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Health checkThroughput Accounting – a small simplified example
Let’s review a simplified example of the nonsense of traditional cost accounting.
In this example, we compare three time periods of a manufacturing organisation:
| Period 1 | Period 2 | Period 3 | |
| Units made | 10 | 10 | 15 |
| Units sold | 10 | 5 | 5 |
| Selling price per unit | £6 | £6 | £6 |
| Material cost per unit | £3 | £3 | £3 |
| Other costs – per period | £20 | £20 | £20 |
How does traditional accounting report this?
For Period 1 – the Sales are £60. The costs are £50 – Material £30 plus Other costs £20 and so the Net Profit is £10
Period 2 – Sales are £30. The costs are more complicated because we have to carry forward some stock of finished goods unsold – 5 units. The spend was the same as Period 1 - £50 but we calculate that the carry forward for each unsold unit is £5 (Material £3 and Other costs £2) – so the costs to be reported for the P&L account are £50-£25 = £25.
Period 3 - Sales are again £30. We have to calculate the effect on costs of stock brought forward and carried forward. The spend was £65 (Materials £5 x 15 units = £45 plus Other costs £20) – to this we add the stock brought forward £25 and we take off the stock carried forward £75 (15 units) giving us a costs figure of £15. The Net Profit is therefore £15.
In summary:
| Period 1 | Period 2 | Period 3 | |
| Sales | £60 | £30 | £30 |
| Costs | £50 | £25 | £15 |
| Net Profit | £10 | £5 | £15 |
“Tell me how you measure me and I will tell you how I will behave!”
When the people realised at the end of Period 2 that making more that you sell increases your profit – then in Period 3 they outperformed themselves in production with very high efficiencies.
Everyone is happy – in Period 3 we tripled the profit of Period 2 and even beat the profit of Period 1 when we sold twice as much.
This is in fact NONSENSE – the organisation is making profit from stock piling not from sales and will eventually run into:
- Cash shortages
- Space and stock control issues
- Write offs for slow moving or obsolete stock
If the company had adopted the paradigms that:
- profit is realised only when a sale takes place [instead of when manufacture takes place] and
- that the value of inventory is only the Truly Variable Cost (in this example Materials) and
- efficiency is not a measure of profitability
then there would be no distortion of the results.
Under Throughput Accounting the reporting would be:
| Period 1 | Period 2 | Period 3 | |
| Sales | £60 | £30 | £30 |
| Costs | £50 | £35 | £35 |
| Net Profit (Loss) | £10 | (£5) | (£5) |
This reporting would drive the behaviour very differently.
Contact us to find out more about the difference that Throughput Accounting could make to your business decision making, either complete the form below or call us on (0) 1234 834510. Alternatively, click here to enrol for a programme on Throughput Accounting.
