Constraint accounting in a credit constrained economy
Written by Peter Crossley
Having avoided the specifics of double-entry book keeping for most of my 40 years, I was thrust into a professional situation that demanded my full and present attention and it got me thinking about two very important things: the science of accounting and the art of graphical re-presentation; creating pictures as a powerful aid to understanding.
My professional challenge in this case was to introduce complimentary software tools to manage the accounts and inventory of a business. The necessity to connect with basic bookkeeping came from the fundamental premise, common to all system changes: that in order to change a system, you must first have a profound understanding of that system, W.E Deming. This was the truism that made understanding debits and credits and their transactional implications imperative in this case.
My research lead me to a friendly CPA, my wife, who did a great job of briefing me on the fundamentals of Debits and Credits and how they operated in normally Debit balance and normally Credit balance accounts. I drew the following diagram to help learn and embed this principle in my graphically-inclined mind:
The direction of the arrow indicates the direction of value flow. For example, in the bottom (debit) sphere, a Cr fills the account and a Dr empties it. A Dr from the top (credit) sphere takes money into a debit account, as a Cr. I find this a handy mental picture.
It got me thinking again about how I could represent graphically two simple but potent ideas:
1. Every company has a scare resource (person, machine, knowledge, sales etc) that limits the acquisition of its goal units and
2. An organisation will maximise delivery of its goal units when it delivers the outcomes with the highest value per unit of its scare resource
For an open system-thinking mind, an identified constraint is a golden opportunity to align all areas, strategic and tactical, operational and financial, rational and aesthetic to focus on maximising value.
Part of the fabric of our business is TOC. TOC is a species of the same systems thinking / continuous improvement genus to which Lean and Six Sigma belong. The “Five Focusing Steps” is a TOC methodology for maximising valuable output from an enterprise; read profit where the enterprise is a for-profit business. I’ll explain the diagram above using the Five Focusing Steps and why that should be important, especially in our current economic situation.
In the diagram above, marbles representing products and services, flow through a gap in the wall into the market. The enterprise cannot produce enough marbles to satisfy demand (like gravity, if a marble is presented to the gap, it will fall through). Profit is generated when marbles pass through the gap.
The goal of the exercise: turn as many marbles into profit as possible in the shortest possible time.
What is the constraint to reaching that goal?
Here are the Five Focussing Steps we take to help us to reach that goal:
Step 1: Identify the constraint; the hole that governs the rate at which marbles move into the market
Step 2: Exploit the constraint; in this case, we cannot get more through the gap than one at any time
Step 3: Subordinate to the constraint; all remaining marbles should be tightly queued behind the constraint, in order of profit potential, highest first. Any spaces in the queue will mean the rate at which the constraint transforms contribution margin into profit will decrease; the company will be less profitable over time than it otherwise would have been
Step 4: Elevate the constraint; consider an investment at the constraint to let marbles go to market faster, a bigger gap.
Step 5: Avoid inertia; assuming you get more capacity at the constraint (a wider gap) the constraint may have moved so go back to step 1.
These are the basics of constraint management and are operationally straight forward, until it comes to accounting.
The contribution margin calculation should take into account time spent consuming the constraint resource. Trouble is, it mostly doesn’t. In the Cost Accounting world that prevails, there is often no direct link between the financial measures and operational ones. Cost Accounting absorbs a portion of the cost of operations into products proportionally, but does not value products based on their consumption of the scare resource. In operating this way, they miss a big trick. Aligning the enterprise around a clear, common, measurement framework specifically engineered to deliver more profit. In a Constraint Accounting view, it is clear how much contribution is being generated by the business daily. It is also clear where to leverage investment because you can clearly identify the constraint and demonstrate how more capacity (the Elevate step) will deliver additional value to the business. And in the austere and uncertain environment in which we will live for at least the next 12 months, it will clearly signal when to avoid investments that would work against the goal of the business, by elevating non-constraints. Of course, with a whole-of-system view there is a little side-effect of accounts and operations actually talking the same language. How refreshing.
We will spend 2009 co-creating solutions that demonstrate these principles and practices in action. It may finally be time to take the deep breath and employ Constraint Accounting to help create a more certain economic future.
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