Throughput accounting is based on three simple measurements: throughtput (T), investment (I) and operational expense (OE). These measurements are then used to calculate two measurements that determine the profitability of a company: Net Profit (NP) and Return Over Investment (ROI). The formulas for these two variables are:
- NP = T – OE
- ROI = (T – OE) / I
Let’s use an example. Suppose you own a grocery store with the following results per month:
Sales $10,000
– TVC (65%) $6,500
= Throughput $3,500
– OE $2,000
= NP $1,500
Investment $50,000
ROI 3%
The store is generating $1,500 every month, and since Investment is $50,000, the ROI is 3% per month. Throughput accounting is primarily used to evaluate decisions by calculating the impact on NP and ROI. If ∆NP and ∆ROI is positive, the decision should be approved. According to most TOC bibliography the formulas are the following:
- ∆NP = ∆T – ∆OE
- ∆ROI = (∆T – ∆OE) / ∆I
Let’s continue with our example. Suppose that your supplier delivers in 5 days from the moment you place an order. If we assume that order lead time is 1 day, then the total replenishment time (RT) is 6 days. This means that 10 days worth of inventory should be more than enough to ensure good availability. The person in charge of procurement is suggesting to change to a different supplier that has the same quality, that is 10% cheaper and that delivers in 2 days instead of 5. Would you change supplier? What does your intuition tell you? The most probable answer is that we should definitely change supplier, but let’s follow the process and calculate the impact on NP and ROI.
- ∆Sales = $0 (Let’s assume sales won’t increase)
- ∆TVC = – (10% of $6,500) (The supplier is 10% cheaper)
- ∆T = $650 (Throughput will increase in $650 per month)
- ∆OE = $0 (Let’s assume OE stays the same)
- ∆I = 50% of $50,000 = -$25,000 (Negative I because inventory is cut in half due to shorter RT)
At first glance, this seems like a very nice deal. Throughput increases, OE stays the same and Investment reduces significantly. Let’s check the impact on NP and ROI.
- ∆NP = ∆T – ∆OE
- ∆NP = $650 – $0 = $650 (Net Profit increases in $650 per month)
- ∆ROI = (∆T – ∆OE) / ∆I
- ∆ROI = $650 / –$25,000 = –6% (ROI decreases 2.6%)
According to ∆ROI you shouldn’t change suppliers because even though NP increases, ROI decreases significantly. If the initial ROI was 3% and ∆ROI is 2.6% then final ROI would be 0.4%; a pretty bad deal. But wait a minute, how can this be? After all, changing suppliers will free cash tied up in inventory and TVC will go down 10% increasing throughput by the same amount. How can this have a negative impact in the store’s performance? The answer lies in simple arithmetic:
∆ROI can be also expressed as final ROI minus initial ROI, or ROI1 – ROI0. Since ROI = (T – OE) / I then
∆ROI = –
If you decide to find a common denominator, then the expression would expand to be:
∆ROI =
Which is definitely not equal to (∆T – ∆OE) / ∆I
To avoid making this mistake, we suggest two options. One, is to calculate ∆ROI by calculating ROI1 (the ROI after the decision) and then subtracting ROI0 (the ROI before the decision). In our example, the P&L before and after changing supplier would be:
| P&L | Initial ROI
(ROI0) |
Final ROI
(ROI1) |
Variation
(ROI1 – ROI0) |
| Sales | $10,000 | $10,000 | $0 |
| – TVC | $6,500 | $5,850 | –$650 |
| = Throughput | $3,500 | $4,150 | $650 |
| – OE | $2,000 | $2,000 | $0 |
| = NP | $1,500 | $2,150 | $650 |
| Investment | $50,000 | $25,000 | –$25,000 |
| ROI | 3% | 8.6% | 5.6% |
So this means that ∆ROI is equal to 5.6%! Our intuition (once again) was right. However, doing a whole P&L statement for any decision we are contemplating is cumbersome so analyzing just the variations makes sense, but as we showed earlier, the formula for ∆ROI is a mathematical nightmare! This is why our preferred approach is to calculate the payback period instead of ROI:
- Payback Period = ∆I / ∆NP
In the above example:
- Payback Period = –$25,000 / $650
- Payback Period = –5 months
A negative Payback Period can be easier understood because this simply means that the decision is so good, that any investment required already paid for itself! Trying to justify a negative ROI just doesn’t make sense. Besides, we believe that the concept of Payback Period is easier to interpret and assimilate than ROI.
