After our recent episode on the Theory of Constraints, we’re diving into a related topic: throughput accounting. Listen to find out how this method of accounting can support better decision-making and more profitability in your business.
Topics we cover in this episode include:
- How business decisions may look different using throughput accounting
- Traditional job costing vs. throughput accounting
- How to implement throughput accounting practices
- How throughput accounting and Profit First could have helped contractors make better decisions during the recession
- Why you need a traditional accounting system with job costing to do throughput accounting
Find all episodes and related links at ContractorSuccessForum.com.
Join the conversation on our LinkedIn page: https://www.linkedin.com/company/contractor-success-forum
FIND US ONLINE
[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today, we’re discussing what cost accounting systems don’t tell you and talking about throughput accounting, and what it is. Here at the Contractor success Forum, we discuss how to run a more profitable, successful construction business.
And we have with us Stephen Brown, McDaniel Whitley bonding and insurance agency. And we have Wade Carpenter with Carpenter and Company CPAs. And I’m Rob Williams with IronGate Entrepreneurial Support Systems.
And so today guys, what is a cost accounting system? What, what does that tell you? And then I’m dying to know more about what throughput accounting is. Stephen, have you wondered this stuff? Have you laid awake at night wondering?
[00:00:52] Stephen Brown: I have, Rob. I have, it’s really bizarre, but I have been awake at night worrying about this. There are things that cost accounting systems don’t tell you. You know, we’ve been preaching cost accounting systems on almost every episode. Haven’t we guys? I mean, it’s the fundamental part of being a– okay, well maybe not every one, Wade, but there I go again.
But we’ve been talking about the importance. If you don’t allocate job costs, you don’t know how your jobs are doing, and you don’t know whether you’re gonna make the profit. You don’t know if you’re gonna hit those numbers. But accounting is all about tracking those numbers and understanding how you’re performing from a financial standpoint, especially now with all these added costs going on, all these unknowns that change the cost of a job.
And you’ve got a situation where owners are wanting more time to award the job and you can’t do it. I heard the other day, a supplier gave 48 hours to approve a bid, and the job wasn’t going to start for another 270 days. They ended up not turning in a bid. That particular owner had zero bids, 0 0, 0. So it’s probably more important now than ever.
[00:02:10] Rob Williams: Wow. So sensei Wade, what can you teach us? The wise wisdom–
[00:02:15] Wade Carpenter: Well, I don’t know about that, but…
Stephen, I know you said we don’t have all of our contractors doing it, but all of our contractors, in my opinion, should be doing job cost accounting in some form or fashion. That is one of the big determinants to whether they’re gonna make a long-term profit and can stay on top of their jobs.
But we kind of brought this concept of throughput accounting up when we started talking about Theory of Constraints and the supply chain issues that were going on right now. So we’re gonna talk about that a little bit. It was basically, Dr. Eli Goldratt, he coined the Theory of Constraints. I don’t know if he coined the term throughput accounting, but he’s the one I attribute throughput accounting to.
Business decisions you may look at differently using throughput accounting
[00:03:01] Wade Carpenter: He thought about it a little differently. He was more in the manufacturing realm than construction job costing, retail, or any other. So there’s some very big differences, but, I think we need both types of systems and if we can get a traditional job costing system in there, that’s what you need first. But as we talk through this, I think we may ask ourselves some different questions and make some different assumptions and decisions about our business if we’re using throughput accounting.
[00:03:30] Stephen Brown: Give us an example.
[00:03:33] Wade Carpenter: Well, do we make different spending decisions if we’re using job cost accounting versus throughput accounting? Job cost accounting, a lot of times will make us make decisions based on the cost.
So, just to give you a quick example. Should we have overtime on this job bid? A lot of times there’s an edict, there’s no overtime, that’s gonna cost us more money. But if it puts more throughput on our profit, then maybe that is the right. Questions like, should I buy this equipment or lease it? Should I use my in-house labor or should I sub this job out? And a lot of times you come to a different answer.
