In this article, we will explain, with a practical example, how a modern managerial approach, such as the Theory of Constraints and its management accounting model, Throughput Accounting, are innovative tools to help managers and entrepreneurs to have helpful information for the value creation process.
We will discuss inventory and whether it is an asset or a liability. In particular, we will discover how Throughput Accounting removes the distortions of common managerial accounting principles in inventory evaluations. We will analyze the impact of GAAP vs. Throughput Accounting with a practical example, highlighting their impact on the bottom line.
The problems with inventory in the financial statements
How often do the CFO, the Chief Revenue Officer, and the COO find themselves discussing results that are surprisingly different from the expectations of actual operations? From our experience, we can confirm that the event is not uncommon.
The inventory, and the way we evaluate it, play an essential role in the clarity of the information produced by the management accounting system.
Why, for example, in an exceptional year in which the company was able to sell the stocks accumulated in previous years, could we find ourselves discussing a financial result "surprisingly" lower than expected?
Ever happened to see the controller extricate himself in a jungle of numbers in an attempt - often in vain - to explain what may have occurred by rattling off complicated variance analysis, talking about volume and mix effect, delta efficiencies, under absorption, and so on and so forth?
Anyone who has taken the accounting exams during his Economics studies will indeed have "hated" the treatment of stocks in preparing financial statements.
An increase in stocks of finished products is calculated as "Value added", as a positive component in the income statement.
Accounting values inventory as an asset. It's not necessary to hold a Ph.D. to understand that an asset is something we want to hold more.
At this point, things get complicated. Without being an expert in the field, it is well known that all modern managerial best practices (TOC, Lean, TQM) aim to minimize inventory since the production of excess stocks creates a series of significant negative ramifications.
So we are faced with a paradox:
accounting principles that value inventory as an asset, so the more, the better;
managerial principles that consider inventory as a liability, so the less, the better.
How can we reconcile good management practices, which suggest keeping inventory to a bare minimum, the sufficient quantity to sustain operations, with accounting which pushes management in the opposite direction? Who is "the final judge" of the work of a manager?
Managers often know that they should reduce inventory but are reluctant about the repercussions of this action on the income statement and, therefore, on their performance evaluation. That is why they rightly go there with carefulness.
Is there a way to reduce this trade-off between good management principles and valuation logic?
We will explain how the main reasons for this "conflict" are some incorrect assumptions in traditional management accounting systems, particularly the allocation of fixed transformation costs to products.
For clarity, we will draw a parallel between valuation with Throughput Accounting metrics and traditional cost accounting.
We've already presented the metrics of Throughput Accounting and Throughput Economics in a previous blog, so that we won't go back over them. For those who do not know them, you can download them at the following link.
Throughput Accounting and Theory of Constraints (TOC)
Before delving into the numerical example, we consider it worthwhile to explain some principles of the Theory of Constraints, a necessary introduction to understanding the inventory issue better.
The Theory of Constraints is based on a simple assumption:
Every organizational system, whatever its complexity, is influenced by a limited number of variables, even just one, which limits its ability to achieve greater quantities of its goal. These variables are the system's constraints.
From this hypothesis, the Theory of Constraints has formulated the management algorithms to be applied to achieve a greater quantity of the organizational goal. The algorithm, known as the "Five Focusing Steps," has defined several principles.
One of the most important is subordination to the constraint: since the performance of the organization depends mainly on the performance of the system constraint, every action and decision, including the "local performance" of other parts of the organization, must be subordinated to the need to maximize the performance of the constraint.
To protect the constraint and maximize the flow and productivity of the system, the principle of subordination sometimes imposes decisions that may conflict with the principles commonly accepted by traditional management accounting principles.
Let's see in detail the main conflicts.
Conflict #1: Maintain protective capacity.
Apart from the constraint, activating the other resources at 100% of their availability is entirely counterproductive. Any attempt to balance the system, aiming to exploit 100% of the capacity of all resources, generates an unstable system, unable to handle variability, in which lead times grow dramatically. The system ends with excess work in process (WIP) and a poor ability to meet customer commitments.
On the other hand, the maintenance of protective capacity would seem to have adverse effects on the cost of the product and the income statement (under-absorption of fixed costs), so it is discouraged by the accounting system. The real problem is that the management accounting system can only measure the cost of production capacity. Still, its metrics cannot effectively capture the positive and indirect beneficial effects on the flow. Traditional cost accounting gives us only a partial representation of the problem.
Conflict #2: Reconciling the Economic Order Quantity (EOQ) and the Flow.
The flow needs to be improved to increase system Throughput, and best practices recommend planning small batches, as this will help reduce lead times and variability. In Lean, the concept is extreme to the point of talking about "one piece flow."
