Now we come to throughput accounting. And before we discuss this, let's have a very brief history of cost accounting. The techniques in cost accounting and cost analysis were developed in the UK during the Industrial Revolution, the firm of Josiah which would and the Karen Ironworks, which was based not 10 miles away from where I'm recording now, both used cost accounting methods from the late 1770s. And some history suggests that Andrew Carnegie introduced cost accounting into the US from Scotland in the mid 1800s. Standard costing came into its own in the United States in the 1920s. With the advent of mass production, the DuPont powder company developed Absorption Costing techniques, and General Motors introduced them throughout its vast businesses.

The philosophy of standard cost accounting Is that profitability is maximized when labor and machine utilization are maximized both throughput accounting and Lean Accounting reject that stance. So, what is throughput accounting? throughput accounting is designed to support the concept of the Theory of Constraints and it focuses on the economies of flow rather than the economies of scale. So, when a standard cost accounting seeks the lowest cost per item through economies of scale, throughput accounting argues that this concept does not apply in a high variability multi product environment. in such an environment, profitability is maximized when the rate of flow is maximized. And that is the focus of throughput accounting, which is defined by the accounting dictionary as a management accounting system that seeks to maximize the return on bottleneck activities.

Theory of Constraints international certification organization gives another definition of throughput accounting and management accounting method that is based on the belief that because every system has a constraint which limits global performance, the most effective way to evaluate the impact that any proposed action will have on the system as a whole is to look at the expected changes in the global measures of throughput, investment and operating expense. And that definition brings us to the performance measures of throughput accounting. And there are three key measures of throughput accounting. Indeed, throughput accounting argues that the business process can be managed with just these three measures combined into full KPIs which we'll see on the next slide. The three measures of throughput accounting therefore are firstly throughput to contribution t is defined as net sales, less total variable cost and total variable cost of the truly variable costs in the process.

The second measure is investment I. This is defined as the money tied up in the process or value stream, that is equipment, inventory facilities, buildings and other assets and liabilities that form part of the value stream or business process. And we should note that throughput accounting values inventory strictly on the total variable cost only basis without any labor or overhead allocation. The third measure of throughput accounting is operating expense Oh II and this is other direct costs associated with the value stream or process excluding any allocations or external overheads. We'll look at examples of these three measures shortly but firstly Look at the four ratios of throughput accounting, the throughput accounting KPIs if you like. The first of these is net profit, and throughput accounting defines net profit NP as throughput, less operating expense, that's t minus o E. The second KPI is return on investment, and throughput accounting defines this as net profit divided by investment expressed as a percentage.

So that's NP over AI. And this is a useful measure to compare value streams. We can improve a value streams return on investment, by increasing the revenue of the value stream by reducing inventory as we improve flow and by reducing waste. The third KPI of throughput accounting is productivity. And this is defined as throughput contribution divided by operating expense expense. as a percentage, that's t over o E. And this measure is a reflection of the level of contribution in the value stream.

The fourth throughput accounting KPI is called investment turns. And that's defined as the throughput contribution divided by investment expressed as a ratio. So t over AI. Any decision that improves this ratio for a value stream will improve the profitability of the value stream. Thus, investment turns this measure is a useful way of ranking alternative decisions. Why then would we use throughput accounting?

Well, it's all about flow. If we believe that improving the flow of work through business process improves profitability, then throughput accounting or Lean Accounting are the approaches to apply according to throughput accounting, if we improve the flow at the constraint, we end prove the throughput of the entire process. And that sounds logical. by aligning custom revenues with the flow of work through a business process or called value stream, we can begin to see that the performance of the process and its costs are linked, improve the flow, and we also reduce the cost. The philosophy of throughput accounting is that we increase profitability and reduce costs by increasing the rate of flow through the whole process of value stream. Thus, throughput accounting is an example of flow accounting, as is Lean Accounting when we come on to it, which means it's a good time to start talking about business processes and flow