[00:04:12] Rob Williams: Yeah, we definitely looked at it those ways. Which it, sometimes it was good. Sometimes it was bad. On the spreadsheet before we started, it was always good to look at the throughput, but then when we didn’t have the volume, it, it got kinda ugly. Especially do we buy or do we lease? I didn’t have the risk factor put in there as well. So sometimes then when things would slow down, I’d be stuck paying for a bunch of equipment that I wasn’t fully utilizing because my math was not the same as reality later.
[00:04:40] Stephen Brown: That’s what you were saying earlier, Rob. That in your business, you were using throughput accounting, and your dad was doing the cost accounting in his head. If you had it to do over again, how would you set it up to understand exactly what kind of profit you were making?
[00:04:56] Rob Williams: Well, the big thing is, you would do both, really, I would think. Wade will probably get into this, but I think understanding what you’re doing is the most important part. And when you’re doing the costing. But to me, I’m definitely more conservative now that I’m older.
And I don’t believe the spreadsheet and minimizing the cost. I think I would be more about making sure we have more cash flow in the downtime where, when I was younger and aggressive, I was more looking at maximizing the profit and the uptime. Everything had a silver lining. And so I didn’t look at the dark clouds when I was in my planning and buying stages.
[00:05:33] Stephen Brown: Yeah. Okay.
[00:05:34] Wade Carpenter: Can I put this in context a little bit better guys? So that–
I’m gonna use the example we used on the previous podcast where we talked about this.
An example of throughput accounting and decision-making
[00:05:41] Wade Carpenter: If I gave you a job where, we could work on one path or another: one job is 1.2 million and we give you 20% profit and it’s gonna take you entire year to do. Versus $300,000 job that makes 17%, so it would take four of these jobs to equal the same revenue. Well, obviously you would make less profit at the end.
So assuming you burned off a hundred thousand a month over the course of a year, you’d have your 1.2 million on the first. If you had these $300,000 jobs, and they also take you three months to do each time and you do four of them, well, you’re not doing better. But what if we, instead of three months or 13 weeks to get these jobs done, what if you could actually turn these $300,000 jobs in 10 weeks? You would actually make 11% more profit, or you could take five weeks off during the year and do nothing, and still make the same level of profit you would on that $1.2 million job.
Throughput accounting, when we apply it to construction is like, how much revenue, how fast are we doing it? So it’s a concept of time.
[00:06:50] Stephen Brown: Yeah. It’s all about time. Time is money.
[00:06:53] Rob Williams: We so often spent a lot of extra money. It was just like using components. When we used building components, we were told it was gonna save us 10%. It actually usually cost us 20%, on the framing, more. Because we were in such an inexpensive framing area.
But we looked at the throughput, we could double our production with the components along with the systemization that came with the components. So that’s what we were looking at. Our throughput was doubled, but our margin per job was lessened by a good bit. We maybe made 10% less on each job. But we doubled our productivity. We doubled our throughput. So we decided to stick with building components. Until the market got slow. Then that was ugly, because we didn’t have the demand to keep the thing. Then it was like, oh that’s this is ugly. So that was.
Traditional job costing vs. throughput accounting
[00:07:43] Wade Carpenter: Well, to go back to the cost accounting issues, let me kind of define this a little better. Traditional job cost, if you got labor on that job, you’re gonna apply all that labor. If you own your own equipment, you’re gonna apply something for that equipment to the job in traditional job costing.
Now what throughput accounting says, is that okay, if you’ve got labor on this job and you’ve got people that, no matter what, if they’re not working, you’re not gonna send ’em home, you’re gonna pay them anyway. That’s a fixed cost.
If you’ve got equipment, like this big yellow iron, I mean, you’ve got all this money you’ve invested in this equipment and it’s sitting idle, it’s not a job cost. It’s a fixed cost that you’ve gotta cover. Whereas, going back to the labor, again, if you’ve got fixed costs like a PM that you never send home, or somebody like a day labor or a subcontractor, or actually, if you do have job labor that you send home when they’re not working, that is variable cost.
If you’re doing things like equipment on this job and you’re renting equipment and you’re applying it directly, that would be a cost to the job under throughput accounting. In traditional job cost accounting, you’ve got probably more costs allocated to the job and less fixed cost.
Throughput is less cost allocated to the job, but a whole lot more fixed cost to cover. So if you do the break even calculation, you get a very different answer.
