Business Valuation (#61)

In this podcast episode, we discuss FASB’s statement number 141R, as well as the need for business valuation services when engaging in acquisitions. Key points made are:

• The original Statement 141 addressed the use of fair value when recording a business acquisition.

• The revised Statement 141R included a number of changes, including the following:

  • Changed the definition of a business.

  • Equity securities issued as part of an acquisition are valued on the closing date.

  • Includes an estimated fair value for any earnout provisions.

  • Acquisition costs are charged off separately.

  • In-process R&D is valued and carried on the balance sheet.

  • The allocation of the purchase price is about the same as before; includes fair values for tangible assets and intangible assets.

• When deriving a valuation for acquiree assets, can use a valuation firm to develop a valuation report. This report is more defensible, since these firms have a lot of expertise. A valuation project typically takes 4-6 weeks, and costs $15,000-$30,000.

Related Courses

Accounting for Intangible Assets

Business Combinations and Consolidations

Business Valuation

Mergers and Acquisitions

Profit Recovery: Vendor Relationship Management (#60)

In this podcast episode, we discuss how an examination of the relations between a company and its vendors can uncover profit recovery opportunities. Key points made are:

• Conflicts of interest between a company and its vendors can cause major expense increases.

• Companies tend to look for fraud internally first, which means that vendor investigations are delayed or never happen at all.

• A common profit recovery scenario is when a company makes duplicate payments to a vendor, which has not sent them back. This could be a vendor error, or it could be fraud.

• It is difficult to spotlight cozy relations between company staff and vendors, but you can use the Internet to uncover some of these relationships.

• Need strong procurement practices to examine vendor relationships on an ongoing basis.

• A conflict of interest may be OK, as long as the company is getting a good deal; verify whether this is the case with benchmarking, or use a full audit to search for anomalies.

Related Courses

Cost Management

Purchasing Guidebook

Lean Accounting (#59)

In this podcast episode, we discuss how lean accounting works, and the circumstances under which it works best. Key points made are:

• Lean accounting is a management system designed to operate in conjunction with lean production techniques.

• Lean accounting is oriented toward making internal corporate improvements.

• It issues reports much more frequently than the monthly reporting used by a financial reporting system.

• The focus is on the cost of goods produced, as well as on processes.

• Lean accounting tends to result in reduced inventory levels, which can negatively impact profits in the short term.

• Lean accounting tends to reduce assets and headcount.

• Lean accounting is most useful where lean production is used; works in manufacturing and service environments.

• Lean accounting makes it easier to identify opportunities for revenue increases and cost reductions.

• With lean accounting, you may not need to track as many individual transactions.

• Lean accounting requires a significant new project installation, possibly on a pilot basis, with a full roll-out at a later date.

Related Courses

Lean Accounting Guidebook

Investor Relations: Forward-Looking Statements (#58)

In this podcast episode, we discuss the background for investor lawsuits against companies, and how the use of forward-looking statements and cautionary statements are designed to avoid those lawsuits. Key points made in the episode are noted below.

The Reason Why Public Companies Did Not Forecast Results

Public companies used to have a major problem with telling investors anything at all about their forecasted results.  Until 1995, investors could sue a company to recover damages from a perceived securities fraud.  What usually triggered such lawsuits was pretty much whenever the stock price dropped.  As a basis for these lawsuits, investors used section 10b of the Securities Exchange Act of 1934. That section basically says that it’s unlawful to make an untrue statement of a material fact or omit to state one.  So… if a company said anything at all about its future plans and then those plans didn’t come to pass – then you had a lawsuit on your hands.

If someone did file suit, the usual process was that the company then filed a motion to dismiss, on the grounds that the alleged facts were not sufficient to create a liability under Section 10b.  This motion to dismiss was absolutely critical, because if the court allowed the case to proceed, then the investor could bury the company with demands for information, which is called the discovery process.  Which could cost millions.  At that point, the company usually settled out of court in order to avoid the cost of providing information.

Now if the company elected to take its chances in court, the investor could seek a class certification, which turned the case into a class action lawsuit.  So, if the company lost the case in court, the verdict would apply to all of its stockholders.  And then it would be really expensive.

You can see that investors could essentially point a double barreled shotgun at a company, and say “pay me now, out of court,” or “pay me a whole lot more in court.”  So because of the way the system worked, there were lots of lawsuits, and companies usually paid up.  Even if they hadn’t done anything wrong.

This was a bad state of affairs, because a key part of investor relations is to give the investment community some idea of what you intend to do in the future.  But because of the risk of lawsuits, no one dared to say anything.

The Private Securities Litigation Reform Act

Luckily, Congress fixed the problem in 1995 with the Private Securities Litigation Reform Act.  In brief, the Act forces a plaintiff to present a stronger case up-front.  This makes it easier for a company to have a case dismissed.

But in addition to that, the new Act includes a nifty section called Safe Harbor for Forward Looking Statements, which is Section 102.  As the name implies, it provides companies with a safe harbor from liability for forward-looking statements – but only if you identify them as forward-looking, and you add what the Act calls meaningful cautionary statements.  These statements need to specify the most important factors that can cause actual results to differ from what you’re saying in the forward-looking statement.

This doesn’t mean that you can keep using the same boilerplate cautionary statements, because the company’s risk profile might change over time.  Instead, you can refer to a complete set of identified risks, such as you’d find in a company’s annual 10K report.

This is obviously an important protection for a forward-looking statement, but that then brings up the question of what is a forward-looking statement?  Well, according to the Act, it covers a half-dozen areas.  The following four are the most important:

Projections of revenue, income, earnings per share, capital expenditures, dividends, or other financial items.

A statement of plans or objectives.

A statement of future economic performance.

Any statement about the underlying assumptions for those first three items.

You also need to know what is not covered by the Act.  Not covered items include discussions about roll-up transactions, going-private transactions, tender offers, and initial public offerings.

The Nature of a Cautionary Statement

So, what does a cautionary statement look like?  Well, let’s say you’re issuing a press release.  After the main contents of the release, you should add text that is something like this:

“In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the company notes that some statements in this press release look forward in time, and involve risks and uncertainties that may affect the company’s actual results of operations.  The following important factors, among others that are discussed in company filings with the SEC, could cause actual results to differ materially from those set forth in the forward-looking statements.”

And at this point, you can add some company-specific factors, such as “we may be unable to hire a sufficient number of qualified technical personnel,” or “competing offers may cause us to lose projects that are competitively bid.”

Let’s face it, this is a great deal of butt-covering, but if it can prevent even a single lawsuit, then I’m all in favor.

Any by the way, you’ll find that the cautionary statement may quite possibly be as large as all of the other text in your press release, combined.  So expect the cost of your press releases to go up.

And one last point about the Act.  You’re under no obligation to keep updating forward-looking statements, even if the information in the last one has become obsolete.  The Act specifically says, and I quote: “nothing in this section shall impose upon any person a duty to update a forward-looking statement.”  Of course, if you want to build a decent long-term relationship with the investment community, you’d bloody well better keep updating your projections, but you don’t have to.

When preparing any kind of forward-looking statement, it really helps if you first clear it with the company’s attorneys.  They’ll want to make dead certain that it complies with the Safe Harbor provisions of the Act.  So don’t just copy forward the language you used in the last press release or speech, because it may need some updating.  Don’t forget, the attorneys are there to keep you out of trouble, so use them.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Target Costing (#57)

In this podcast episode, we discuss the nature of target costing and how the process functions. Key points made are noted below.

The Uselessness of Cost Variances

Remember in your accounting classes in college, where the professor droned on about price variances, and volume variances, and efficiency variances?  Well, all of those variances involve the cost of a product after its already been designed.  The trouble is that most of the cost structure of a product was built into it.  And that means that all of those variances that you learned -- and may have been calculating since then -- don’t really help the product margin very much.  Instead, variance analysis only helps you understand if extra costs are being incurred over and above the baseline cost of the product.

