Simplify Metrics by Focusing on Growth

Have you ever felt confused or frustrated about measuring how your work is going? Be that tracking the profitability of a project, keeping on top of sales, checking the effectiveness of the latest marketing campaign, or measuring the productivity of your team?

One of my hobbies is to study companies to invest in. I like to analyse their financial statements, learn about how their business works, how their industry functions etc. And eventually come to a reasonable valuation for the business, so I know whether I should buy shares or not.

The thing is, financial statements can be fiendishly complex. And the ways of measuring success vary a lot depending on the type of business, the amount of debt, its history, competitors... So many factors.

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What I really enjoy is turning that complexity to a simple understanding of what's going on. So I was excited to find a new way to understand manufacturing businesses through something called Throughput Accounting. It's an alternative to the paradigm of Cost Accounting that permeates the accounting field and most businesses.

Throughput Accounting was developed by a thought leader in process improvement, called Eliyahu Goldratt. Goldratt came up with many innovations such as the Theory of Contraints. I won't go into the details of that here, but in essence he taught that improving the flow of product through a company (its throughput) is a much better way of making money than focusing on reducing costs.

For example, let's consider a business growing and selling apples. Its managers can look at how to use their competitive advantage to sell more apples (for example by marketing to a new country for export). Or they can focus on reducing costs on their existing apple production (such as improving transport, so less apples go rotten before reaching the market). The growth opportunity has a very high upside (there could be potentially millions of new customers to attract in a new country), whereas the cost reduction opportunity has a limited upside (once all harvested apples reach the market before going bad).

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So we can see that focusing on throughput and growth is usually preferable to cost reduction. At least until the market is saturated or the production capacity can't be increased any more.

The Costs of Cost Accounting

Many businesses have a bias towards cost reduction built into their metrics. Employee productivity, operating expenses, limits on training hours or expenditure, and endless discussions about which cost centre to allocate these expenses to.

I used to work at a large consulting firm where middle management would regularly argue about cost allocations to protect their own team's metrics. I wanted to purchase a $10 book that would help me use a $500 piece of software better, but it took over two weeks of badgering my boss about it before she eventually caved. Cost Accounting at its finest! (She was a great boss by the way, but had to deal with the system.)

Savvy managers will know to track growth as well, through numbers like total sales, gross profit, and future workload. Even these can be distorted by Cost Accounting to mask how things are really going. The end result? A complex spreadsheet with at least 6 or 7 disparate numbers, perhaps calculated per project or per team. It can be confusing to know how to use these numbers, as they may not be directly actionable or relevant depending on your role in the company.

At another company I worked at, collecting, calculating and presenting these numbers took about a week. (About 20 hours of billable time across the team.) We ran the metrics every month. Perhaps 2-3 people truly understood what each number meant, and were in a position to act on it.

This is all a long winded way of saying that Cost Accounting can be very complex and unhelpful.

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How does Throughput Accounting work?

There are three 'base' metrics to measure:

1. Throughput = Sales (invoiced, not accrued!) - Totally Variable Cost (raw materials). Seek to increase this.

2. Investment = Capital Expenditure that increases productive capacity. Seek to decrease this.

3. Operating Expense = all overheads needed to convert raw materials to finished product. Seek to decrease this.

There are another four 'derived' metrics calculated from the above:

4. Net Profit = Throughput - Operating Expense

5. Return on Investment = Net Profit / Investment

6. TA Productivity = Throughput / Operating Expense

6. Investment Turns = Throughput / Investment

The powerful thing with these set of metrics is that they are easily actionable. The first three numbers guide operations. Seek to improve throughput first, maybe by increasing selling efforts or reducing work in progress. Then look at reducing the required investment, such as paying down debt or using assets more effectively. Finally, look at reducing operational expenses once the other two numbers have been maximised.

The second set of metrics guide strategic decision making. How did that project perform? What is the likely return if we purchase more equipment or office space? How well is our team performing? How quickly are we turning investment into results?

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Goldratt's system is biased towards manufacturing businesses, but with some adjustment they can apply just as well to service oriented companies and other industries. Throughtput Accounting integrates really well with an Agile style of working - which also seeks to maximise growth, reduce work in progress and (ideally) keep metrics simple.

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If you would like to learn more about the Throughput Accounting system, the Wikipedia article on it is very informative or pick up one of Goldratt's books. I highly recommend The Goal, which teaches the Theory of Constraints in a fictional story format. Otherwise, feel free to reach out to me for a chat.