Throughput (T) is a central concept in TOC and it should be a central concept for all management. I see it as expressing the added-value created by the organization. I focus on the value of using T, I and OE for making superior decisions.
The formal definition of T for profit organization is: Revenues minus the truly-variable-costs (TVC).
We use T as a periodical performance measurement and use it also for judging the economic impact of a single decision – the delta-T generated by the decision minus the delta-OE (operating expenses) caused by the decision at hand.
The revenue part of the definition of T is relatively straight-forward. The definition is still open whether one should consider the timing of receiving the revenues. Is T of $1,000 to be received next year the same as T of $1,000 today? This is quite a topic to deal with at another time.
An even more relevant issue is the impact of uncertainty on the revenues. As decisions always aim at the future, the prediction that we’d generate revenues is always based on forecasting.
On top of how to predict the revenues there is another issue: what should be included in the TVC? Eli Goldratt added the term “truly” to the “variable cost” to warn us to be careful about what we regard as TVC.
I like to highlight two important problematic areas with TVC.
One: are the costs of raw-materials always TVC?
Two: high level decisions might include costs that do not vary with smaller decisions. Should we treat those as TVC?
Why do we claim that raw materials are truly-variable-costs?
Purchasing raw materials is usually done long before firm orders for the end-product are received. It means that the cost has been spent no matter whether we have sold or not. Thus, the cost is not directly triggered by the sale! So, why do we usually consider the material cost as part of the T and not part of the operating expenses (OE)?
When raw materials are regularly replenished we can safely assume that any sale of end-products initiates purchasing of materials.
In such a case it is right to treat the cost of raw materials as TVC as we are used to do.
This observation means that when a decision to stop further production of specific items has been made then the subsequent sales of that product should not treat the cost of materials as TVC. It is a mistake to refrain from selling items, whose production is stopped, because the market price is lower than the cost of materials. The only two relevant questions are whether we have enough available capacity, which cannot be used for existing demand, and whether selling old products for reduced price would cause loss of sales of full-price items or reduced the image of the brand in the market.
Suppose you hear that the cost of materials went up by 20%. Fortunately you still have enough inventory of the materials for the next two months. When would you update the TVC, causing significant reduction of your T per product-unit?
My view is that the T should be updated immediately! Remember the assumption: any sale triggers replenishment of the materials. This is the basic assumption behind including the material cost in the TVC.
The other case to consider is the variable costs of a high level decision. Example: The TVC of adding a passenger on a flight is pretty low, mainly the impact of the additional weight on the fuel consumption. However, when a decision to cancel, or add, a flight is considered we are exposed to very different level of variable costs. The fuel consumption of the whole trip is definitely a significant variable cost item. The cost of the crew include variable elements that depend on actual hours of flight and the stay in a far away city. I claim that even the maintenance costs of a flight have to be considered TVC, because those costs are mandatory for X hours of flights, thus any cancelation of flight reduces the relative future cost of maintenance.
However, should those “higher level TVC” be part of the T?
I suggest calling TVC only the truly-variable-costs of a SINGLE SALE! For such a sale we have a clear definition of throughput and any high level decision, like adding or cancelling a flight, would anyway involve certain delta-OE, which considers all the expenses caused by the decision. Thus, the decision criteria of delta-T – delta(OE) > 0, is still intact.
Readers who happen to live in Europe and look to understand the potential of throughput accounting for their business, and to be exposed to wide expansion of the power of T, I and OE, should be aware of my session in Paris in October. Have a look at: http://www.marris-consulting.com/en/Formation-Throughput-Accounting-253.html