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Throughput Accounting 2 · Lesson 4 of 6

Measuring plants, channels and departments

How do you judge a plant, a sales channel or a customer without allocating shared costs? Value inventory at truly variable cost, keep shared costs at the level that shares them, and measure productivity as throughput per rupee of expense and investment.

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The temptation to allocate, again

Once a company stops allocating overhead to products, the same question comes back one level up. Which plant is profitable? Which sales channel? Which customer? The usual answer is to allocate head-office costs, shared warehouses and shared machines to each one, and compute a profit and an ROI for each.

That repeats the P&Q mistake. A shared cost that doesn’t go away when one plant, channel or customer goes away will simply land on the others, and the next report will make them look worse. It is the death spiral again, one level up.

The rules for measuring subsystems

  1. Value inventory only at its truly variable cost. You don’t need to change your statutory financial reports. Just use truly variable cost for every decision.
  2. Only truly variable costs are costs of a product.
  3. Only costs that are not shared are costs of a subsystem: a plant, a sales channel, a client. A plant’s own rent and staff belong to it. The head office, a shared warehouse or a shared IT system don’t.
  4. Costs that can’t be identified with one subsystem stay at the higher level that shares them.
  5. Shared investments aren’t allocated either. Only investment that belongs to one subsystem alone is that subsystem’s investment.
  6. Don’t calculate net profit or ROI for subsystems. Measure each by the throughput it generates, the operating expense and investment that are truly its own, and how it affects the constraint.

Pause and think: a company has two sales channels. After allocating head-office cost by sales, the online channel “loses” ₹20 lakh a year. Its own throughput is ₹90 lakh and its own costs, its team and platform, are ₹60 lakh. Should it be closed?

  • Yes, it loses ₹20 lakh
  • No: closing it removes ₹90 lakh of throughput and only ₹60 lakh of cost; the head-office cost stays and falls on the other channel
  • Only if online sales are falling
  • It depends on the allocation basis

The channel contributes ₹30 lakh a year to the company’s shared costs. Close it and company profit falls by ₹30 lakh, while the other channel suddenly looks worse.

Local measures that fight the goal

Inside a plant, the most common local measures are efficiency and utilisation: keep every person and machine busy. Part 2’s first lesson showed what that does at non-constraints: more inventory, longer lead times, lower output. A measure is useful only if improving it locally improves the whole.

Exercise: which local measures point towards the goal?

  • Utilisation of every machine
  • Orders delivered on time and in full
  • Absorbed overhead, or “recovery”, per month
  • Constraint time lost to breakdowns or missing material
  • Department cost per unit
  • Work in progress, in days of throughput

When a local measure drives behaviour that reduces throughput, the measure itself has become the constraint.

Productivity: growth or expansion?

If not profit per plant or per product, how do you know the company is improving? Look at productivity, in throughput terms:

  • T ÷ OE: how much throughput each rupee of operating expense brings in. Call it people productivity.
  • T ÷ I: how much throughput each rupee of investment brings in. Call it capital productivity.

These separate two very different kinds of progress. A company that doubles its sales by doubling its people, plants and stock has expanded. It is bigger, but no better. A company that sells more with the same people and less stock has grown: its productivity has improved, and every rupee of new throughput falls almost entirely to profit. Many companies celebrate years of rising revenue and profit while their T ÷ OE barely moves. That is expansion, not growth, and it leaves most of the opportunity untouched.

Three priorities

Put these together and the priorities for any part of the business are:

  1. Increase throughput, period after period. It is the only measure with no ceiling.
  2. Increase T ÷ OE: more throughput from the same operating expense.
  3. Increase T ÷ I: free up investment, especially inventory.

The next lesson shows why this order matters.

Check your understanding

Answer all five. Get four right to complete the lesson.

1. Which costs belong to a sales channel?

  • A share of head-office cost, by sales
  • A share of everything, by headcount
  • All the company’s costs
  • Only the costs that are not shared, such as its own team and platform

Shared costs stay at the level that shares them.

2. Should you calculate net profit and ROI for each plant?

  • No: that needs allocation of shared costs and investment
  • Yes, always
  • Only for the biggest plant
  • Only once a year

Measure each by its throughput and its own OE and I.

3. A company doubles sales by doubling its people and plants. In throughput terms it has…

  • Grown
  • Become more productive
  • Expanded, without improving productivity
  • Reduced its constraint

T ÷ OE and T ÷ I haven’t moved.

4. T ÷ OE measures…

  • Capital productivity
  • How much throughput each rupee of operating expense brings in
  • Inventory turns
  • Product margin

Sometimes called people productivity.

5. Which local measure points towards the goal?

  • Utilisation of every machine
  • Constraint time lost
  • Absorbed overhead per month
  • Department cost per unit

Every minute the constraint loses is lost throughput for the whole company.