[00:09:12] Stephen Brown: Completely.
[00:09:14] Rob Williams: We were doing with throughput cost. I mean, even Wade, our variable cost. I mean, when when we were doing lean manufacturing in the building component side, I mean, they would even say that we were going to give those guys 40 hours a week. In our plant, they would even sabotage the equipment and stuff so they could slow down. So when you’re guaranteeing, them the 40 hours, they would stay and sweep the floors, or they would do whatever. It might sound inefficient, but what it did is it improved the rate of efficiency while they were working. And then it forced us to try to fill up the plant.
There are certain reasons why I don’t like that, forcing to fill up the plant if you don’t have the demand sometimes. Because that means cutting prices and do some other things that are not attractive. It’s an interesting thing, but we definitely did some throughput and we did it both ways.
But one of the interesting things, Wade, is there’s accounting and then there’s our management interpretation of the costs. We did a lot of cost studies that were not part of our accounting system. I think at the time we were using Peach Tree and there would be things in there, but we had all kinds of cost reports that we were keeping up. So we kinda were doing both and looking at it in two different ways.
[00:10:28] Wade Carpenter: That’s one of the things that traditional job costing, or standard costing in manufacturing, which is probably more of what you were doing with the plant. People make decisions based on costs. So exactly what you said, we’re gonna stay here and work so that we can get our hours in, which is not necessarily the best decision. And Goldratt says, maybe you’d be better served just letting them sit idle if they’re not working on something.
[00:10:54] Rob Williams: Well, we did that. We did that. Exactly.
[00:10:56] Wade Carpenter: But again, that’s a manufacturing standpoint versus construction. So, going back to, what kind of decisions would we make? Would we buy this equipment or would we lease it?
One of the other fundamental questions, I used to have a lot of heavy yellow iron guys, had tons of money in bulldozers and excavators and stuff like that. And before the great recession, people had all kind of money tied up in that, but when things slowed down, they were stuck with these fixed costs. It’s easy to say, well, okay, my payment on this machine is gonna be cheaper if I buy it and I’m paying it over five years or something, and I’ll just have to keep it busy. Versus you rent the equipment, you go use it, and then when it’s done, you turn it back in. You don’t have that fixed cost. Same with subcontractors, versus hiring your own internal people.
10, 12 years ago, when we had the great recession, would we have made different decisions based on, the traditional guy that has zero job costing, versus somebody that has a traditional job costing accounting, versus throughput accounting.
[00:12:00] Stephen Brown: That’s a good point. I mean, Wade, you made that point about equipment and I imagine the number one question you get from your construction clients are should I buy, or should I lease equipment? The onsite project managers probably rather rent because parts are so hard to get right now. And the rental fleet is more dependent on that equipment operating so there’s no downtime. But the owner might think about the overall cost of that equipment, how long they have to spread it out. And also how much longer these jobs are taking to perform because of the economy.
[00:12:34] Wade Carpenter: Well, that’s where we’re trying to figure out revenue per week– or, I shouldn’t say revenue. I should say profit per week. The actual true goal of theory of constraints is, let’s get profit, but not just profit this year. Sustainable profit that we have year after year. That’s the ultimate goal of what we’re trying to do.
How to implement throughput accounting practices
[00:12:53] Stephen Brown: How would our average listener kind of implement these ideas, Wade?
[00:12:57] Wade Carpenter: Well, number one, you need the traditional job costing system first. But then once you’ve got that in there, if you can segment out your, say your labor separately, a project manager or whatever, instead of automatically just allocating.
That’s one of the problems with the traditional job costing, but it’s the standard way we do it. And we have to have some kind of standard for turning financial statements in to Stephen. But if you’ve got one job that’s heavy on materials and subs, versus one that is heavy on labor, you may get the same amount of labor burden allocated to one or the other, even when it’s not fair. Things you sub out, it’s things you have a heavy material on. Just because we’re using a cost to cost type allocation structure, we’re gonna get a very different answer. And so again, it doesn’t really tell the economics of what’s happening in these jobs.
