How to measure the company's potential to create value
How to measure the company's potential to create value? The Theory of Constraints defines a pivotal metric to assess a system's ability to generate value and calls it Throughput, and describes it as "the rate at which an organization generates units of its goal."
If we think of a for-profit company instead of a generic organization, the goal becomes making money. In such a case, we can be better understood if we talk about Financial Throughput. We thought of coining this term because when we talk to people in the company who deal with management accounting or a CFO, the word "Throughput" is challenging to understand. If, after a few days, our interlocutor searches on the internet, he will find concepts related to the engineering and physics sphere of Throughput, such as the following, losing track of the original message we wanted to convey.
Although the concept of frequency and speed are commonly understood, we preferred to coin the term Financial Throughput, to try to be more specific, believing that it can be more easily understood when we talk about the goal of a profit-oriented company. The definition is then the same as that introduced by Goldratt in "The Goal - A Process of Ongoing Improvement" when Jonah explains to Alex Rogo the three fundamental metrics to evaluate business performance: that is, Financial Throughput is "the rate at which the system generates money through the sale of products and services."
Throughput, Margin, and Financial Throughput
The Throughput of a production process is the rate at which it releases finite units of its output. There is a relationship between production throughput and the system's ability to produce money. The question is how to measure this relationship.
Cost accounting has accustomed us to measuring profitability by evaluating the margin achieved through the sale of products and services, where the product margin is the difference between the selling price of the product and the cost to produce it.
The product margin is a well-known paradigm: driven by this paradigm, it is common for people to think it is necessary to push the products with the highest margins on the market to let the company earn more money.
Yes, but. Can this paradigm be followed to the letter? Does pushing the product mix with the highest margins always guarantee maximizing Financial Throughput? In other words, is focusing resources on the products that offer the highest product margin a necessary and sufficient condition to maximize the amount of money the company generates?
The deductive criteria underlying the product margin concept
When making "mix decisions" considering each product's contribution to profit generation, the measure of product margin overlooks one key aspect: the product's impact on the system in the production and marketing processes.
Let's assume that our company produces two products. Product A generates a product margin of €1,000 per unit sold, and Product B generates a margin of €200 per unit sold.
To the question: "which product should we push?", no doubt that driven by the product margin paradigm, everyone (almost) will answer "Product A." Any management information system based on cost accounting would suggest such a decision.
But if the system can produce two units per day of A and fifteen units per day of B, can we still assume that A is preferable to B?
The problem from the point of view of Financial Throughput
The point of view of the Theory of Constraints is to measure the system's performance.
Making decisions relying on local metrics and information (such as the product margin) poses the decision-maker with the risk of making potentially wrong choices, if not even harmful.
Every decision and action on any part bears repercussions on the whole system. In other words, the system "changes" as soon as we act on any of its variables. For this reason, decisions should not rely on "pre-established" local performance information, such as the product margin taken as a reference for mix decisions.
We are talking of a pre-established measure because, when we rely on product margins' data, we must use standard margin metrics due to the impossibility of determining it in real-time. We assume that the standard is valid for a whole year, regardless of the thousands of actions we make that constantly change the system's state.
The Financial Throughput measure takes into account two factors ignored by the logic based on management accounting of product margins:
The capacity and speed at which the system generates money
The impact constraints have on that capacity and speed
Considering speed and constraints, deciding the preferable product to generate profits changes radically. The graph shows that, when considering not only the margin but also the throughput rate, Product B can yield a more significant amount of Financial Throughput per unit of time than product A.
If we want to be precise in measuring the actual capacity of the system to produce money, we should recalculate the margins of €1,000 and €200 per unit. We should remove the fixed transformation costs commonly (and wrongly) allocated from the margin calculation. This adjustment is necessary because the fixed expenditures of transformation do not change as a function of productivity and speed but are the effect of the decision to set up a specific production capacity. But we don't want to make it too complicated now to explain the concept.
What matters is that when we start thinking with the Financial Throughput concept, we open the doors to a new world and new paradigms in planning and decision-making processes.
The Financial Throughput measure has multiple facets:
It can measure the system's capacity to create value (Financial Throughput Potential). We can use this measure to assess the impact of any decision
It can report the actual performance achieved (Actual Financial Throughput)
It can capture where value is lost (Financial Throughput losses) and delayed (Financial Throughput delay)
All these evaluations are possible because the Throughput intimately depends on the system's speed.
The reader can download more details about Throughput Economics metrics at the following link.
How to implement Financial Throughput metrics
Implementing the Financial Throughput metrics is straightforward from an application point of view. Instead, successfully applying it at the organizational and decision-making level requires some support and coaching.
Considering the aspects of Management Reporting, Financial Throughput can be implemented with simple tricks in management reporting systems to distinguish purely variable costs and to separate those resulting from cost allocation.
More profound interventions may be needed to apply it to support planning and decision-making processes, depending on the situation from which the organization starts and the level of maturity of the Sales & Operations Planning process.
For organizations already using the sedApta's supply chain planning and execution suite, we have made this transition easier.
We have developed together with the sedApta group the application of Financial Throughput & Operations Planning, which integrates sales planning and operations processes with Financial Throughput metrics to perform the plan's financial evaluation in real-time and compare different decision scenarios.
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