Financial measures that support Systems Thinking and Continuous Improvement

Depending on what literature you read, cost accounting is either enemy number 1 or the foundation to good manufacturing accounting principles.

As with many management principles, Cost accounting was formulated at a specific period in time and although business has evolved, cost accounting has remained the same. It fits perfectly into the linear world, and in fact the CA measures continue to drive linear thinking.

Over the last 40 years, industry has changed considerably due to evolving technology, social media, consumer demand for variety and increased competition as a result of globalization.

Customer centricity is an important factor driving business today and is one of the main factors driving the evolution of business. In order to remain competitive, we need to compete against a multitude of options available to the consumer, which highlights the importance of changing the way we manage our business practices. Change management has become an important tool in making sure that we are able to move from our traditional organizations into a systemic structure that supports the value chain and focuses on the customer.

In The Fifth Discipline, considered one of the seminal texts on Systems Thinking, Peter Senge advocates the concept of the Learning Organization and a questioning culture. The objective is to encourage a different approach by questioning our current existence. Why do we do things this way? Is it the best way to do things? What can we do better? How can we be more competitive? How can we improve flow?

Cost accounting comes from the era where cost was a major contributor to the development of manufacturing in the 20th century, and was a powerful solution. As the world has changed, so focus must change, and we need to adapt the way we measure accordingly. As an operations person, I don’t advocate trying to change the entire financial system, but rather to see how we can change the way we measure the supply chain and operations in a way that supports customer centricity and at the same time doesn’t compromise Finance.

Cost accounting tries to address the impact of local actions and decisions on overall performance, and this in turn drives our focus to ensure that every activity we carry out is value adding through the concept of product cost and product margin. The result is an inward focus on costs and the loss of focus on the Customer. As we know, there is always a drive to improve margins. In the cost world, this can be done in 2 ways, either we increase selling price, or we cut cost. The former isn’t very practical in today’s market we will just force consumers to look at our competitor products.

The direct impactThere is a saying that you can’t grow your business by cutting costs. This is very true, because at some point you are going to impact on delivery to your customer and on product quality. Cost cutting is only a short-term solution that eventually comes back to bite you. Becoming customer-centric is the most positive approach to take in the current economic climate as it changes your focus from myopic solutions to outward visionary ones and as satisfying the customer becomes the focus, businesses start identifying how they can deliver a better quality, cost effective product to market at the right time and in the right quantities.

Systems thinking, as an integral part of this vision ensures that we look at the business in a holistic manner instead of taking a reductionist or analytical view, so when looking at a “loss product”, we step back and look at its impact on the overall business, and not in isolation as a single item. Ask yourself, what is the impact on overall operating cost, and what will we need to trim from the business if we remove this product from our basket? To enable this approach at an operational level, we need to change the way we measure so that we can easily and quickly assess the impact of our decisions, and also very easily do scenario planning to validate decisions before we formalise them.

The TOC approach isn’t strictly according to the formal costing accounting principles, but it simply and clearly gives operations staff an accurate approximation of the impact of changes.

If we look at the equation below, taken from the Theory of Constraints by Eliyahu Goldratt,

Net Profit = Throughput – Operating Expense

                                Investment (inventory)

Throughput: The rate at which the system generates money through sales.
Investment (Inventory): All the money the system invests in purchasing things the system intends to sell.
Operating expense: All the money the system spends in turning inventory into throughput.

INDIRECT IMPACT INVENTORY AND CARRYING CHARGESUsing these measures, we can now start looking at the bigger picture and see how we can streamline our supply chain and operations to better support efficiencies and throughput. What is the impact on Operating cost if an indirect department increases it staff compliment? What is required from the throughput side of the equation to counteract the increase in cost?

Adopting this measure on the shop floor will encourage improvements which will automatically drop through to the bottom line.

To find out more about TOC and Systems Thinking, or have challenges in your supply chain, contact Dave at SA Coaching  You can also follow Dave on LinkedIn

Diagrams are from The Race by Eliyahu Goldratt, published in 1986.

Theory of Constraints, Systems Thinking, Throughput, Operating Expense, Customer Centricity, Continuous Improvement.

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