The Nature of Target Costing

But they don’t give you any insight into how to reduce the baseline cost.  And that’s where target costing comes in.  In brief, target costing is about figuring out in advance what price the market will bear, and then designing a product that has a predetermined margin, based on that price.  If the design team can’t create a product with the right margin, then it stops the project.

That sounds pretty simple, but there’s a fair amount of iterative work involved.  First of all, the marketing department needs to research what other products are in the market already, and the types of products that competitors sat they’re going to introduce.  This also involves some estimates of the total market size, and the market share that the company thinks it can obtain.  The end result should be some decent estimates of the price point and features that a new design should have before management allows it to be introduced into the market.

Now the cost accounting people get heavily involved in this work.  They have to determine cost of all the key components, based on the estimated number of units to be produced.  When they subtract these expenses from the per-unit price point, the result needs to be at least in the general range of the target gross margin.

At this point, the product project will very likely have too low a margin, because the design team has not yet put any effort into cutting costs out of the design.  But that’s all right, because all we’re trying to do at this stage is to determine if it’s worth the effort to proceed.

So, let’s assume that management decides to continue with the project.  If so, the company assembles a design team that includes marketing, engineering, and accounting staff.  Under the target costing concept, the basic strategy of this group is to gradually reduce the designed-in cost of the product until it reaches the target margin.  The marketing staff helps by figuring out which product features are the most important and valuable to customers.  And the cost accounting staff continually re-runs cost estimates as the designers change the design.

And there is a lot of design work to be done.  The engineers can interact with the marketing people to see if it’s acceptable to design the product with a reduced level of durability or reliability – and that’s because some products are seriously overbuilt.  And for other products, customers don’t keep them long enough for there to be any concerns about durability.

But keep in mind that this is not just a design effort that reduces the cost of materials.  You can also add industrial engineers to the group, to see if there’s a less expensive way to manufacture the product.

Also, you can add purchasing staff to the team, because they can figure out how to most cost-effectively source materials, or maybe it makes more sense to outsource some or all of the production.  And they will certainly want to look at using substitute parts that are less expensive – but which may require some design changes so that they’ll work.

And it might also make sense to figure out a different distribution channel, such as Internet only, or through a distributor network.

Because of all these extra factors, the cost accountant might be running multiple costing scenarios at once, depending upon how the product is design, and sourced, and built, and sold.

To do all this, the cost accountant needs to compile a lot of costing information.  This can include the cost of purchased parts and of entire subsystems of parts at different volume levels.  This is really useful not only for more easily calculating the latest iteration of a design, but also for sensitivity analysis.  For example, if the product sells a lot less than expected, the supplier price points for some materials might jump a lot, which triggers a massive profit drop.

The cost accountant should also quite definitely do an analysis of how much time the product will require through the company’s bottleneck operation – whatever that may be – to see how badly it might clog up the bottleneck.  For more information about this topic, go back to my episodes 43 through 47, which are on throughput accounting.

So, getting back to the general process, during the early stages of the project, you can expect to have a swarm of costing models running concurrently, while the team works its way through a bunch of scenarios to see which one optimizes total profits.

But over time, all of these models need to be whittled down into a smaller cluster of options.  The way the team manager does this is to set up a series of milestone reviews, perhaps once a month.  At each review, the team has to be a little closer to the target margin.  So for example, at the start, the target margin may be 40%, but the initial margin estimate is only 10%.  So at the first milestone review, the team has to bring its margin estimate up to 15%, and to 20% at the next review, or else the project is scrapped.

By taking this forced improvement approach, design teams have to very quickly arrive at a competitive and profitable design within a fixed period of time – or else the project is cancelled.

Now, if a project is cancelled, this doesn’t in any way mean that the project team has a beer bash and a ritual burning in the parking lot of all its design paperwork.  No, that would be bad.  Instead, the team carefully assembles its files and stores them.  The reason is that the market’s price point may change, and material costs may change.

And for that matter, the company may alter its target margin.  So if these variables shift around enough, it’s possible that the project may become viable again.  If so, you reassemble the team, pull their research materials out of the archives, and get them going again – but this time they have a head start, because they kept their original materials.

The Result of Target Costing

So what is the end result of target costing?  It can lead to a massive improvement in profits, because companies don’t waste enormous amounts of time tinkering with products that realistically have no chance of becoming profitable.

And it certainly avoids the old technique of cost-plus pricing, where a company just builds what it thinks the market wants, tacks on a standard margin, and hopes the price point will be acceptable in the market.  That approach almost always leads to excessively high prices, which usually results in poor market share numbers.

The Downside of Target Costing

But what is the downside of target costing?  It requires the cooperation of a lot of departments on the same team – and that’s not easy to manage.  And another problem is that the target costing process can winnow out products even if the company needs them for strategic purposes.

For example, a car company may feel that it needs a top of the line luxury car, which sometimes yields a trickle-down quality image on the entire product line.  The target costing analysis on that particular car may result in a rejection of the product, because the margin is too low.  But if you look at its impact on the entire product line, it may still make sense.

So, use target costing selectively, keeping in mind the company’s overall goals in the marketplace.

Related Courses

Activity-Based Costing

Cost Accounting Fundamentals

Inventory Record Accuracy (#56)

In this podcast episode, we discuss the actions you need to take in order to achieve a high level of inventory record accuracy. Key points made are noted below.

Requirements for Excellent Inventory Record Accuracy

For lots of accountants, it’s pretty difficult to close the books when you’re not sure at all about inventory record accuracy.  In some cases, I’ve seen controllers insist on a complete manual count of the entire inventory every single month – because they just don’t trust the system. So, let’s create a system that works.  To do this, you need to address four main areas which are: the software, the rack layout, initial counts, and ongoing counts.

Inventory Tracking Software

For the first area, you need inventory tracking software that tracks inventory by bin location, and preferably for multiple bin locations.  Also, it must update records immediately, not in a batch.  If it’s in batch mode, then records will be inaccurate until you run a batch update, and that’s not acceptable.  If you don’t have software with these two features, then stop everything and buy some that does.

And by the way, there are software packages with many more features than that, going up to ultra-complex warehouse management systems.  But if you don’t have those two features, then you’re basically doomed.

The Inventory Rack Layout

Now let’s go to the second area, which is the rack layout. The first step here is to fix the physical layout of the storage racks.  There’re lots of issues to consider, like leaving aisle room for forklifts, and clustering racks for small parts in one place, and storing slow-moving items in the back.  This is a surprisingly technical area, so you might want to consider hiring a consultant who can design it for you.

Once the rack layout is set up, you need to create rack locations. 

Location codes are usually in at least three parts, with a letter for the first part that designates the aisle, then a two-digit number for the rack within the aisle, and then a letter for the level within each rack on each aisle.

That sounds complicated, but it’s not.  For example, C-17-B means that you’re in aisle C, rack 17, level B.

Now, as you walk down an aisle, the rack numbers should offset each other on each side of the aisle.  For example, you start off with rack 1 on the left side of the aisle, then rack 2 on the right side, and then rack 3 on the left side.  By numbering racks like this, inventory pickers can pick from both sides of the aisle as they walk down it.

Once you have the racks labeled, go back and create permanent labels with a bar code and the alphanumeric code side-by-side on the same label.  Make you print out the bar code format that’s used by your bar code scanners.  Then, put a clear plastic laminate over the labels, so there’s less chance they’ll be damaged.  And by the way, forklifts damage these labels all the time, so have a weekly procedure to replace whichever ones are no longer readable.

The Initial Inventory Counts

OK, let’s move to the third major area, which is initial inventory counts.  The goal here is to put the inventory into a fairly well organized system, so that you can then launch the ongoing counts in a reasonably efficient manner.

The first step for initial counts is to keep the inventory from being screwed up any further, and that means locking down the warehouse.  Yes, people do come in and take items of the shelf, and they don’t record the deductions.  They also take items from one shelf and then put them back somewhere else, which also does not help the record accuracy.  So, you need to lock them out completely, with a fence and a lock on the gate.  If this seems like overkill, please keep in mind that I’ve taken four inventory systems up to at least 98% accuracy, and each one of them had no chance until we installed the fence.

