Conventional accounting systems in for-profit companies tend to focus on measurements like Net Profit, Return On Investment, and Cash Flow. This is good and appropriate, because these measures are important indicators of the success of a company, and are required for financial reporting. The problem comes when these measures are used for making day-to-day operating decisions. Doing so is a little like driving your car with paper blocking the view forward through the windshield - that is, you are blocked from seeing the immediate impact of any decision you may make; you can only see the results sometime in the future by looking in the rear view mirror known as year-end or quarterly figures. In effect, the manager is forced to ask, "What do I think the impact of this decision will be on Net Profit at year end?" This is a very difficult outcome for managers to predict, and virtually impossible for the average worker.
This inadequacy has long been recognized, and has resulted in the creation of "local" measurements that are believed to be connected to net profit or ROI. These measures generally are intended to more precisely determine the "cost" of producing a certain product, or to calculate the cost variance (i.e. the difference between a predetermined "standard cost" and the calculated "actual cost"). Such attempts are based on assumptions that are faulty and usually lead to poor management decisions. What is needed are "local" measurements that truly are linked directly to the long term global measures of Net Profit, ROI and Cash Flow.
Throughput, Inventory, and Operating Expense are measurements which, when properly understood at the global level, make it possible for everyone in the organization to predict the immediate impact a decision they are faced with will have on net profit, return on investment, and cash flow. The impact that a decision is likely to have on the investment in Inventory is usually clear: if new investments have to be made in equipment, and/or more raw material will have to be held, then Inventory will rise by the corresponding amount. When figuring the impact of any decision on Operating Expense, note that amounts of direct or indirect labor are immaterial; the true bottom line impact can only be judged by determining whether people will be hired or fired, or whether overtime will have to be worked. Finally, the impact on Throughput can be judged by determining the selling price minus totally variable costs times the volume of the sales. These figures enable a manager to predict much more reliably how an immediate local action will impact net profit, ROI, and operating expense. And the best part is that even the workers can easily understand the definitions and can accurately predict the impact that some immediate decision they have to make will have on Throughput, Inventory, and Operating Expense.
In the book The Goal, (North River Press,
1984), throughput is defined as:
Using this definition, some people equate sales revenues
with throughput. This is incorrect. Financial credit should only be
given to your system for the value that your system has added, i.e.,
after you've paid your vendors. The term for sales revenue minus
payments to vendors is "contribution" dollars. Rewording the
conventional definition to make it clear that revenues that simply pass
through your books on the way to you vendors results in the following:
Inventory was originally defined in The Goal
by Goldratt as:
Using that definition, many people tend to think of only
raw materials, work in process, and finished goods inventory. However,
the concept is larger. For that reason, we will label this measurement
"Inventory&Investment." A working definition is:
Operating expense is formally defined as:
A reworded definition is:
Inventory dollar days (IDD)
A measure of the effectiveness of a supply chain – i.e., did it do things that it shouldn’t have done and as a result is the supply chain holding inventory of products the customer doesn’t want? IDD accounts for two things: 1. the time from when a unit is placed in stock until it is actually needed by a customer; and, 2. the monetary value of the inventory being held. IDD is calculated by multiplying the monetary value of each inventory unit on hand by the number of days since that inventory entered the responsibility of that link. The system should strive for the minimum IDDs necessary to reliability maintain zero throughput dollar days.
NOTE: The resulting unit of measure is "dollar-days". It is neither monetary nor time based. Attempts to compare dollar-days to other monetary measures are invalid. IDDs can be compared only to other IDD levels.
Throughput dollar days (TDD)
A measure of the reliability of a supply chain. TDD considers two things: 1. the monetary value of the things a link is committed to deliver but does not; and, 2. the number of days by which the link misses its commitment to deliver. TDD is the summation of the commitments not delivered on time during the chosen time period. The TDD value of individual missed commitments is calculated by multiplying the dollar value of the end product times the number of days the commitment is/was overdue. The system should strive for zero throughput dollar-days.
NOTE: The unit of measure "dollar-days" is neither monetary nor time based. Attempts to compare dollar-days to other monetary measures are invalid. TDD levels can be compared only to other TDD levels.
You may notice that the word "money" plays the central role in this definition. This is because of the "goal" of a for profit company is to make money now and in the future. (See What is the Goal?) For this reason, it only makes sense that the primary measurements of progress toward the goal must be expressed in the same unit of measure as the goal – namely money.