Costs include Material, Freight In/Out, Outside Services and Sales Commission. Items that are not Totally Variable Costs would be Direct Labor and Overhead as they do not vary totally. Velocity Pricing System is the ONLY pricing system which is based on Throughput-margin.

How do you calculate Throughput-margin per Hour?

The Throughput-margin divided by the relevant interval of time required is the calculation for Throughput-margin per Hour. Understanding your constraints and capacity is critical for this calculation. See our MINI-MASTERCLASS on Job Costing for more information.

How is Throughput cost calculated?

The Throughput Cost of an item is the sum of the Totally Variable Costs. Totally Variable Costs are those costs that vary totally with an activity, meaning if the activity is engaged in, the costs will be incurred, if the activity is not engaged in, the costs will be saved. Examples of Totally Variable Costs include Material, Freight In/Out, Outside Services and Sales Commission. Items that are not Totally Variable Costs would be Direct Labor and Overhead as they do not vary totally.

What is business Throughput?

Throughput is only measured in non cost-based forms of accounting. Throughput is ignored by other conventional forms of accounting. Throughput can occur for a business as a whole, for a business unit or division, or for a product or service. The calculation for Throughput is Revenue less Totally Variable Costs. Totally Variable Costs are those costs that vary totally with an activity, meaning if the activity is engaged in, the costs will be incurred, if the activity is not engaged in, the costs will be saved. Examples of Totally Variable Costs include Material, Freight In/Out, Outside Services and Sales Commission. Items that are not Totally Variable Costs would be Direct Labor and Overhead as they do not vary totally.

What is Throughput capacity?

Throughput Capacity is the capacity a company has to generate Throughput-margin. Conventional accounting systems utilizes unit as the basis for evaluating capacity. Throughput-based systems utilize alternative dimensions to evaluate capacity over relevant planning horizons, typically a year.

How do you calculate Throughput in accounting

Throughput is only measured in non cost-based forms of accounting. Throughput is ignored by other conventional forms of accounting. Throughput can occur for a business as a whole, for a business unit or division, or for a product or service. The calculation for Throughput is Revenue less Totally Variable Costs. Totally Variable Costs are those costs that vary totally with an activity, meaning if the activity is engaged in, the costs will be incurred, if the activity is not engaged in, the costs will be saved. Examples of Totally Variable Costs include Material, Freight In/Out, Outside Services and Sales Commission. Items that are not Totally Variable Costs would be Direct Labor and Overhead as they do not vary totally.

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