Now that things are safely locked up, you need to consolidate the same parts into one place.  This makes it much easier to count them later.  You will not complete this in one shot, because the same inventory item might be stored in a dozen places, and you won’t find them all on the first try.

Next up, have some experienced people who know the parts assign part numbers to everything.  Absolutely never use an inexperienced person to assign part numbers, because they will screw it up.  It might even make sense to use teams of two, so they can cross-check each other.

After that, have the same experienced people verify the units of measure on the parts.  Put the correct unit of measure on the same inventory tag that contains the part number, so it’s all in one place.

Then you have to pack the parts.  This means putting them in containers, then sealing the containers, and then labeling them with the part number, unit of measure, and number of units that are stored inside.  Also, leave a few loose parts for immediate use.  By doing this, it’s vastly easier for the warehouse staff to count parts later on.

After that, conduct an initial count, and drop all of this information into the inventory database.  Once again, only allow experienced people to do this count.  Any manager who allows the front office staff to count inventory should be shot.  An inventory count is more difficult than you think, so keep non-warehouse people off the premises.

That completes the third phase, which gives us the tools for an accurate inventory – but it isn’t accurate yet.  To do that, we need ongoing inventory counts, which are known as cycle counts.  And that is the final phase.

Ongoing Inventory Counts

To do ongoing counts, first train the warehouse staff in how to cycle count.  This means that they need to know how to run reports, do counts from the reports, and investigate variances.  And in case I haven’t said it before, cycle counting should only be done by experienced warehouse personnel.

Once everyone is trained, start cycle counting.  In brief, this means you print out a portion of the inventory list, sorted by location, and then match the report to the actual inventory.  To do so, the counter should review a complete block of inventory, such as a couple of side-by-side racks.  When doing the count, the employee matches the information on the report to what he sees on the shelf.  In addition, he matches what he sees on the shelf to what is on the report.

Please note: These are two separate activities.

Everyone counts from the report to the shelf, but by also tracing from the shelf to the report, you spot inventory that’s not recorded in the inventory database at all.  Managers like this extra count, since it increases inventory, and therefore reduces the cost of goods sold.

The frequency of cycle counting varies by company.  For a high-volume warehouse, you might need to cycle through the entire thing once a month.  Or, if some of it is slow-moving, once a year might be enough.  Or, keep recounting items that are always running out, or that are the most expensive.

Now, here’s the key part.  Whenever a cycle counter finds a mistake – and he’ll find lots of them at first – he doesn’t just go to the inventory database and update the record with the correct number.  The real trick is to have them investigate why the error occurred, and make sure that it doesn’t happen again.  To get to this level of investigation, the warehouse manager really needs to buy into the whole inventory accuracy concept, because this will chew up lots of cycle counter time, especially during the first few months.

The Need for Inventory Auditing

At this point, the system is in place, but I’ll guarantee you that it will not work as well as you’d like.  The reason is that the warehouse staff does not yet understand the importance of cycle counting, so they tend to let it slide.  Here’s what I do.  I have someone audit a small part of the warehouse once a week, and post the results on a white board in the warehouse.  We also assign specific aisles to cycle counters, so that we can post accuracy information by employee.  If any counters are having really good accuracy results, then we hand out a small bonus on the spot.

That’s the carrot part of the equation.  The stick part is that the warehouse manager’s performance is partially based on the overall accuracy of the inventory – so he may not do too well if he doesn’t meet his accuracy targets.

That covers the process. However, if you think this’ll give you a fabulously accurate inventory in a few weeks – think again.  There are likely to be a couple of dozen procedural problems that are causing inaccurate inventory, so until the cycle counters discover and correct each one of them, the accuracy will not be good enough.  So, based on my own experience, I can safely say that you need to budget a minimum of six months to achieve really high-grade inventory accuracy, which I consider to be 98%.

Related Courses

Accounting for Inventory

How to Audit Inventory

Inventory Management

Targeted Collections (#55)

In this podcast episode, we discuss several methods for concentrating your collection efforts in order to maximize the amount of cash collected. Key points made are noted below.

Collections Strategy

The strategy with collections is to pull in the largest amount of money for the minimum amount of effort – and in the shortest possible amount of time.  But, keep in mind that you can’t achieve all three parts of the strategy at the same time – at most only two out of three.  You’ll see this as we go along.

Focus on the Largest-Dollar Items

First, consider that first guideline of collecting the largest possible amount of money.  This means that you don’t waste time collecting small dollar items, or that you only use low-cost collection techniques for those items.  For example, the most expensive type of collection activity is using a collection specialist.  These people have to spend time collecting information about an overdue account, reviewing past collection records, and then contacting the customer.  This takes a lot of time.  In fact, the cost of just one call may be higher than the amount of the invoice.  So, what do you do?  After all, it seems crazy to not even try to collect a small dollar invoice.

Dealing With Small-Dollar Invoices

You have two choices.  First, use the accounting system’s automated dunning letter feature, and crank out a nice, inexpensive letter or e-mail reminder every few weeks.  Second, if the collection staff has completed collection calls to larger-dollar customers, then have them call about the small-dollar items.

After all, many collection employees are salaried, so despite what I said earlier, there’s not really any incremental cost to having them contact small-dollar accounts.  It’s just more effective for them to contact larger accounts first.

If neither approach works, then don’t waste any further effort.  Dump these small accounts onto a collection agency, and write them off.

So in this first scenario of collecting low-dollar amounts, we’ve achieved only one of the three parts of the strategy, which is to expend minimal collection effort.  But this is OK, because the dollar amounts are also minimal.

Collect Large Amounts Fast

Now let’s go back to the collection strategy.  We’ve addressed small overdue items, so how about large ones?  This is where we focus our collection resources.  But now we have a trade-off of wanting to use the minimum amount of effort, but also of collecting large amounts of cash within the shortest possible period of time.

In this case, we’ll forget about minimizing collection efforts, and instead focus everyone’s attention almost entirely on bringing in the cash as rapidly as possible.  There are lots of ways to do this, but keep in mind that you only use this level of activity for the really large outstanding receivables.  What I’m going to describe next requires a lot of effort, and it’s just not cost-effective for smaller collections.

First of all, contact the customer before the invoice is even due for payment, to make sure that the payment is scheduled.  If not, there’s probably a hang up somewhere in the customer’s payment process.  This calls for repeated communications right away to correct the issue.  Feel free to involve your salespeople.  They have different contacts in the customer’s organization than your collections people have, so use those contacts.

And speaking of the salespeople, e-mail them a receivables aging report once a week, preferably for only those accounts for which they’re responsible.  If they’re staying in close touch with their customers, they might spot problem invoices really early, and let you know.

If the customer happens to be a new one, you can also use this early contact period to go over your preferred payment procedure, so they know exactly where you want to have payments sent.  And you can follow that up with a letter that outlines the procedure in more detail.

Now, along the same lines, the collection manager should review the customer complaints database every day.  This is a really good way to spot upcoming collection problems, because the customer service department usually hears about problems well before the accounting department does. 

And the same logic applies to the deductions database, if you have one.  This is where you can find the types and amounts of deductions that customers have taken in the past, and the reasons for those deductions.  If a customer has a history of subtracting large deductions from their payments, this is a good place to find out why.

So far, we haven’t even reached the payment due date, but we should have a pretty good idea of any potential problems.

The next step is to do whatever it takes to accelerate the receipt of payment from the customer once the due date arrives.  For example, you can volunteer to have a salesperson or a courier pick up the check, or have them send it to a lockbox.  Or you can authorize the customer to use your corporate FedEx or UPS number to send the payment by overnight mail.  Or they can pay by credit card.  Or, of course, try to get them to send you an electronic payment, or to authorize you to debit their bank account with an ACH transaction.  In short, do everything possible to bring in the cash exactly on time.

But even if the cash comes in, it doesn’t help your collections staff unless they see the receipt in your accounting system.  Logging in cash receipts can be a bottleneck area, so make sure that all receipts are logged in the minute they arrive.  This keeps collections people from wasting time calling customers about invoices they’ve already paid.