From an accounting point of view, production in small batches is discouraged, as batches smaller than EOQ negatively impact the cost of the product (setup and changeover costs).
Before mechanically applying the logic of cost accounting, it would be appropriate to ask: if the frequency of set-up and changeover increases, do costs really increase? Is it indispensable to hire new people to make additional setups? Or, even if it was necessary to reinforce the tooling team, has it been evaluated whether the increase of OPEX can be more than offset by an increase in productivity and throughput?
The problem is that cost accounting assigns these costs to the products and imagining actions that increase the product cost is an absolute "management taboo."
Having introduced these two conflicts, we now want to talk about the most devastating effect of cost accounting mechanisms, which manifests itself in inventory evaluation.
Inventory valuation: a simple example
To explain the differences between the two accounting models, we will analyze the three-year data of two imaginary manufacturing companies that are completely equal: both produce the same products, which we will call A, B, and C, with the same production capacity and cost structure, producing the same volumes and selling the same quantities on the market. The only difference between the two companies is the management accounting principle applied: the company "TR" adopts full costing management accounting, while the company "TA" uses Throughput Accounting.
We will see how the same operating results are reported differently in the two companies' income statements and balance sheets, depending on the accounting model adopted.
In particular, we will analyze the distorting effect of inventory valuation policies and principles.
Year 1 - The story begins
Below are the data for year 1: to avoid complicating the case, we assume that there are no initial inventories.
The data shows that in the first year, the two companies are accumulating inventory (13,000 units produced against 11,575 units sold).
The table also shows the unit costs of direct materials for the three products, the hourly rate of direct labor, and the hourly rate to apply manufacturing overheads to products, i.e., all other industrial costs.
Below are the remaining cost data related to the capacity that, for simplicity, we will keep constant for all three years, and therefore we will not replicate from time to time.
In total, each company has the same capacity and incurs operating expenses of €858,000 per year, split as follows:
€416,000 for direct labor. Dividing such cost by the 18,390 hours of production carried out, we get the direct labor hourly rate of €22.6 per hour.
€234,000 of manufacturing overheads, consisting of €78,000 of indirect labor and €156,000 of other fixed industrial costs. Dividing the cost by 18,390 hours of standard production, we get the hourly rate of €12.7 / hour to apply the overheads to products.
€208,000 classifiable as structure costs (the common SG&A)
The annual data, for simplicity, have been calculated by multiplying the weekly data by 52 weeks (to simplify, we assumed a flat capacity for the whole year without any closure period). We also assumed that labor cost per worker is a standard flat rate in each department to keep the case as simple as possible. Finally, there are no deviations between the actual results and the budget: everything we planned comes true without any variance.
According to the traditional cost accounting model, the TR company reports a profit of €45,781 at the end of the year.
The income statement shows that, out of €858,000 of operating expenses, €604,219 was absorbed into products and reported as the cost of sales, and €208,000 was reported below the gross margin as SG&A.
Let's see what happens to the TA Company that instead adopts Throughput Accounting.
The TA company does not report any profit or loss: it has reached break-even.
Why this huge difference?
The reason is simple. TR is suspending the conversion costs of the unsold products manufactured to the balance sheet accounts. The amount suspended is the difference between the 650,000 euros of industrial expenses incurred during the year and the 604,219 euros reported in the cost of sales. It corresponds to €45,781, the profit recorded in the balance sheet.
The TA Company, with Throughput Accounting, is instead reporting all its transformation costs in the income statement as operating expenses. For accumulated stocks of finished products, only direct and purely variable material costs were entered in the balance sheet inventory accounts.
Year2 – The market worsens
Let's move forward to year 2, keeping all capacity and production data unchanged for simplicity for both companies but only changing sales data.
With the same production plan and capacity, we find that the two companies have worsened their sales performance on product C due to a reduction in demand, which, compared to year 1, has gone from 5,000 to 4,000 units sold with a decrease of 20%.
In other words: every company is producing precisely the same mix and volume as in Year 1, and the capacity and level of operating expenses have remained constant. The only difference is that both companies sell less and produce more stock of product C.
Keeping prices unchanged, we should expect worse economic performance for both companies. In theory...
Let's look at the data again.
The TR company determines its result with traditional management accounting and reports an improvement in the bottom line compared to the previous year...
While the TA Company continues to report its results according to Throughput Accounting and reports a worsening result compared to the previous year.
Which accounting system offers the most helpful guide to management? If an accounting system reports an improvement in the financials when the company sells less while bearing the same operating costs, is it providing the right guidance to management? Should we celebrate the 55% profit increase (from €45,781 in year 1 to €70,652 in year 2) that we see just in the accounting books?
It would seem sufficient to sell less and produce more to increase profits. Interesting theory, we could increase the capacity of the factory and give more holidays to our sales force...
