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How Making Money Really Works: Key Concept #1 – Throughput-Margin is Additive.

Key Concept #1:  Throughput-Margin is Additive

What if every job adds some money toward the bottom-line for the month?

What if all the jobs add up to the “money-in” for the month, and in total, you made money for the month because all of the money-in added up to more than your “money-out”?

Money-in is called Throughput-margin.  Throughput-margin is the revenue from a job less the Totally Variable Costs of the job. Totally Variable Costs, which include materials, subcontracting, and freight, are deducted from revenue to calculate Throughput-margin. Unless you are selling a job for less than its Totally Variable Costs, it is providing Throughput-margin (money-in).

Money-out is called Operating Expense.  Money tied up in the system is The Goal by Eliyahu M Goldrattcalled Inventory.  These terms are part of the Theory of Constraints Throughput Accounting and were used in “The Goal” and the result of this new way of thinking about how to make money was the reason why such a remarkable turnaround occurred in just 3 months (that’s the story in the book).

In this context, what if there was no such thing as an unprofitable job?  And if there is no such thing as an unprofitable job, then there is no such thing as an unprofitable customer.  If this is in fact true, then its likely you would look at your decisions regarding jobs in a very different light.

Customers are the source of money-in that helps add up to the total.

If you got rid of jobs and customers that help add to the total for the month, perhaps the total of money-in would not be enough to cover all of the money-out.

Isn’t that a very different way of thinking about How Making Money Really Works?  But it is simple and straight-forward.

Dr. Eliyahu Goldratt, author of the popular and best-selling book “The Goal”, developed these concepts into what he called “Throughput Accounting”.

Throughput Accounting was developed to replace cost accounting.  Dr. Goldratt, a scientist, proved cost accounting was badly damaging those companies that used it.  The damage comes from having distorted measurements which unavoidably leads to making bad decisions.  Especially job costing measurements.

Profitable Jobs and Profitable Customers

For example, thinking of jobs as profitable and customers as profitable or unprofitable is incorrect.

Also, cost accounting incorrectly treats direct labor as a variable cost.  Yes, it varies, particularly if you pay for overtime.  But it is not totally variable.  So, using Throughput Accounting, it is part of Operating Expense (money-out) for a time period (for example, a month, quarter, or year).

And if you were to stop and think about the situation, you would realize that direct labor acts much more like a “fixed” cost. You have the same workers, working roughly the same hours each week, month, year, etc.  Sure, there’s PTO, overtime, etc., but when you think of your direct labor, we’re sure a number comes to mind of what it usually is in total each month.

You already add up all of the money-out for the time period.  That is standard practice.  You just are not used to adding up all of the money-in for the time period and then comparing money-in to money-out to determine the Net Profit for the time period.

Notice that when you think of it in this way, costs do not need to be allocated to jobs.  In fact, cost allocation is unnecessary and misleading.

The allocation process creates gross margin on a job by allocating (on an arbitrary basis) direct labor and overhead to jobs.  However, have you ever stopped to consider that if you simply got one more job completed, shipped, and invoiced in a month that gross margin dollars would increase? Probably not.

In fact, if you were asked, “How can gross margin dollars be increased?”, it’s likely you would say something about reducing your labor or overhead costs. And for all the time, effort, and energy spent on trying to reduce costs, there just is not that much to cut.

And what’s more, even if cost accounting says you decreased your labor costs somehow…how can costs go down when you have the same headcount? Did a magnanimous employee take a pay cut for the month? Not likely.

That’s why labor is classified as an Operating Expense in Throughput Accounting. Labor does not vary totally with the number of jobs you take on each period. If labor was totally variable, then you would save the expense of the labor if you did not run a particular job. But that’s just not so; you already have the workers hired and the shifts being ran.

A company makes money when Throughput-margin is greater than Operating Expense for a time period.

Recognizing that each job produces some amount of Throughput-margin, we now see that we can simply add up all the Throughput-margin for the jobs we completed, shipped, and invoiced for a month and compare it to the total Operating Expense for the month and determine if the company made or lost money.  It is just that simple.

Note in the example below, we have three jobs:  Job 1, Job 2, and Job 3.  Each job has Revenue.  Each job has Totally Variable Costs (TVC).  Each job has Throughput-margin.  But jobs do not have Operating Expense.

How making money really works. Key Concept#1: Throughput-Margin is Additive!

Only the company has Operating Expense.  Total Throughput-margin minus Operating Expense is Net Profit for the time period.  In the example, $20,000.

Notice how simple and clean an income statement presented in the Throughput Accounting format reads.  It’s very clear where the dollars are coming in from (on an individual and total basis) and how much are going out in total.

Also note, with Throughput Accounting the jobs on the income statement are not distorted (you won’t see unprofitable jobs in Throughput Accounting) nor is the income statement itself distorted by cost accounting.

Have you ever looked at your income statement and wondered, “Who’s results am I looking at?”.  You’re not alone.  Cost accounting can so distort the financials that good months look bad and bad months look good.  It would not be recommended to make decisions on such distorted results.

In summary, with Throughput Accounting we do not allocate labor or overhead, we have a totally different view of how our jobs create “money-in”, and we have a much simpler income statement that can actually demonstrate why the numbers are what they are.

In the next post we’re going to share with you how the additive aspect of Throughput-margin can impact your bottom-line.

To find if/how Throughput Accounting can help you in your shop, sign up for a free Strategy Session.  We’ll go deep and dig into YOUR financials to see if Job Shop Pricing is a good fit and how much improvement is possible for YOU.

Bonus Video:

To find if/how Throughput Accounting can help you in your shop, sign up for a free Strategy Session.  We’ll go deep and dig into YOUR financials to see if Job Shop Pricing is a good fit and how much improvement is possible for YOU.