Now at this point, the due date should only be a couple of days in the past, but you should already have a good idea regarding which invoices won’t be paid on time – and more importantly, why they aren’t being paid.  If the issue is that the customer has no money, then the collections staff can go through the usual process of setting up a payment schedule, using financing, getting the goods back, and so on.

For this type of routine collections work, you definitely want to assign your best collections people to the largest dollar accounts.  Some people just have a flair for working with customers and getting cash in the door faster.  If you have people like this, then by all means target them where they have the greatest impact.

Unfortunately, the real problem is when the customer won’t pay because some other department of the company itself is causing the problem.  For example, the deliverable was flawed or incomplete, or improperly engineered.  There are lots of reasons.

And this is where a lot of collection departments don’t know what to do, because the collection manager doesn’t want to bug some potentially powerful department managers who very likely outrank him.

The solution is not to shift the problem up to the controller, even though he may have more power to deal with the problem.  If you do this, the controller just gets buried with the details of following up on an unending stream of internally-generated collection problems.

The much better method is to set up a standard process that all of the department managers agree to in advance, where the collections staff shares problems directly to their counterparts in the other departments.  If an issue isn’t resolved fast, then the process automatically escalates the problem to higher and higher levels of management.  Also, the performance reviews of these managers should be partially based on their ability to resolve the underlying problems that cause collections to occur.

If you use this method, then the entire company gets behind the collection effort, rather than letting a group of perpetually understaffed and overworked accounting people try to fix everything.

And this brings us back to the collection strategy.  Again, for large-dollar collection issues, you want to bring the full attention of the collections staff to bear on it, and this extends to the other departments.  But it does not mean that you involve other departments in the collection of small dollar items, because that is not cost effective.  So, if you set up an in-house process for having other departments assist in collections, only use it for the largest collection problems.  Don’t abuse the system with small stuff.

Also, keep in mind that some collection techniques are not effective for collecting these larger-dollar invoices.  For example, don’t bother with a dunning letter or an automated faxing system.  Those solutions are designed for small-dollar collections, not large ones.  Instead, use the personalized approach that I’ve described above.

When to Use Collection Agencies

Finally, what about collection agencies?  Normally, you only bring them in after some time has gone by, because you want to try every other technique in order to avoid paying their collection fee.  However, let’s get back to the collection strategy.  A key target is to bring in cash in the shortest possible amount of time.

So, if you have a large overdue account, you’ve tried all normal in-house collection techniques, and nothing works, then don’t waste time.

It makes no sense at all to wait six months and then shift the receivable to a collection agency.  Instead, make the decision as soon as possible, and put the receivable into the hands of someone who can possibly make a difference.

Parting Thoughts

To summarize the targeted collection strategy, picture yourself using a broadside from a battleship to collect the largest overdue amounts, and only the most minimal efforts for small accounts.  Broadsides tend to win battles fast, but they also need a lot of gunpowder, so they can only be used sparingly.  The same principle works for collections.  Focused activity works much better than spreading your efforts too thin over too many invoices.

Related Courses

Credit and Collection Guidebook

Effective Collections

Payroll Cycles (#54)

In this podcast episode, we talk about optimizing the use of payroll cycles, and point out a legal issue that can interfere with one of the more common payroll cycles. Key points are noted below.

The Nature of a Payroll Cycle

A payroll cycle is the length of time between payrolls.  If you pay people once a week, then you have 52 payroll cycles per year.  Usually, it takes about the same amount of time to complete a one-week payroll cycle as it does for any longer period of time.  So, for example, if you pay people once a month, you only have 12 payroll cycles per year, which means that you expend about ¼ of the annual effort that you would if you had weekly payroll cycles.

Payroll Cycle Choices

Obviously, it makes a great of sense to have longer payroll cycles than once a week.  You could go with the example I just gave and pay employees once a month, but that can be really difficult for anyone living from paycheck to paycheck. So, that pretty much leaves you with two alternatives, which is either every two weeks or semi-monthly.  Semi-monthly means that you pay on the 15th and last days of the month.

If you use a two-week cycle, then there are 26 cycles per year, versus 24 cycles if you use a semi-monthly cycle.  If you select a two-week cycle over a semi-monthly cycle, that requires about 8% more effort.  If that were the only criterion, then most people would pick a semi-monthly payroll cycle.

But not so fast.  There are two more issues to consider.  Once is, that if you use a two-week cycle, employees get used to the idea of generally receiving two paychecks per month – so when they get an extra paycheck two times per year, they really like that.  It’s a subtle point, but employees generally prefer a two-week cycle to a semi-monthly cycle.

Illegal Payment Intervals

Let’s say that you’re using a semi-monthly payroll, so your last payroll of the month falls on the 30th day.  This day happens to fall on a Wednesday – so you’re paying employees on that Wednesday.  Your payroll service provider needs to process payroll three days in advance, so you have to submit the payroll the previous Friday. 

However, most timekeeping systems are based on weekly time reporting, so your payroll administrator logically enforces a cutoff as of the preceding weekend.  After that weekend, any hours worked will fall into the next payroll cycle.  What this means is that there’ll be a gap of eight pay days before employees are paid.

Guess what.  In seven states, it’s illegal to wait that long.  You cannot make employees wait more than 5 days in Arizona, or 6 days in Massachusetts and Vermont, or 7 days in Delaware, Hawaii, New York, and Washington.

If you’re an international listener, then check your local government rules.  There might be a similar restriction.

This is a real problem if you have a semi-monthly cycle.  Even if you live in one of the other states that allows a longer delay, you might someday have employees in one of those states, possibly through an acquisition.  Also, if your company has a union, check the union contract – it might have the same kind of restriction.

Parting Thoughts

So where does this leave us?  If you look at all of the issues impacting a payroll cycle, the two week cycle is the best combination of efficiency and ability to meet the labor laws.

And in case you think I follow my own advice, I impose a semi-monthly cycle on every company we acquire.  I just keep a close eye on how long it takes to issue a payroll after timekeeping periods have closed.

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Best Practices Problem Avoidance (#53)

In this podcast episode, we talk about the various techniques that can be employed to improve your odds of installing best practices. Key points made are:

• Determine who manages the process to be changed. Could be trouble if you are impacting the area of responsibility of another manager. If so, try some other best practice.

• You may not be in the right; review the issues of other parties to see if their concerns about a best practice are valid.

• If you have not installed a best practice before, obtain lots of advice before proceeding.

• Space out installations, so that the department has a chance to settle down in between major changes.

• Slice up large projects into smaller pieces, so that some items can go live sooner. Improves the odds of overall success.

• In-house capacity impacts your ability to complete installs; need to free up staff time.

• Each successive project frees up more staff time, making it easier to work on the next project.

• Review projects for dependencies, and verify in advance that you can work through them.

• Verify that a new best practice integrates into the corporate system of controls.

• Stick with off-the-shelf software; it rarely makes sense to develop a customized solution.

• Maintain a full list of best practices to work on, so that you can easily switch over if there is a problem with the current project.

• Chat with other managers periodically to see if any of them are interested in a best practice.

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Profit Recovery: Internal Auditing (#52)

In this podcast episode, we talk about how the internal auditing function can be used to increase the amount of profit generated by a business, by looking for excessive expenditures. Key points made are:

• Internal auditing was usually held back from profit recovery work by the focus on control improvements that was initiated by the Sarbanes-Oxley Act.

• Profit recovery is a great way to pay for the internal auditing department.

• Profit recovery could be a separate function within the internal auditing department.

• The work could be done by the procurement department, but internal auditing is the better option.

• Can use control work to find departments that are in trouble, and then use profit recovery analyses to help them fund control fixes.

• Could outsource profit recovery work to a third party and still generate a net profit by doing so.

• Can pair the internal auditing staff with the third party recovery firm, to learn best practices.

• Profit recovery work could be delayed if these tasks are mixed in with other priorities in the internal auditing department.

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Cost Management Guidebook

Accounting Technology: Data Analysis Software (#51)

In this podcast episode, we talk about the features and uses of data analysis software, especially in terms of how it can be used in an accounting or auditing environment. Key points made are:

• Data analysis software imports data and analyzes it without having to write a program.