Throughput Accounting shows a significant decline in the result, as can be expected, which goes from the break-even of the previous year to a dry loss of € 50,000 per year 2. A result that is decidedly more consistent with market performance.
Comparing the two P&Ls, the TR company reached a bottom line of €120,653 higher than the company TA. How did they make all these profits?
Let's look at the respective balance sheets again to understand the difference. Here under the balance sheet of TR at the end of year 2.
Looking at the balance sheet, we realize that the capacity costs suspended in the inventory accounts now amount to €166,433. If we subtract from this amount €45,781 suspended in the first year, we find precisely this difference of €120,652.
The TA company's inventory accounts in the balance sheet show only the direct costs of materials totaling € 145,500.
Accounting principles that have little to do with the real results of operational management begin to manifest all their distortive effects.
Year 3 – An exceptional seasons
We continue to maintain sales results for products A and B. Still, we see an outstanding performance of product C: both companies sold all production of the current year plus all stocks accumulated in previous years. Therefore, the closing inventory for product C amount to zero.
At this point, management should expect an exceptional year-end result and rich bonuses. Let's look at the data again.
Let's see what happened to the TR company. The controller has just finished consolidating the numbers, and there is a nasty surprise.
The discussion meeting opens with great chaos:
"We have maintained the same production efficiency and the same volumes as the previous year without spending an extra euro"
Begins the COO of the company TR aloud...
"... our sales reps have done an outstanding job, and we have also improved overall revenues by 16% with 182,000 euros more than the previous year, completely disposing of stocks on product C, and we are discussing a reduction in pre-tax profit of 64,000 euros compared to the previous year. Something's definitely wrong."
The Chief Revenue Officer, who leaves the meeting enraged, blames the controller for miscalculating.
What about TA? The controller, confident in the simplicity of the mechanics of its Throughput Accounting model, reports a profit of 80,000 euros, with the total satisfaction of the management and Bonuses for the whole team.
Now we have learned to explain these differences:
The increase in sales of product C was not supported by the rise in production but by inventory accumulated in previous years.
Thus, TR's profit and loss account was charged not only with the costs incurred during the year but also with the costs incurred in previous years, which had been suspended as inventories in the balance sheet.
Looking at the balance sheet, it is clear that the transformation costs suspended went from €166,433 in year 2 to €94,420 in year 3, with a difference equal to the difference in net profit of the two companies.
Let's draw the conclusions
Wrapping up, it is clear that:
The traditional accounting model adopted by the TR Company rewarded inventory accumulation: the company enjoyed higher profits in years 1 and 2 when it accumulated its stocks.
The Throughput Accounting adopted by TA Company has rewarded maximizing throughput and minimizing inventory: this is evident as the TA Company enjoyed its highest profit in Year 3, in which it completely disposed of C-product inventory and generated more throughput.
Regardless of what GAAP requires, which of the two representations is more truthful and realistic to analyze the results from a mere management point of view? Can we consider the profit of year 1 for the company TA a real profit? A profit that the following year will not allow us to pay suppliers?
What harm do we do if, on the one hand, we ask management to do certain things but then measure them with tools that suggest doing the opposite?
If all the theories of modern management, from TQM (Total Quality Management) to Lean Manufacturing, to the Theory of Constraints, agree in considering the production of excess inventory a waste, then...
Why do we continue to use, for management control purposes, a model that favors the accumulation of stocks, which creates complexity in the interpretation of data and does not facilitate decisions? Why not adopting, at least from a managerial point of view, a measuring standard that considers stocks neutrally?
Not forgetting that inventory is not only an opportunity cost but causes relevant "real" management costs: warehouse space, handling costs, insurance, deterioration, obsolescence, pilferage, etc.
The paradoxes that cost accounting brings with it are also risky and expensive:
The gap between the economic and financial results (cash flow) is amplified, with the consequence that cash pressures must be financed with third-party capital loans (for inventory financing);
pay financial charges to remunerate borrowed capital;
pay the costs related to stock management.
Moreover, suppose a new technology will make the accumulated inventory obsolete. In that case, the devaluation of that inventory will worsen the situation: forcing the company to sell the stock at a heavily discounted price, if not scrap it.
Next steps
For now, let's leave our controller of the TR company to check all the data again for the next review meeting.
In the next blog, we will analyze how profitability analyses are different and demonstrate how Throughput Accounting is superior to the profitability analyses of Traditional Accounting based on product costing.
An important note: Throughput Accounting is not intended to replace traditional US GAAP or IFRS accounting standards that must be adhered to for public disclosure of information. Throughput Accounting is a valuable accounting tool for management, therefore, for internal purposes and strategic and operational management business decisions.
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