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Throughput Accounting Versus Cost Accounting

From the earlier equation for Net Profit, it is possible to deduce that Throughput and Operating Expense are of equal importance. As I have shown, T is very intangible, but OE, though difficult to predict, is calculable in more mature organizations or historically measurable. This fact tends to focus managers on reducing OE in order to improve Net Profit.8 For this reason, developers fill out time sheets every week.

Cost control is at the heart of the management accounting method known as cost accounting. Cost accounting was created in order to manage assembly lines designed using Taylor's Theory of Scientific Management [Taylor 1911]. Cost accounting was devised in order to accurately measure the efficiency of the men and machines used in the assembly lines of scientific management—the efficiency of energy expended. Cost accounting focuses on cost efficiency, that is, units of production per dollar for each man or machine in the system. This seems intuitively valid until you consider that cost accounting treats labor and machinery operation as a variable cost. The assumption is that men or machines that are inactive do not incur costs. As there is a direct relationship between cost and man or machine hours, efficiency is expressed in those terms.


Cost accounting assumes that local efficiency leads to global efficiency. The problem with this is easily exposed. Because inactive men or machinery are not truly variable, the costs they incur are placed in a bucket known as "overhead." Overhead is cost assigned to the system as a whole. Hence, local efficiency is no indicator of global efficiency.

In comparison, Throughput Accounting focuses on delivered value. It seeks to maximize the efficiency of the flow of value through the system. In other words, it wants the latent value added in an investment to be released as quickly as possible as Throughput. Throughput Accounting measures how effectively the system moves the Investment value through the system and converts it to Throughput. This is more usually described as "effectiveness." The business press likes to report the competitiveness of businesses such as auto manufacturing. These days they report the cost efficiency (sic) as the number of hours it takes to build a car. Ironically, we seem to be stuck with the language of cost accounting when the metric being reported is a Throughput Accounting metric.


Throughput Accounting assumes that men and machines are not easily removed, and the costs associated with them are fixed. Hence, efficiency cannot be expressed in terms of cost. It must be expressed in terms of value delivered.


We can express these metrics in more common language by saying that value efficiency or effectiveness is more easily measured as the Lead Time from system input to system output.

Value efficiency answers the question, how many hours or minutes to earn a dollar of value added? Cost efficiency, on the other hand, answers the question, how many units can be transformed for a dollar of local expenditure?

Cost accounting is only applicable in a world where true direct (marginal) costs greatly exceed fixed costs [Corbett 1998, p. 20]. Proponents of modern cost accounting methods such as Activity Based Costing (ABC) argue that Throughput Accounting is only applicable over short time periods, and that ABC is applicable when the time period under consideration is longer. Over a long time period, it is argued, all costs are variable, that is, it is possible to close down a whole division of a company or lay off hundreds of IT workers.

A manager must decide which facts to use in order to make intelligent management decisions that will result in more profits now and in the future. In a world where the business environment is constantly changing, changes that result in ever fluctuating software requirements, it only seems appropriate to evaluate management decisions using a short time window. Ideas for software systems and products are extremely perishable in nature due to the constantly changing nature of the business environment. Such requirements could be obsolete in one year—perhaps less. Hence, the management accounting method used must reflect the fact that the time window is short.

The reality is that labor costs are fixed over a short time window. Software developers are paid every day they come to work, whether or not they are actively involved in the production of working code. Hence, Throughput Accounting is the correct choice for managing software development.

Relative Importance of T, I, and OE

For the same reason, cost accounting has become obsolete as a management tool in Lean Manufacturing, even though it is still in common usage and the basis on which General Accepted Accounting Practices (GAAP) accounts are prepared. Companies have been forced into using one management method for making globally optimal business decisions and another for reporting their accounts to both governments and owners.

The problem with focusing on reducing cost in order to improve the profitability of a business is that it is bounded by zero, that is, below zero it is impossible to reduce costs any further. Achieving zero is impossible. Hence, focusing on costs is limiting. It limits the vision of the business, and it has the psychological effect of focusing managers on internal matters, not customers.

Alternatively, if a focus on delivering customer value is taken as more important, the limits are unbounded. Focusing a business on increasing Throughput leads to outward thinking managers worried about customer satisfaction and to unbounded ideas for continuous improvement. Hence, T is of the greatest importance. In Lean Production, this is referred to as "focusing on value."

If T is of greatest importance, is OE or I the second most important? The answer is that Investment is greater. Reducing I increases ROI and decreases OE through reduced carrying costs of borrowing. However, it is the effect on reducing Lead Time (LT), through reduced inventory that is the more important effect. If a business is to be agile and to deliver customer value faster, then inventory must be reduced. Hence, I is the second most important. In Lean Production, this focus on reducing Lead Time is referred to as "focusing on flow."

By implication, OE is least important in a world of business systems designed to optimize the system goal—increased profits now and in the future.

Figure 2-10 shows the differences in the importance of T, I, and OE between cost accounting and Throughput Accounting.

02fig10.jpgFigure 2-10. Alternative focus of accounting models.

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