• It is used by auditors to examine general ledger detail, accounts receivable detail, and accounts payable detail.

• It is used by companies to preview data before the auditors arrive, as well as to review the validity of human resources records, and estimate the amount of periodic inventory adjustments needed. It is heavily used in the internal audit department.

• It takes in data through a data interface that accepts many data types, including PRN and PDF files.

• A modest amount of training is needed, usually around three days.

• The price is in the low thousand-dollar range for single users. There are add-on modules for an additional charge that are used to test specific accounting areas.

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Standards: Convergence (#50)

In this podcast episode, we discuss the ongoing convergence project between the FASB and IASB. Key points made are:

• The FASB and IASB have been working on convergence, which is the elimination of material differences between GAAP and IFRS.

• Either party could adopt the position of the other party.

• In some cases, the FASB and IASB may jointly undertake projects to improve both of their positions.

• A recent example of convergence is the capitalization of interest during construction projects.

• There is a tendency for the outcome to lean more in the direction of IASB positions.

• It is not likely that the FASB will go away; it will find a reason to continue to exist.

• The current situation is comparable to what the AICPA went through, when standard setting was shifted to the FASB.

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Standards: Fair Value (#49)

In this podcast episode, we talk about FASB standards 157 and 159, relating to fair value issues. Key points made are:

• Statement 157 addresses the framework for measuring fair value and increases the range of required disclosures. Statement 159 is the fair value option, which gives organizations the option to measure certain assets and liabilities at their fair values.

• This is an election to record financial assets and financial liabilities on the balance sheet at their fair values, and to record changes in these fair values over time. It is an election, so one can pick and choose the assets and liabilities to which it applies.

• The fair value option can give management more reporting flexibility.

• The fair value option will result in a mixed balance sheet, with some assets and liabilities recorded at fair value and others at cost.

• The fair value option could be used to intentionally record a loss when initially recording an asset or liability at its fair value.

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Profit Recovery: Overview (#48)

In this podcast episode, we give an overview of the basic analysis tools used to review a company’s spend data and find opportunities for improvement. Key points made are:

• Health care, audit fees, and utility bills are among the best profit recovery areas to target.

• Look for opportunities where controls are weak, systems changes have recently been implemented, or where acquisitions have just been completed.

• Review accounts payable data files for clues, especially the invoice header file and invoice detail file.

• In mergers and acquisitions, cost savings are more likely when the acquiree has at least $20 million in sales.

• For a duplicate payments audit, the spend should be at least $10 million before you can expect to find significant savings.

• For analysis, summarize spend by supplier and then by expense category.

• Look for suppliers who are sole source providers; could open up for competitive bidding.

• Look for suppliers who have an increasing cost trend; could open up for competitive bidding.

• Look at the volume of transactions vs. the dollar spend; plot on a scattergraph.

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Throughput Accounting: Controls (#47)

In this podcast episode, we cover the reasons for controls associated with a bottleneck operation, and where they should be placed. Key points made are noted below.

The only topic we haven’t covered yet is controls.  Now, in a normal accounting system, you only place controls where you think there’s a risk of loss.  That means you have extra controls over things like materials purchases or payroll or cash or fixed assets, because these are places where you can potentially lose a fair amount of money.

Controls Over Throughput

But in a throughput environment, the main places to have controls are, of course, somewhere else.  The main control point is the bottleneck operation, and the only goal is to raise a big red flag when it’s not 100% utilized.  You do that with a daily report that shows the utilization percentage on a trend line.  In fact, don’t even print a report.  Just use a dry eraser marker, and post the information on a white board right next to the bottleneck operation.  That’s the best way for everyone to see it.

You can also measure the proportion of downtime that’s used by maintenance.  This is one of the few valid reasons for downtime, so the other side of the measurement is to show the remaining amount of downtime that’s caused by everything else.  That can include material or labor shortages, quality problems, machine downtime – things like that.

You should also track the bottleneck production to make sure that it only produces exactly what it’s supposed to produce.

Detection of Long Production Runs

There are still production managers out there who think they should have extra long production runs in order to look more efficient.  This is never a good idea, and especially at the bottleneck, because doing an extra-long production run just means that you’re sticking some extra inventory into the warehouse, instead of producing something that could’ve been sold right now.  To detect it, compare actual production run volumes to the authorized volumes.  If the run volumes are consistently high, then it’s time for a chat with the production manager.

Scrap Tracking

Another control is to track anything that gets scrapped downstream from the bottleneck.  This is important because you just wasted some valuable bottleneck time to build something, and now you’re chucking it out – and that is lost throughput.  This one doesn’t have to be reported continuously, but it doesn’t hurt to issue a report on it about once a week.  That’s usually a fast enough feedback loop for managers to figure out what happened.

Inventory Buffer Tracking

Another place where you need a control is at the inventory buffer that feeds the bottleneck.  If this buffer drops to zero, then the bottleneck runs out of work, and you lose throughput.  Now, for this control, it’s not good enough to just say that the buffer dropped to zero at such and such a time.  The real value of this control is to figure out what upstream problem caused the inventory to drop to zero, so that someone can fix it.

This is a major control.  The care and feeding of the bottleneck is really what drives company profits, so if you have a limited amount of time to spend on throughput controls, this is a good one to focus on.

Sprint Capacity Tracking

Now, speaking of upstream workstations, another control is to monitor their sprint capacity.  You need to create a running utilization percentage for every upstream workstation.  Whenever utilization levels go too high, then sprint capacity is reduced, and that increases the risk of a shortage at the bottleneck.  So, you use this control to figure out when to increase capacity levels.

Production Scheduling Tracking

Throughput controls can also address production scheduling.  If too many jobs have been scheduled into the production area, then there’s going to be a logjam somewhere that may keep inventory from reaching the bottleneck.  If so, consider installing a report that simply shows how many production jobs have been released into the system.

This number can obviously vary a lot, depending on the size of the orders, but it’ll be really obvious when there are simply too many jobs in the system.  Again, use a trend line for this, and report it once a day.

Controls Over Work in Process

In addition, don’t just set up controls for inventory that’s in process.  Throughput can be totally hosed if inventory never arrives on time from a supplier, too.  To keep an eye on it, create a report that’s limited to only those materials that can shut down the bottleneck, and track the number of days supply on hand.  Or, report any key materials that are late in arriving.  Whatever works for your situation.

The Need for Accounting Controls

After all of this talk about new controls, you might wonder if there’s still a need for all of the accounting controls that you already have.  Yes, of course there is.  In fact, if you’re with a public company, you’ll have a mighty tough time passing a Sarbanes-Oxley controls review if you don’t keep those controls.

Parting Thoughts

The main difference between traditional controls and throughput controls is that traditional ones focus on not incurring unnecessary expenses, while throughput controls focus on increasing throughput.  In other words, traditional controls focus on expenses, and throughput controls focus on revenue.  Two entirely different types of controls.

And that’s all I have for throughput accounting.  I think this is a great topic, because until you figure where your bottleneck is located, you really have no control over your profitability.  And as I’ve mentioned several times in the last few episodes, this isn’t just for a manufacturing company.  It can be anywhere.  Where I work now, the bottleneck is undoubtedly in the sales department, and I’ve seen it elsewhere in the engineering department.  So, throughput concepts work pretty much anywhere.

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Throughput Accounting: Financial Analysis (#46)

In this podcast episode, we cover a variety of scenarios that can impact the amount of throughput generated by a bottleneck operation. Key points made are noted below.

In this episode, I’m going to run through a bunch of financial analysis scenarios, so you can see how throughput applies to it.

The Base Case Scenario

First, let’s set up a base case scenario.  We have orders for two products.  Product A has a total throughput of $10 and requires 5 minutes of time at the bottleneck operation per unit, so it generates $2 per minute of bottleneck time.  That’s the throughput of $10, divided by 5 minutes.  There’s a customer order of 500 units for Product A, so that requires 2,500 minutes of bottleneck time.

