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per unit × 100 units for the original quantities) in addition to the $8000 investment. With this additional time, however, more units of Product Y can be produced and sold. How many additional units are possible? Not 10 (200/20), but 11 (200/18). With an original Throughput per unit of $183, 11 additional sales of Product Y will bring in $2013 each week. This amount, minus the $1000 in additional cost for Raw Material #3, means an additional $1013 in operating profit. Resource 4 has sufficient available time not only to use 9 min of processing time on the 11 additional units, but for the entire market demand of 50 units. The payback period for this investment would be $8000/$1013, or less than 7.9 weeks. Assuming the cost of the investment can be amortized over 52 weeks, operating income will increase by $3986 each week.37 This is a great investment, but it would have been turned down using traditional accounting metrics!

The Problem of Identifying Decision-Relevant Costs and How to Avoid a Disaster

Throughput (contribution margin), Inventory (investment), and Operating Expense (fixed costs) changes are always relevant. However, it is extremely difficult to accurately select the relevant costs and revenues (including those associated with lost opportunities) of many, if not most, management decisions. For example, when multiple changes are occurring to more than one element of a process (the second engineering ECP is an example), keeping everything straight for a correct analysis can be difficult. The advice provided throughout the book, Supply Chain Management at Warp Speed (Schragenheim et al., 2009), is to consider any change (product mix, investment, make versus buy, special orders, rationalization of product lines, etc.) in terms of its impact on total amounts of Throughput, Inventory, and Operating Expenses (contribution margin, investment, and fixed costs, in accounting terminology). This same advice, couched in terms of the dangers of allocating fixed costs, is included in virtually every cost and management accounting textbook (see, for example, Hilton, 2009, 600–601, 612; Garrison et al., 2010, 588–589), and should be followed without exception to avoid costly errors.38

Inventory Changes and GAAP Accounting

Basic goals of TOC are for Throughput to increase, Inventory to decrease, and Operating Expense to decrease. Throughput increases and expense decreases will be reflected favorably on external reports that conform to GAAP. Inventory reductions, however, will be reflected unfavorably on GAAP statements by reducing both assets and operating income. Therefore, inventory reductions should be handled with special care.

Because some accounting and other people have trouble understanding exactly how reducing inventory results in decreased income, I have developed several examples over the years to validate this result.

For example, assume a company that has no beginning inventories of WIP or finished goods, produces 20,000 units and sells 15,000 units for $20 each. There is no ending WIP inventory. Budgeted costs (as traditionally prepared) include the following:

A traditional (absorption costing) income statement and a Throughput (variable or direct costing) income statement (both assuming costs are the same as those projected) are shown in Fig. 13-8.

As shown in Fig. 13-8, the traditional income statement shows net operating income of $71,250, while the Throughput income statement produces net operating income of only $51,250. The difference of $20,000 ($72,250 – $51,250) can be reconciled solely by the change in inventory fixed costs. That is, the increase of 5000 units in finished goods times the fixed manufacturing cost of $4.00 per unit equals the $20,000 increase in traditional (GAAP) income over the Throughput income of $51,250.

FIGURE 13-8 Traditional and Throughput income statements.

A more detailed example involving materials and WIP changes, as well as changes in finished goods, can be found in a spreadsheet entitled “InventoryReductionExample” located at www.mhprofessional.com/TOCHandbook.