The primary concept underpinning throughput analysis is that you should look at investment decisions in terms of their impact on the entire system, rather than on the specific area in which an investment is contemplated. The system view is based on the fact that most production costs do not vary at the level of the individual unit produced. When a unit is manufactured, only the associated cost of materials is incurred. All other costs are associated with the production process, and so will be incurred even in the absence of any unit-level production.
For example, in order to operate a production line at all, there must be a conveyor belt, production equipment, and a minimum number of employees to staff the line. Irrespective of the presence of any production activity, these costs must still be incurred. Consequently, the focus of attention should be on the process that produces goods, rather than on the goods themselves.
The Throughput Analysis Approach
The system approach advocated by throughput analysis uses a whole new set of terms, rather than the cost of goods sold and gross margin concepts that are most commonly applied to units produced. The following concepts are of particular importance:
- Throughput. This is sales minus totally variable expenses, which usually translates into sales minus the cost of direct materials, and perhaps commissions. Because so few costs are truly variable, throughput as a percentage of sales should be quite high.
- Operating expenses. This is all expenses, not including the totally variable expenses used in the calculation of throughput. In essence, these are all of the costs required to maintain the system of production. Operating expenses may have some variable cost characteristics, but are generally fixed costs.
- Investment. This is the amount of cash invested in order to increase the capacity of the production system to produce more units.
These concepts are included in the following three formulas, which are used to solve a number of financial analysis scenarios:
Revenue – totally variable expenses = throughput
Throughput – operating expenses = net profit
Net profit / investment = return on investment
Questions to Answer in Throughput Analysis
When altering the system of production, one or more of the preceding formulas can be used to decide whether the contemplated alteration will improve the system. There must be a positive answer to one of the following questions, or else no action should be taken:
- Is there an incremental increase in throughput?
- Is there an incremental reduction in operating expenses?
- Is there an incremental increase in the return on investment?
The best system improvements are those that increase the amount of throughput generated, since there is no theoretical upper boundary on the amount of throughput. Conversely, an action taken to reduce operating expenses is less important, since expenses can only be reduced to zero. Also, be wary of any decisions to reduce operating expenses that pose the risk of also reducing the maximum effective capacity of the production system, since this may impinge upon throughput.