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February 24, 2011

Lean Accounting and Throughput Accounting

I am often asked what the difference is between Lean Accounting and Throughput Accounting. “Not a huge amount”, is the answer.

Both Lean Accounting and Throughput Accounting seek to align costs with the flow through a Value Stream or process. Lean accounting and Throughput Accounting, therefore, both fall under the heading “flow accounting”, whereas traditional cost accounting has no concept of flow.

In Lean Accounting and Throughput Accounting we understand that costs arise through a process – a chain of activities (both value-adding and non-value-adding) – and that the only way to cost-reduce a product is to improve the process. Traditional cost accounting misses this link with the process which generates the cost.

While the aim of traditional cost accounting is to maximise the “efficiency” of resources in the process (labour hours or machine hours), in Lean Accounting and Throughput Accounting we understand that improving the efficiency of any given resource may not (and often does not) reduce the cost of the process as a whole – it will, in many cases, merely build inventory.

In Lean Accounting and Throughput Accounting the philosophy is that we reduce cost, or increase profitability, by increasing the rate of flow through the whole process or Value Stream.

So Lean Accounting and Throughput Accounting have the same philosophy behind them, but they differ in substance. I think it is fair to say (though some may disagree) that Throughput Accounting is primarily intended as a tool of analysis and decision making. Lean accounting provides a much more comprehensive costing system which provides total alignment between costing and value streams.

Nevertheless, Throughput Accounting provides some useful tools for understanding and improving flow in a process or Value Stream. These can help any lean organisation and could benefit from a higher profile in Lean Accounting as well.

First we need some definitions:

“Throughput” in Throughput Accounting is defined as Net Sales less Total Variable Cost. Total Variable Cost is usually taken as material cost only, though there may be other truly variable costs in a particular process. Thus “Throughput” is very similar to “Contribution” in management accounting.

“Investment” is defined as the money tied up in the process or Value Stream -that is the equipment, inventory, facilities, buildings and other assets and liabilities assigned (not apportioned) to the Value Stream (or process). Note that Throughput Accounting values inventory strictly on totally variable cost (material cost) only – without labour or overhead.

“Operating Expense” is the other direct costs associated with the Value Stream or process excluding any allocations or external overheads. This is the same as the Lean Accounting term “Value Stream Cost”.

Thus “Net Profit” (in Lean Accounting we would call this Value Stream Profit) = Throughput less Operating Expense.

“Return on Investment” in Throughput Accounting terms is Net Profit divided by Investment, expressed as a percentage. This is a very interesting measure and useful to compare Value Streams. It is more sophisticated than the rather simplistic “return on sales” percentage we often see in Value Stream Profit statements. I have always considered “return on sales” to be too short-term focussed, and the Throughput Accounting measure of “Return on Investment” is probably more useful to show senior management that we can improve a Value Stream’s return on investment, not only by increasing the revenue of the Value Stream, but by reducing inventory as we improve flow, and by reducing waste.

“Productivity” in Throughput Accounting is defined as Throughput divided by Operating Expense, expressed as a percentage. This is a reflection of the level of “contribution” in the Value Stream.

The Throughput Accounting term “Investment Turns” is defined as Throughput divided by Investment, expressed as a ratio. This is also an interesting measure. Any decision that improves this ratio for a Value Stream will inevitably improve the profitability of the Value Stream. Thus the “Investment Turns” measure is a useful first-cut way of ranking alternative decisions.

Both Throughput Accounting and Lean Accounting are easy to understand and apply, so it is not a competition between them. They are complimentary systems: align your cost centres with Value Streams or processes and you are ready to go.

I’d be very interested if readers of this blog incorporated these measures – particularly “Return on Investment” and “Investment Turns” – into their Box Scores over a period of time to see how useful they prove. Please let us know by commenting on this blog.