The Unbearable Lack of Knowledge about True Variable Expenses

The keywords in this definition are “rate,” “system” and “through sales.” How much money did we make today, this week, this month, through sales? The amount of money made per time period because of sales.

Throughput is a holistic metric, for the system as a whole, not for a part of a system like for example a product or project or division or department. Throughput is only recognised when a sale external of the system is concluded – all dependent upstream steps in producing the product has been completed.

Business Throughput is calculated as sales revenue (SR) less true variable expenses (TVE). The logic is that a business cannot claim sales as the money it has made. The expenses that must be incurred in the process of having a sale must be deducted first before the real top-line can be known.

TVE is the expenses to purchase raw materials as well as transport, commissions, heating fuel, maintenance, truck tyres, fuel, etc. These are expenses that are not incurred when an order does not have to be filled, if nothing is to be produced. These expenses are negligible in a few very rare exceptions and can then be lumped together with other fixed expenses, Operating Expenses, without impacting the quality of a management decision. Examples of when TVE can be negligible are delivering a remote IT support service, hosting an IT system or producing embroideries where the raw materials are only very cheap thread.

Management has the responsibility to make decisions that maximises Throughput and is always based on a set of assumptions. But assumptions can only be valid with good knowledge of the current reality, the current TVE/unit of the finished product.

In decision-making aimed at maximising Throughput (e.g. setting prices, deciding where to produce an order, whether to pursue a new opportunity, declining or accepting an order, etc.), the mandatory expenses that are expected to be incurred to have a sale must always be recognised in the decision-making process. Only considering more expected sales (volume) or the expected selling price is insufficient. The expenses that must be incurred to have the sale must be part of the decision. Operating Expenses may not increase if more sales are realized, when the order can be delivered with excess capacity. But true variable expenses will always be incurred, without a doubt, in all instances – it is mandatory expenses.

The importance of TVE in decision-making is typically not recognised when a financial IT system is specified and configured, making it very difficult to have accurate information on current TVE. It is not a standard feature of financial systems, it is not required by GAAP or any tax authority, but it is absolutely necessary to enable managers to make good decisions.

A financial system must provide answers to the question “How much money will the business make if we sell at this price, if we deliver to that location, if we buy the raw materials at a higher price, if we pay a commission to get a sale?”

Operating expenses will only change if the capacity to fill an order is not available, so there is no need to allocate Operating Expenses to a product or a process. There is however a need to know whether a decision will over-load the Capacity Constrained Resource in which case there will be an increase in Operating Expenses necessary to realize the Throughput.

A financial system must provide the information on the change in Throughput, less the change in Operating Expenses to calculate how a decision will change the profitability of the business, for every management decision. The financial system must be integrated with the delivery planning and execution system to ensure that the rate of delivery is improved and that the load on the capacity constrained resource is part of the decision-making process.

The goal of a business is to make more money now and in the future. Maximising Throughput is the management focus to achieve this goal.

Paradigm Software maximises Throughput with their built in delivery planning and execution system. Achieve your business goals and maximise productivity with Paradigm Software.