Next, Product B has a total throughput of $20, and requires 4 minutes of time at the bottleneck operation per unit, so it generates $5 per minute of bottleneck time.  There’s also a customer order of 500 units for Product B, and this requires 2,000 minutes of bottleneck time.

Scenario #1

So, here’s our first analysis problem.  The bottleneck only has 4,000 minutes of time available per week, but we have 4,500 minutes of required production time between the two products.  So, what do we not produce?  The answer is to always produce the maximum amount of any product that generates the largest amount of throughput per minute, which in this case is Product B.  It generates $5 per minute, versus $2 per minute for Product A.  Therefore, we produce all of the order for Product B, and we intentionally fall short of production on Product A, which maximizes profits.

So, let’s extend that example.  The sales manager, bless his heart, gets a huge order for Product B that can tie up all of our production capability, but only if we accept a price drop that reduces throughput per minute to $4 from the original $5.  Is this a good deal, or do we fire the sales manager?

The solution is actually pretty simple.  Under the base case, the total throughput we earned was 2,000 minutes of Product B and 2,000 minutes of Product A, which totaled $14,000.  Under the new scenario, anything better than $14,000 is a good deal.  Since we’ll now be running 4,000 minutes at $4 of throughput per minute, the new total throughput is $16,000.  So, we give the sales manager a cookie.

Scenario #2

Let’s try another situation.  We receive a proposal from the production manager, where he wants to pre-process some of Product A before it reaches the bottleneck operation, so that it requires less time at the bottleneck – in fact, it only requires 2 minutes per unit, instead of the old 5 minutes.  This increases its throughput to $5 per minute of bottleneck time.  With the faster processing speed, we can now run all of both orders, for a grand total throughput of $15,000.  We get that number from $10 of throughput for Product A, times an order size of 500 units, and $20 of throughput for Product B, times an order of the same size.

So we’ve established that our throughput will increase by $1,000 per week if we implement the change.  The real question is, what investment and added expense do we incur in exchange for the $1,000 throughput increase?  This becomes a management decision that depends on the circumstances, but – for example, what if the investment was a one-time outlay of $5,000?  Then it would pay for itself in five weeks, and I think most managers would accept that proposal in a few seconds.

Scenario #3

Let’s try another example.  How about if there’s a quality problem with Product B, so that an average of 100 units are scrapped per week, after they’ve been processed through the bottleneck?  Well, each unit earned $20 of throughput, so we’re losing $2,000 every week because of the quality problem.  The question is, should we install a quality review station directly in front of the bottleneck whose sole job is to review Product B parts?

The answer is - yes, as long as that quality workstation costs less than $2,000 per week.

Scenario #4

OK, let’s do another example.  What if the employees who run the bottleneck operation take some time off each day for breaks, so that the work station has total weekly downtime of 200 minutes?

In this case, Product A has less throughput per minute, at $2 per minute, so it will always be scheduled to go after Product B, and therefore if there is downtime, fewer units of Product A will be completed.  Since we’d be losing $2 of throughput per minute times 200 minutes, there’s a potential profit loss of $400 per week.  So, if we can get a part-timer who costs less than $400 per week to fill in during those breaks, then we’ll make more money.

The Product Cancellation Decision

And then we have one of my favorites, which is the product cancellation decision.  The cost accountant applies $11 of overhead to each unit of Product A, which now appears to give it throughput of -$1, and makes a recommendation that we therefore cancel the product.  But, if we did that, the bottleneck would no longer have enough work to do, and we’d be walking away from $5,000 of throughput – just to repeat, our base case was $10 of throughput per unit, times an order for 500 units, which is $5,000.

The solution is to ignore the overhead application, we do not cancel the product, and we keep on producing Product A.  This gives us more profit than if we cancelled Product A.

But there is a situation where we do cancel Product A, which is when the engineering department creates a new product.  In this case, if the throughput of the new product is more than the $2 per minute of bottleneck time that we had with Product A, then the company as a whole will make more money if we dump Product A in favor of the new product.

When There is No Bottleneck

And finally, what if the bottleneck has enough capacity to produce every possible order?  In this case, there is no production bottleneck.  Instead, the bottleneck may very well be located in the sales department instead.  Or, it may be located outside of the company entirely, in which case the company might actually make more money by dropping its price in order to bring in more order volume.  As long as the new price is not too low, the company could use its extra production capacity to crank out more throughput dollars than it had before.

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Throughput Accounting: Capital Budgeting (#45)

In this podcast episode, we cover the flaws in a traditional capital budgeting system, and how to improve the situation by incorporating constraint analysis concepts. Key points made are noted below.

The Traditional Capital Review Process

Now, in a traditional capital budgeting environment, everyone throughout the company looks around at their areas of responsibility, and decides if they need to replace equipment, or add to what they have, or use more automation.  Then they write down each request on a capital request form, including an analysis of whether the request will result in enough positive cash flow to exceed the company’s cost of capital.

This form then goes to a review committee, which allocates funds based on which projects will generate the most cash, and they do that until all funding is used up.

Once you understand how throughput accounting works, you’ll realize that this approach is all screwed up, for several reasons.

First, there’s no consideration of how each project request fits into the entire system of production.  Instead, each request is designed to optimize a local work center that may do nothing to increase the total throughput of the company.

Second, no one has any clue where the bottleneck is even located, so the decision makers who’re allocating capital have no idea where they should invest funds.

And third, using projected cash flows is an incredibly inefficient way to allocate funding.  The reason is that these projections are really hard to derive, and reality may be so far off the original projection that it’s downright funny.  And for that matter, some managers make up their cash flow projections out of thin air, just to get their projects approved.

In short, if you use a traditional capital budgeting system, it’s a minor miracle if you end up investing money in the right places, so that throughput actually increases.  Most of the time, all you’ve done is invest money to improve the efficiency of areas that have nothing to do with the bottleneck, so that your return on investment actually declines.

Capital Budgeting Using Throughput Analysis

So, let’s do capital budgeting the right way.  Your first goal is to invest only in those areas that improve the capacity of the bottleneck.  You do this by comparing the incremental additional throughput created by making an investment to the amount of the investment and any related change in operating expenses.

You should also spend a lot of time reviewing any requested improvements to the bottleneck operation.  Just because you now want to invest money in it, that absolutely does not mean that you install a massive, fully automated machine there.  Automated equipment has a bad habit of breaking down, which completely wipes out your throughput.  Instead, it may make a great deal of sense to invest in multiple, lower-end machines that require a lot less maintenance.  That way, the bottleneck may now be comprised of - let’s say - ten concurrently operating machines – so if one or two of them needs to be down for maintenance, no big deal.  Most of the machines are still operational, and you still have throughput.

Just to pound on that topic a bit more, it is generally a bad idea to replace less complex equipment with more complex equipment at the bottleneck.  Whenever you do that, the risk of equipment failure increases, and this is the wrong place to have more risk.

As you may recall from the last episode, it also makes sense to selectively increase capacity in some upstream areas, because this gives you more sprint capacity.  If you have areas like that, then absolutely consider investing in more capacity.  Especially when you’ve had cases where they didn’t have enough capacity to catch up from a system crash, and it impacted the bottleneck.

However, this does not mean that you need an overwhelming amount of sprint capacity.  Just analyze the situation, and base the investment on the capacity levels at which the equipment is currently running.

Also, if someone puts in a request for funding in an area that has no impact on the bottleneck, then basically beat the hell out of it – especially if it’s for a lot of money.  That means interviewing them about why they need it, requiring extra levels of approval, examining the impact on the entire system, and so on.  Now, this doesn’t mean that you’ll automatically shoot down every non-bottleneck request.  There are lots of cases where a non-bottleneck investment can mitigate risk, or it may reduce operating expenses. But, you should absolutely dig into these proposals to make sure that they’re really necessary.

By viewing capital budgeting from the perspective of throughput analysis, you get some really interesting results.  Obviously, overall throughput will probably increase.  What’s less obvious is that total investment may drop by an incredible amount.

