Throughput Accounting 1 · Lesson 6 of 6
Profits in the warehouse
Produce more than you sell and cost accounting reports a bigger profit, with the same sales and less cash. See how the matching principle creates artificial inventory profits, and why that rewards the wrong behaviour.
A bonus, then bankruptcy
In the 1990s, an automobile company that had always made money reported its first loss. A new chief executive arrived and asked one question: how busy are our most expensive machines? Very busy, about 99%, came the answer. How many shifts? Two.
Add a third shift.
By the end of the year the plants were full of inventory and work in progress, and the company reported a huge profit. The chief executive took a large bonus. Next he asked for the product costs, and outsourced every item that a supplier could make for less. Six months later he did it all again.
Two years later, the company went bankrupt.
How can a company report record profits while it heads for bankruptcy? The answer lies in a rule of financial accounting.
The matching principle
The matching principle says that expenses must be charged to the period in which the revenue they helped to earn is recognised. For a manufacturer, that means a share of the period’s fixed expenses is attached to each unit made, and only charged against profit when the unit is sold. Unsold units carry their share into the warehouse, as inventory on the balance sheet.
A simple case. A company makes 3,000 units and sells 1,000 at ₹1 each. Material is 50 paise a unit; fixed expenses are ₹400.
| Cost accounting | Throughput accounting | |
|---|---|---|
| Sales | ₹1,000 | ₹1,000 |
| Material of units sold | ₹500 | ₹500 |
| Fixed expenses | ₹133 (a third of ₹400, for the units sold) | ₹400 |
| Profit | ₹367 | ₹100 |
₹267 of this year’s expense has moved into the warehouse with the 2,000 unsold units. It will hit the profit and loss statement whenever they are sold, or written off.
Company XYZ
Company XYZ can make 10,000 units a month, but the market buys only 7,000 at ₹15. Raw material is ₹2 a unit, indirect manufacturing cost ₹70,000 a month, period expenses ₹15,000 a month. Move the slider: how much should XYZ make?
At 10,000 units, cost accounting reports ₹31,500 of profit. Throughput accounting reports ₹6,000: exactly what XYZ reports if it makes only the 7,000 it sells. The ₹25,500 difference is this month’s expense, parked in 3,000 unsold units. And the cash is ₹6,000 worse, spent on material for goods nobody has bought.
Pause and think: XYZ’s plant manager is measured on product cost and the profit and loss statement. What will the manager do?
- Make only what is sold, to keep inventory low
- Reduce the price to sell the extra 3,000
- Run the plant flat out: lower unit cost, higher reported profit
- Close the plant one week a month
Every extra unit spreads the fixed cost thinner, lowers the product cost and raises the reported profit. The measure rewards overproduction, the very behaviour that ties up cash, fills warehouses and, as with the car company, can sink the business.
What the warehouse is hiding
Producing for stock does more than inflate profit:
- Cash goes into material and stock instead of the bank.
- Lead times grow, as work in progress queues in front of every machine.
- Quality problems surface late, when hundreds of units already carry the defect.
- Obsolescence: when the product changes, the stock is written off, and the inflated profit turns into a real loss.
- Effort goes into what is easy to make, not what customers are waiting for.
Throughput accounting removes the incentive by valuing inventory only at its truly variable cost, the material. A unit made but not sold adds nothing to profit. Only a sale does.
Bridging local and global
Look back at the course so far. Product cost was meant to be the bridge between local decisions and the company’s profit. In every case we tested, it pointed the wrong way:
| Decision | The cost report said | What actually happened |
|---|---|---|
| Product mix | Push Q, the high-margin product | P first made ₹600 a week more |
| Sharper report | Stop making P | Profit would fall by ₹3,300 a week |
| Low-margin order | Reject: it loses 50 paise a unit | Accepting turned −₹450 into +₹290 |
| Improvement | Fund the ₹500-a-week saving | It saved nothing; the rejected one made ₹540 a week |
| Make or buy | Buy in at ₹75 | Making it earned five times more |
| Overproduction | Profit up ₹25,500 | Same sales, less cash |
So where is cost accounting going wrong, and what should replace it? That is the subject of Part 2: Throughput Accounting in Practice.
Check your understanding
Answer all five. Get four right to complete the lesson.
1. The matching principle says that…
- Sales must match production
- Expenses are charged in the period when the revenue they relate to is recognised
- Prices must match costs
- Inventory must match demand
So a share of fixed expense travels with each unsold unit into inventory.
2. XYZ makes 10,000 and sells 7,000. Cost accounting shows ₹31,500; throughput accounting ₹6,000. Where is the ₹25,500?
- In extra sales
- In lower material prices
- In the bank
- In the value of the 3,000 unsold units
3,000 units × ₹8.50 of absorbed expense = ₹25,500.
3. Making more than you sell does what to cash?
- Reduces it: material is bought for goods nobody has bought
- Increases it
- Nothing
- Doubles it
XYZ generates ₹6,000 less cash at 10,000 units than at 7,000.
4. In throughput accounting, inventory is valued at…
- Full product cost
- Selling price
- Truly variable cost
- Replacement cost plus overhead
So making for stock never creates profit on paper.
5. Why did the car company report a big profit before going bankrupt?
- Sales doubled
- A third shift built up inventory, which absorbed fixed expenses and inflated reported profit
- It cut prices
- It sold a plant
The profit was in the warehouse, not in sales.