Fundamentals of TOC · Lesson 2 of 6
Measuring progress
Net profit and ROI tell you the score, but they arrive too late to steer by. Throughput, Investment and Operating Expense connect daily decisions to the goal.
Once the goal is clear, the next question is how to tell whether you are getting closer to it.
The bottom line, and why it isn’t enough
Three measures tell owners whether a company is making money:
- Net profit: how much money was made, in absolute terms.
- Return on investment (ROI): how much was made relative to the money tied up in the business.
- Cash flow: whether there is enough cash to survive. When cash is short nothing else matters; when it’s plentiful it hardly matters at all.
These are the right scores, but they come at the end of the month or the quarter, and they say nothing about a decision on the shop floor today. Should we accept this order? Run this machine on overtime? Buy in bulk? You need measures that connect each decision to the bottom line.
Three operational measures
TOC uses three:
| Measure | What it is | Examples |
|---|---|---|
| Throughput (T) | The rate at which the system makes money through sales. Sales revenue minus truly variable costs. | Price of a product minus its raw material and per-unit sales commission |
| Investment (I) | All the money the system has tied up in things it intends to sell, or that it needs in order to sell. | Raw material, work in progress, finished goods, machines, buildings |
| Operating Expense (OE) | All the money the system spends turning Investment into Throughput. | Salaries, rent, power, maintenance |
Two details catch people out:
- Throughput counts only money that comes through sales. Goods made and stacked in the warehouse are not throughput; they are investment waiting to become throughput.
- Truly variable costs are only the costs that go up by one unit when you sell one more unit, typically material. Labour is usually not truly variable: you pay your people whether or not the extra unit gets made.
Exercise: where does each item belong?
- Monthly salaries of the production team
- Steel sitting in the store
- A new machine
- The factory’s electricity bill
- Material used in each product you ship
- Sales price minus material cost of the orders shipped this week
- Finished goods waiting in the warehouse
- Sales commission paid per unit sold
Connecting them to the bottom line
The three measures add up to the bottom line in two lines:
- Net profit = T − OE
- ROI = (T − OE) ÷ I
So a decision is good if it raises T, or lowers I, or lowers OE, without hurting the other two more. Try it:
Which lever matters most?
Look at the sliders again. Operating Expense and Investment can only go down so far, never below zero, and long before that you are cutting into the people and equipment you need. Throughput has no ceiling.
That is why TOC puts the three in a clear order: Throughput first, then Investment, then Operating Expense. Traditional cost accounting works in the opposite order, chasing cost savings first. We will call that the cost world. In the next lesson you’ll see why chasing cost everywhere so often fails to lift the bottom line.
Check your understanding
Answer all five. Get four right to complete the lesson.
1. Your plant makes 500 units this month but ships only 300. Throughput counts…
- All 500 units, at full price
- 500 units, at material cost
- Only the 300 units sold, at price minus truly variable cost
- Nothing until the month closes
Throughput is money generated through sales. The other 200 units are Investment until they are sold.
2. Which formula is right?
- Net profit = T − OE
- Net profit = T − I
- ROI = T ÷ OE
- ROI = I ÷ (T − OE)
Net profit = T − OE, and ROI = (T − OE) ÷ I.
3. Overtime for the whole team is usually…
- A truly variable cost
- Investment
- Throughput
- Operating Expense
It’s money spent to run the system. Whether it pays off depends on whether it raises T by more than it costs.
4. Why does TOC put Throughput first?
- Because costs don’t matter
- Because T has no upper limit, while I and OE can only be cut so far
- Because T is easier to measure
- Because accountants prefer it
Costs still matter, but cutting them has a floor. Growing throughput doesn’t.
5. Buying a year’s raw material in one lot to get a 3% discount mainly…
- Raises Throughput a lot
- Lowers Operating Expense a lot
- Raises Investment, which can lower ROI and tie up cash
- Has no effect on the measures
The small saving on the unit price comes with a big rise in money tied up in stock.