How Does A Job-Costing System Differ From A Process-Costing System Operational Effectiveness – Another Way of Looking at Performance

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Operational Effectiveness – Another Way of Looking at Performance

Many organizations measure the performance of the organization on efficiency. The field of cost accounting is built around these concepts and principles. The problem is that efficiency is no longer an effective measure of what is happening in the operation of the organization. It is possible to achieve high levels of efficiency and still operate at a loss.

Today’s organization requires a different measure – Effectiveness In other words, how effective are the resources being applied to the operation? Efficiency – The ratio of the output to the input of any system – Skillfulness in avoiding wasted time and effort; “she did the work with great efficiency” [ant: inefficiency]

Effectiveness:

– The ability to identify and do the things that contribute to the organization.

– The emphasis of effectiveness is on ‘doing right things’ and not just solely ‘doing things right’ (which is what efficiency is about)

Benefits of Effectiveness

There are a number of benefits to applying effectiveness measures to the Reliability Oriented Organization:

– The practice of personal effectiveness creates results that are continuous rather than once and done.

– A focus on personal effectiveness greatly encourages the elimination of wasteful activities that do not produce a contribution to the organization’s economic results.

– Personal effectiveness is a skill that transfers with the person: they can apply it even when job roles or situations change. It is not something that no longer applies. It is a lifelong skill.

– On a personal level the knowledge that you are being effective reduces work stress and creates a feeling of well-being.

Use of Efficiency

In the recent past efficiency in business operations was used as the sole focus of a company’s improvement efforts. The logic was that if we can control our costs we can improve our profits. Efficiency focuses on how something is done in order to avoid waste in converting a physical input to a physical output. It is a yield based measure. This was a sensible approach when applied to repetitive operations which could be systematized with a high degree of predictive repeatability. Work Study and Organization & Methods improved efficiency. Factory automation and computers enabled the approach to be carried even further with outstanding success.

Problem with Efficiency

Efficiency focuses on how something is done in order to avoid waste in converting a physical input to a physical output. It is a yield based measure. This was a sensible approach when applied to repetitive operations which could be systematized with a high degree of predictive repeatability. In the process of introducing efficiency – which was often accompanied by significant changes in work practices – the labor force began to shift away from being composed of manual workers to being increasingly composed of people who were not bound by rigid procedures and processes. These people tended to be required to exercise judgment in their work based on their knowledge and experience. This became increasingly true as organizations changed rapidly to keep pace with transformations in the global marketplace. Doing the old job in the old way was no longer possible.

A Different Way of Looking At Throughput

In most companies. Managers think that if they have produced something, it should be called throughput. Throughput can be defined for the Reliability Oriented Manager as: “All of the money that comes into the company minus what it paid its vendors.” The concept is best explained by Eliyahu Goldratt in his novel: The Goal[i]. Goldratt masterfully explained the concept through the eyes of a plant manager who is tasked with saving his plant or shutting it down. The book, first published in 1984 is still worth the time to read it.

What is Throughput?

Throughput is the rate at which the system generates money through sales” (“Throughput” is sometimes referred to as “Throughput Contribution” and has similarities to the concept of “Contribution” in Marginal Costing which is sales revenues less “variable” costs – “variable” being defined according to the Marginal Costing philosophy.) [ii]

Throughput Accounting

Goldratt’s alternative to cost accounting begins with the idea that each organization has a goal and that better decisions increase its value. The goal for a profit maximizing firm is easily stated, to increase profit. This is called Throughput accounting. Throughput accounting uses three measures of income and expense:

1. Throughput

2. Investment

3. Operating expense

Investment is the money tied up in the system. This is money associated with inventory, machinery, buildings, and other assets and liabilities. In “The Goal, the term was used interchangeably between “Inventory” and “Investment.” The preferred term used in Throughput accounting is now only “investment.” One difference between Throughput Accounting and Cost Accounting is that inventory is valued strictly on totally variable cost associated with creating the inventory, not with additional cost allocations from overhead. Operating expense is the money the system spends in generating units. For physical products, OE is all expenses except the cost of the raw materials. OE includes maintenance, utilities, rent, taxes, payroll, etc.

Key Questions

Managers need to test proposed decisions against three questions. Will the proposed change:

– Increase Throughput? – How?

– Reduce Investment (Inventory) (money that cannot be used)? – How?

– Reduce Operating expense? – How?

Summary

Management needs to shift its thinking from cost accounting to take into account measures of effectiveness and they must begin to abandon simply measuring efficiency. They also need to redefine throughput to include a toatal range of raw materials into the system to sales out of the system.

References: [i] The Goal – Second Revised Edition, Eliyahu Goldratt, North River Press, Great Barrington, MA 1992. [ii] Throughput Accounting, Thomas Corbett, North River Press, Great Barrington, MA, 1998, p29

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