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.”