Now, you may think – sure it will drop for a year or two, but what about in a couple of years, when all of those non-bottleneck operations start to wear out, and need to be replaced?  Well, when that time comes, you view replacement investments in terms of how much capacity you really need, versus how much you had.  Chances are, you can invest in less capacity and less automation, so that when a large machine wears out, you can replace it with one or more smaller machines that are less expensive and easier to maintain.

And a few additional thoughts on capital budgeting.  Under the traditional system, this is a once-a-year event.  But realistically, if the throughput level is suffering because of a missing investment, just do whatever it takes to make the right investment right now.  It’s completely ridiculous to only make an investment decision once a year, because you may lose a bunch of throughput dollars by waiting.

Also, you normally hand off a capital request to a financial analyst, who verifies the reasoning behind the cash flows in the request.  But under a throughput-based approach, your main concern is how the capital request will impact the bottleneck, and that calls for a review by a process analyst, like an industrial engineer.  Isn’t that interesting?

And finally, you need to change the capital request form.  Instead of having a big space in the middle for a cash flow analysis, ditch that part entirely.  Instead, divide it into three boxes.  You fill out the first box if an investment will improve a bottleneck operation.  And in this box, you enter the impact of the investment on throughput, operating expenses, and return on investment.  This box requires the smallest number of approvals.

You fill out the second box if a project will mitigate risk.  If so, itemize exactly what risk you’re addressing.  This box has a different set of approvals, including the chief risk officer, if you have one.

And finally, there’s the third box, which you fill out for non-bottleneck investments.  This one requires the most comprehensive justification, and – as you might expect – it requires the most approvals.

So, there you have it.  A completely different way to handle capital expenditures, and it’s all driven by throughput accounting.  In the next episode, I’ll cover how to conduct financial analysis using throughput concepts.

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Throughput Accounting: Bottleneck Management (#44)

In this podcast, we cover how to spot a bottleneck, as well as how to manage it to maximize throughput. Key points made are noted below.

Locating the Bottleneck

The first step in managing the bottleneck is to figure out where it is.  In a complex environment, it can actually be difficult to find.  Here are some indicators.

First, figure out where there’s a work backlog.  This should be an area that absolutely never catches up with demand.  If it involves a manufacturing process, then there should be a pile of inventory in front of it.  But don’t think that this is an absolute way to find the bottleneck, because it could just mean that the preceding work station is super efficient, and is dumping all kinds of work on the next work station in line – which doesn’t necessarily make it the bottleneck.

Another bottleneck indicator is that the maintenance staff is always hovering around a work center.  This is because it’s being operated at way beyond its normal run rate, so the equipment tends to break down more often.  Or, if the bottleneck is a person, such as a salesperson, look for people who never have any time to take vacation or participate in meetings outside their areas.

And the ultimate indicator of a bottleneck is when it stops working for a while, and company profits sink like a stone.

It’s also possible to deliberately designate a work center as the bottleneck, even if it currently is not the bottleneck.  You might want to do this if the work center requires really expensive equipment, or highly paid staff.  So, you cut back on the investment or headcount in that area, and now it’s your bottleneck.

Managing the Bottleneck

So, let’s assume that you’ve targeted the bottleneck.  So.. what do you do with it?  The main point to remember is that the bottleneck should operate at all times.

With this goal in mind, you can make sure that it operates around the clock, and that all employee breaks are covered by replacement personnel.  Or, if there has to be downtime for machine maintenance, then schedule it during an employee break period, so that you can overlap two potential downtime periods.

Also, there’s usually some downtime when there’s a shift changeover, so schedule the incoming staff to arrive a little early, so that you have two production crews in the work center at the same time.  With the scheduled overlap, there’s no reason for changeover downtime.

This next recommendation is a big one, because it applies everywhere, not just in the production area.  If there’re employees involved in the bottleneck, make absolutely certainly that they’re doing nothing but running that operation.  They should not be doing maintenance, or cleanup, or filling out time reports, or anything.

This is really useful for bottlenecks located elsewhere in the company, such as salespeople or engineers, because they should have administrative support who handle absolutely everything for them.  That means the admin schedules meetings for the bottleneck person, answers voice mails and e-mails, brings in lunch, whatever it takes.  The point is to strip away absolutely every activity that keeps that bottleneck person from processing work.

Another way to improve the bottleneck is to review incoming materials for quality issues just in front of the bottleneck.  This strips away any materials that would otherwise be processed through the bottleneck and then eventually be thrown away anyways.

Also, be sure to reduce employee turnover at the bottleneck operation.  If it’s a boring operation, then raise wages to make sure that people show up for work.  Better yet, cross-train a number of people, so that you can easily drop other employees into the bottleneck on short notice if you need to.

And another point – if you have an under-utilized person sitting around in the bottleneck operation, and the cost accountants tell you they’re costing too much money, tell them to go pound sand.  Chances are, any part-timer in the bottleneck area is still creating so many incremental throughput dollars that it would be foolish to pull them away from the operation.

And I’m not done yet.  You can also off-load excess work from the bottleneck to a backup operation within the company, even if the backup is way less efficient than the main operation.  This is a key point, because everyone focuses on the efficiency of an operation, and not its throughput, so they assume an inefficient operation loses money.  Not true.  In most cases, you can break loose a few employees from other operations to work on a backup work center – and since you were paying them already anyways, there’s no incremental cost to having that extra work center.  So, even though it may appear inefficient, it can create a lot of extra throughput dollars.

This also says something about keeping old equipment lying around.  If you can put an old clunker to work as a bottleneck backup, then do it – don’t scrap the equipment.

Another option is to outsource the work.  As long as the throughput generated from outsourced work exceeds the incremental outsourcing cost, then this is a viable option.

You can also improve the bottleneck just by changing work rules.  For example, the upstream work station might have a batch sizing rule which says that it must fill up a crate with parts before sending it on to the bottleneck, where they may already have run out of work.  Instead, install a conveyor belt between the two operations, and send parts over one at a time.  Or, cut the size of the crate in half.  Just do whatever it takes to reduce the artificial buildup of inventory before it moves to the bottleneck.

Another work rule may be to never pay for rush delivery of parts.  Tough.  Always pay for a rush delivery, because the cost of the delivery is usually way lower than the throughput you’d otherwise lose by shutting down the bottleneck.  And the same goes for overtime.  If it takes overtime pay to run the bottleneck, then pay the overtime.

You can also focus on the operations in front of the bottleneck.  For example, if the upstream workstation sometimes falls behind and doesn’t deliver inventory to the bottleneck in time, then invest in an extra upstream work center, so that you have tons of sprint capacity.  And once you have it, run it like crazy for a few days, so you build up a nice inventory buffer just in front of the bottleneck operation. 

That way, even if all of the operations feeding the bottleneck crash and burn for a while, the bottleneck operation can keep chugging along, feeding off that buffer.

Obviously, there are a lot of ways to manage a bottleneck. This also means that, as a manager, you need to spend a really large chunk of your time reviewing the bottleneck operation over and over again.  If you find that you’re spending most of your time monitoring non-essential operations, then you need to re-evaluate your priorities – because you’re not improving company throughput.

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Throughput Accounting: Basics (#43)

In this podcast, we cover the basic concepts of constraint management, including the bottleneck, inventory buffer, sprint capacity, and throughput. Key points made are noted below.

This is the start of a five-part series on throughput accounting.  This is a nifty topic that’s rarely covered in school.  Partially, I think, because it goes against the grain of a lot of the other accounting methodologies.  One bad rap it gets is that it only applies to manufacturing, which is absolutely not the case.  So, if you were about to delete this podcast because you don’t do manufacturing, you might want to wait a little bit longer.

First, I’ll give an overview of the main throughput concepts, and then in later episodes, I’ll describe how you apply it.

The Theory of Constraints

Throughput accounting is based on the theory of constraints, which says that one percent of all events causes 99 percent of the results.  That one percent is the bottleneck operation, which controls the profits of the entire company.  The bottleneck is also called the drum, because it sets the pace for the entire company.  If the bottleneck is well managed, then profits are high.  If not, then profits drop.  If you focus all of your resources on making the bottleneck as absolutely efficient as possible, then you will make more money.  On the other hand, if you invest dollars anywhere else in the company but leave the bottleneck alone, then you’ve essentially just burned all of those invested dollars.

