Dr. Eli Goldratt (1984) came up with a simple way to evaluate (as well as speed up) an operat­ing decision and the link good operational decision making with good financial performance. In Theory of Constraints he uses Throughput (T), Inventory/Investment (I) and Oper­ating Expense (OE). One of the key characteristics of the Theory of Constraints approach is the focus on increasing Throughput (T)

These measures are initiated on the assumption that-the organization's goal is to "make money now and in the future." Woehr and Legat (2003) concur by stating “the emphasis is to make money, not save money... No company ever "saved" their way up the For­tune 500 ladder!”

The definitions of Throughput, Investment/Inventory and Operating Expense are accredited to Dr. Goldratt (1984).

- Throughput (T) is the rate at which an organization generates money through sales of products or services. This is new money coming into the system. This is the difference between revenues and variable costs measured and asses­sed at the unit, product and organizational level. This is considered to be the same as Contribution Margin (selling price -- cost of raw materials). Labor costs are considered to be part of Operating Expense rather than throughput.

Throughput (T) = Sales revenue (total) minus Variable costs (total)

- Investment or Inventory (I) All the money the system invests in things it intends to (or could) sell. This is the total system investment, which includes not only conventional inventory, but also buildings, land, vehicles, plant, and equipment. It does not include the value of labor added to Work-In-Process inventory.

- Operating Expense (OE) All the money the system spends in turning Inventory into Throughput. This includes all of the money constantly poured into a system to keep it operating, such as heat, light, scrap materials, depreciation, etc.

The interaction between the measurements is displayed in figure 1

Figure 1: The enterprise viewed as a system

Source: Woehr and Legat (2002)

In order to provide the results for the overall organization Goldratt (1984) used the following four measurements:

Net Profit = Throughput - Operating Expense

Return on Investment (ROI) = (Throughput - Operating Expense) / Inventory

Productivity = Throughput / Operating Expense

Turnover = Throughput / Inventory

We support Dr. Goldratt (1984) view that a business has one and only one goal: “make money now and in the future.” The emphasis is to make money and not to save money – chasing costs is unproductive. So the emphases should be 1. Increase Throughput, 2. Decrease Inventory, 3. Decrease operating expenses:

An overview of different management approaches is reflected in table 1.

Table 1 Management priorities

Source: Dettmer (1998)

We can implement the correct measurements to provide the focus you need for running your business. We have access to the latest throughput accounting software fully integrated with your ERP software, for more information on measurements please Contact us..

References:

Dr. Eli Goldratt,(1984) The Goal, a Process of ongoing improvement

Woehr and Legat (2002), Delta T-Selling

Dettmer H.W (1998), Breaking the constraints to world class manufacturing