Theory of Constraints Yield Accounting and Labor Cost

Below is a conversation between Brad Stillahn and Dr. Lisa Lang about performance accounting. Several of their clients are highly personalized job shops who frequently exclaim “We lost money on that job!”.

Lace: You give a lot of speeches to business owners. Tell me again, what drives you crazy?

dr lisa: When someone says “We lost money on that job.”

Lace: That’s Cost Accounting speaking. It’s amazing that the owner is still in business, saying something like that. If his competition didn’t think the same way, he would be out of business.

dr lisa: In the Theory of Constraints, truly variable costs such as materials, subcontracting, freight, and sales commissions are typically only a fraction of the selling price. There are only two ways to lose money on a job: 1) charge less than your truly variable costs; or 2) reworking a job over and over again, causing you to incur truly variable costs multiple times and the total of all truly variable costs to exceed the price you charged.

Lace: The industry-wide average for truly variable costs is 40%. And machine shops, for example, are usually much less than that, depending on the type of work they do. So why does the business owner think he “lost money on that job”?

dr lisa: It’s overhead allocation, cost accounting’s number one misconception. Remember, cost accounting was invented at the turn of the last century, when labor was paid by the piece and overhead was less than 10% of total costs.

What actually happened was that the job took longer than estimated. And since cost accounting allocates the cost to that time, the job “cost” more than expected, perhaps more than the price. But this is a mirage. The margin received “selling price less truly variable costs” is the same no matter how long the job took to produce.

Lace: So the problem is that by using more time than estimated, there is less time left in the month to produce and ship the margin for subsequent jobs. Sometimes the margin that is sent in total is less than the fixed costs for the month, and then there is a loss for the month.

dr lisa: Yes, and that’s the problem most homeowners try to avoid. And the way we’ve all been taught to do it is: cost allocation. However, you can make sure you get enough margin in total without assigning any cost, and it’s actually simpler and more straightforward.

Simply plot the dollars of margin you send every day (what we in Theory of Constraints call yield) and compare it to your operating expenses. And remember, if you work overtime, you will have increased your operating expenses. Once you understand the relationship between performance and operating expenses, you’ll have all the information you need to make sure you submit enough work in total to make money.

A company can lose money, but a job rarely does. Jobs are not profitable and, in fact, products are rarely profitable and customers are rarely profitable. Companies lose money because the margin in one month does not cover the fixed costs of one month. Otherwise, the margin from all jobs, products, and customers that exceed fixed costs for that month are collectively added to that month’s overall profit.

Lace: Who cares? Is this really that important? In the 20+ years since Yield Accounting was invented to replace Cost Accounting, not many business owners have heard of it, let alone felt the need to change.

dr lisa: Real. Most just slowly closed. Like the frog in the pot when the heat slowly increased, and it never jumped out before it was cooked.

Lace: When I changed my label printing business from Cost Accounting to Yield Accounting in 1997, it was awkward. The process took time and perseverance. And there wasn’t much help available to me back then. But I found the sweet spot where conventional Cost Accounting leads business owners to believe that they would lose money on jobs, and where Yield Accounting clearly indicated that we were making a lot of money.

dr lisa: It’s really unfair to competitors when performance accounting is understood and priced accordingly. Goldratt calls that “competing with blind kittens” because cost accounting is such an inferior technology.

Lace: Cost Accounting was invented before Model T. Why don’t business owners who are so up to date with other types of technology and appreciate keeping up with the rate of improvement in technology think of looking for improved technology in the business methods? ?

dr lisa: I don’t know the answer to that, but I guess they are more comfortable with new technologies in their area of ​​expertise and less comfortable with new technologies they are not experts at, like financial management. And even if they have some interest in this new Yield Accounting technology (based on Goldratt’s Theory of Constraints), it’s hard to give up the old until you fully understand the new. Hmmm… that sounds familiar.

Lace: WOW, you’re right! It took me a long time to make the change. I guess that explains why it’s easier to stick with the old technology.