Finance & Measurements, as Taught by Eli Goldratt · Lesson 6 of 8
The cost world and the throughput world
Why do companies keep a cumbersome mechanism that gives distorted answers? Because of a conflict between controlling cost and protecting throughput. Meet T, I and OE, then Goldratt's chain: weight adds up, strength doesn't, and the assumption that holds the cost world together.
Helen: “If cost allocation is so wrong, why does every company in the world use it? It isn’t even easy. My team spends weeks on it.”
Ruth: “Exactly. When people keep a mechanism that is both painful and misleading, there’s a conflict holding it in place.”
First, three words
To see the conflict, view the company as a black box, and measure only what goes in, stays in and comes out:
- Throughput (T): the rate at which the organisation generates goal units. In a company run for profit, that is money: sales minus raw material. If you sell a product for $100 that contains $30 of purchased material, you generated $70; the $30 was generated by your vendors and only flowed through you. “Raw material” here means everything bought for the product sold, such as materials and sales commissions: the truly variable cost.
- Operating expense (OE): all the money the organisation spends to generate the goal units, which it keeps paying even if production stops for a while: salaries, rent, insurance. In every organisation, even a hospital or an army, OE is money.
- Investment (I): the money tied up in the organisation: stock of finished goods, receivables, buildings, machines.
For a company run for profit:
| Measure | Formula |
|---|---|
| Net profit | T − OE |
| Return on investment | (T − OE) ÷ I |
| Productivity | T ÷ OE |
| Investment turns | T ÷ I |
Two pressures, two paradigms
There is always pressure for more profit, which makes it imperative to control cost (OE and I). And competition is fiercer than ever, which makes it imperative to protect throughput. Each need dictates its own way to manage the company, and the two ways conflict. Goldratt explained them with a chain.
The chain
An organisation is like a chain: many functions, interlocking links, none working in isolation.
The cost world. What characterises cost is that it adds up: the company’s cost is the sum of the costs of its parts. In the chain, the equivalent of cost is weight: the chain weighs exactly what its links weigh together. If weight is the measure, improving the chain means making it lighter, and making any link lighter by X makes the chain lighter by exactly X. So local improvements are global improvements, and the way to judge a decision is by its local impact. To quantify local impact for every decision, we need cost allocation.
The throughput world. What characterises throughput is that it doesn’t add up: the throughput of two departments, one feeding the other, is not the throughput of the first plus the throughput of the second. In the chain, the equivalent is strength. Making one link ten times stronger doesn’t necessarily make the chain any stronger. So local improvements are not even an indication of global improvement, and decisions must not be judged by their local impact.
Now the conflict is clear
Is it really so, even for cost?
The cost world rests on one assumption: that local impact equals the impact on the organisation. It holds for a physical chain: making one link lighter doesn’t change the weight of the others. Does it hold for a company?
Exercise: have you seen these?
- Saving set-ups in one department forces overtime in the departments after it.
- Purchasing saves money by choosing a cheaper, lower-quality supplier.
- Logistics saves freight by sending only full trucks.
- An unused office lease is ended.
In organisations, a decision that reduces cost in one department often raises cost in another. So even for the sake of controlling cost, decisions should not be judged by their local impact. The assumption is false, and with it, the reason for cost allocation.
But every action, and most decisions, are local. So how should we judge them? That is the question Goldratt answered with the five focusing steps.
Check your understanding
Answer all five. Get four right to complete the lesson.
1. Throughput is…
- Units produced
- Sales minus raw material (truly variable cost)
- Sales minus all costs, including overheads
- Revenue
The money the company itself generated.
2. Productivity, in TOC terms, is…
- Units per hour
- T − OE
- (T − OE) ÷ I
- T ÷ OE
And investment turns is T ÷ I.
3. In the chain analogy, cost is like…
- Weight: it adds up
- Strength: it doesn’t add up
- Length
- Colour
Throughput is like strength.
4. The assumption that holds the cost world together is…
- Cost must be cut every year
- Throughput doesn’t matter as long as costs are controlled
- Local impact equals the impact on the organisation
- All departments are equal
It is false even for cost.
5. Saving freight by sending only full trucks can…
- Only reduce cost
- Raise obsolescence cost in distribution
- Increase throughput, since the money saved is spent on sales
- Have no other effect
Local saving, global cost.