For example, if you implement a massive company-wide efficiency improvement campaign, only the portion that impacted the bottleneck will actually improve the company’s total output, even if the entire company became more efficient.

Let’s continue with the example.  Let’s say that the efficiency campaign was extremely effective in improving the processing speed of a machine located ahead of the bottleneck operation, so that it can now produce twice as many parts.  That’s just great.  The trouble is that the bottleneck cannot handle all of the extra parts, so the new production just piles up in front of the bottleneck.  The net result is that you’ve now invested in more inventory than you had before.  Or, to look at it another way, you would have been better off not to have improved that upstream operation.

Now, I already mentioned that throughput does not just apply to manufacturing, so let’s look at it from the perspective of the sales department.  The CEO wants more sales, so he authorizes the hiring of more sales people.  The new employees are very effective in obtaining customer interest in the product, but now the sales technician who conducts the demos is completely swamped.  And customers won’t buy the product until they’ve been through the demo.  So once again, we have a bottleneck – it does not allow sales to be completed, and it’s not even in the manufacturing area.

The Buffer

That was the drum, or bottleneck, and it’s the central part of throughput accounting.  However, you also need to know about the buffer.  There needs to be a buffer in front of the bottleneck operation, because you maximize profits if the bottleneck is always running, and you need on-hand inventory to ensure that it always runs.  If there’s no buffer, then the bottleneck may sometimes run out of work, and that loss in productivity drops straight to the bottom line.  So, this is the one place in the company where inventory is good.  Most accountants are trying to eliminate inventory from their companies, because it’s a waste of working capital.  But if you do that to the inventory in front of the bottleneck, you’ve just cost the company a pile of money.

The same concept applies in my earlier example with the sales technician.  If someone cancels a demo, then someone should immediately reschedule a demo into that time slot.  Otherwise, the sales technician’s time has been permanently wasted.

The Rope

There’s one more concept to address, which is the rope.  The rope is the method used to release inventory into the production processes ahead of the bottleneck.  The trick is release inventory just in time to ensure that the bottleneck and its buffer are fully supplied with the correct amounts of work-in-process inventory.

If the rope releases inventory into the system too late, then the bottleneck will be starved of work, and the company loses money.  Conversely, if it releases too soon, then you choke the system with too much inventory.  The rope has a lot of similarities to a just-in-time manufacturing system.

Once again, you can use the rope concept outside of the manufacturing area.  Getting back to the sales demo scenario, it’s the job of the sales personnel to keep a steady stream of fully qualified customers lined up, ready and waiting for their product demos.

Taken together, these three concepts are called the drum-buffer-rope system in the theory of constraint management.

Sprint Capacity

In addition, there are two more terms to be aware of.  The first is called sprint capacity.  This is the ability of upstream work centers to generate a lot of output fast when the buffer in front of the bottleneck is used up.  This happens when you have a machine failure or a labor shortage that reduces the flow of inventory to the bottleneck.  If you have enough resources to scramble and rapidly fill that pipeline before the bottleneck operation runs dry, that you have excellent sprint capacity.

Once again, the accountant is usually trained to screw up the sprint capacity system.  To the accountant, there appears to be too much production or labor capacity sitting around, which – they think – is costing the company too much money.  In reality, you have to look at where the capacity is located.  If it’s ahead of the bottleneck, you may very well want to keep it, whereas if it’s after the bottleneck, it might be a good idea to sell it.

Throughput

And the final term – you may have noticed that this podcast is about throughput accounting, but I never defined throughput.  Throughput is the margin that’s left after you subtract the totally variable cost of a product from its selling price.  This usually means that the variable cost is strictly the cost of materials that go into a product, and nothing else.  It does not include overhead, it does not include direct labor.

In a throughput costing environment, our job is to maximize throughput dollars.  Since the bottleneck drives the amount of product that we can produce, the key factor is the minutes of time required to get a product through the bottleneck operation, in relation to the amount of throughput dollars you earn from the product.

That sounded a little too theoretical, so here’s an example.  You can earn $100 of throughput from the sale of one unit of Product A.  That product requires 10 minutes of processing time at the bottleneck operation, so you can earn $10 per minute of bottleneck time used.  On the other hand, you can earn $60 of throughput from the sale of Product B, which requires 4 minutes of bottleneck processing time.  So for Product B, you can earn $15 per minute of bottleneck time used.  This means that the company will earn more money in total if it can push more of Product B through the bottleneck, even though Product A appears to make more money per unit.

This last concept is the whole key to throughput accounting – you have to identify the bottleneck, which is not always an easy thing to do, and then make sure that the right product flows through it.  Pretty obviously bottleneck management is key, and that’s why it’ll be the topic of the next episode.

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PDF Invoices (#42)

In this podcast, we cover how to create a PDF invoice, and the advantages of doing so. Key points made are noted below.

PDF Creation Software

Today’s topic is PDF invoices. What this is all about is converting your customer invoices into electronic files.  This is not scanning, which requires a little too much time, and also a flatbed scanner.  What I’m talking about is buying a copy of Adobe’s Acrobat software, which you can get at adobe.com for $300.  I also just checked on eBay, and you can get there for somewhere in the range of $200 to $230.  Or, you can buy it on Amazon for $250.

Once you install it, the software creates a new printer called Adobe PDF.  Then, when you want to create an electronic version of an invoice, just select the Adobe PDF printer, and the software creates an electronic version in .PDF format.  This is a really common format, and most everyone has Acrobat Reader software that can access the file.

Advantages of PDF Invoices

Now, what’s the big deal with having PDF invoices?  There are a couple of things.  The primary one is that you can send PDF attachments in e-mails to any customers who haven’t paid their bills on time.  When you do this, you avoid the time delay of mailing or Fedexing the invoice to the customer, and you avoid the risk of someone losing a fax.  Instead, the customer has the invoice in their hands right away, and they usually forward it straight to their accounts payable staff, with an authorization for immediate payment.

When we first implemented PDF invoices, we had a major decline in overdue receivables, and also – maybe more important – we found that at least half of all overdue receivables could be handled with just a single e-mail, as long as they had that PDF attachment.

OK, that was the main item in favor of PDFs.  But also, what if somebody in your company wants to include a cover letter with an invoice?  This usually happens with really complicated invoices, where the customer is probably going to call you back for clarification before they pay.  Now, you could just print the invoice and hand it over to the person who’s supposed to write the cover letter.  The trouble is, people don’t like to write cover letters, so they may park the invoice in their IN boxes, and you’ve just lost the invoice.

But, by sending out a PDF invoice by e-mail, you can still keep track of the original, which is also a good reminder to follow up with the letter writer, to make sure that the cover letter is completed fairly soon.

So, there are some reasons in favor of PDF invoices.  How about the mechanics of the creating them?  I already said that the basic process flow is to select the Adobe PDF printer, and you’re done.  But - there are a couple of other issues to be aware of.  First and foremost, some accounting systems already have a feature built in where you just press a button, and it creates a PDF invoice.  So, before you buy Adobe Acrobat, check your software to see if it has this feature.  If it does, you’ve just saved a couple of hundred dollars.

Also, if you’ve already printed the invoice and now you want to create a PDF version, the accounting software may insist on printing the word “Duplicate” on the invoice.  This may present a problem if customers don’t want to pay from duplicate invoices.  A good way to get around this problem is to always create a PDF invoice on the first printing.  And then, if you want a paper version too, then just access the PDF file, and print it from there.  To make this approach easier to remember, set your printer default to Adobe PDF, so the system will automatically create the PDF file as soon as you hit the print button.

As you may have noticed from previous episodes, I will mention accounting products on this podcast, but I don’t specifically recommend them – you can figure out for yourself if a product will work for you, and you can decide for yourself if you should buy it.  But in this case, I can’t state strongly enough that this is the one piece of accounting technology that has helped me the most – and it’s incredibly simple to use.  And no – Adobe has not paid me to say that.

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