[00:13:53] Rob Williams: I’m curious, Wade. One of the things that’s going through my mind is we did so much cost analysis not from the numbers in our books. Is that typical or is that? And you know, maybe it’s because it was a long time ago and it was harder to get the numbers out of our accounting system.
We had a whole series of spreadsheets and database stuff, and then we had the accounting system that these accounting gods came down and sprinkled these numbers, and then they went off into the thing and we got those numbers back. We’re like, what are these things? What are these strange, mysterious things called a journal entry? These end of the year things that came in there. It came out of the blue and just changed everything dramatically.
Part of that was we had so many systems that weren’t tied together back then. But do a lot of people use multiple costing or financial analysis these days, or is it more tied to the accounting system now?
[00:14:50] Wade Carpenter: There should be more. I don’t know if there are people looking at them differently, but talking about you guys used to do is exactly what you should be doing with the Sweet Spot analysis that, you know, Rob’s writing the book on the Pumpkin Plan for contractors.
When you look at what your ideal job is, it’s not just how much is the profit we’re gonna make? But are we gonna have cash flow problems with this job? Are we actually gonna make more money? In that example I gave earlier, you would actually make more money if we could turn it faster.
So absolutely, Rob, you were doing the right things. Especially when you don’t have the job cost information, you’ve gotta look at all these things. But you look at it in combination of every bit of data you got available. I think you really have to do that. And, with the supply chain issues today, I mean, maybe you may change the idea of what your ideal job is because you can’t get a certain part or things may have changed.
[00:15:50] Rob Williams: One thing on breaking this down, Wade, we had what we called sticks and bricks. So it was basically that material that you had delivered to the job, the sticks and the brick, that was truly a job cost, no matter how you looked at it. And then you had everything else.
We had hundreds of employees. We had a ton of our own labor, so we could look at it as allocating it there. Most of the jobs, the stuff that had to do with building the house, typically we did have time cards, but I grew up, in high school doing that. I know those time cards. A lot of times they pull ’em out– today, they have job trackers that you can actually get it accurate, but back then they were so inaccurate. It was just crazy. And we knew that.
So dad would kind of take those sticks and brick numbers and look at a floor plan. He’d say, well, this is this. So he would go back with his pencil and change the costing. And he was almost always right over our accounting methods of those things. So we knew which ones were direct. I mean, not to mention stolen material and I guess even sticks and bricks, especially when you’re doing a volume neighborhood, you may have half a house walk from one house to the next, so we can be tremendously off base when you’re not doing a site thing.
So I guess my point is there’s certain things that you can interpret as being this, but our land development, we talking about yellow iron things. Those were interpreted dramatically different on our land development costs. And then finally we separated the companies because the costing was just crazy. One neighborhood would just be like zero land cost and the superintendent’s making 20% more margins than the guy on the other side of town. So we had to come up with a different method.
But we definitely had a lot of throughput on our land development because we had fixed costs. And then when things slowed down, it’s different. And Stephen, you were talking about the lease. One of the tricks like, ’09, is we had to buy those leases out. They weren’t variable costs. So we may have been treating them like, but we had a contract. It was just like buying it. They were leases in terms of taxable. You didn’t have to separate and depreciate those kind of things. But in terms of cash flow, it was just like buying it and owning it because when we weren’t using them, you didn’t get to quit making the payments. You still had to make those payments.
[00:18:06] Stephen Brown: Just just like you were saying, your dad did it with a notepad. He did it in his head and he was almost always right.
[00:18:13] Rob Williams: -wasn’t, it was on paper and with a pencil though, and-
[00:18:16] Stephen Brown: I know, but his-
[00:18:17] Rob Williams: –make that little, that little paper thing that would print out and he’d take that thing and look down the thing.
[00:18:23] Stephen Brown: My point was, 35 something years ago Mr. Buck did a takeoff on a notepad and his three estimators spent all night doing it and he finished his estimate and we went and ate breakfast, and his estimate was within $1,200 of his three estimators, and it was a big job.
I guess the point is, accounting is something that’s real to the contractor. Getting in the information and trying to decide what to do with it. From a bonding standpoint, cost accounting is so important to us because it tells us how your jobs are performing. And we also think it helps our clients concentrate on getting those costs in their system so they know whether their jobs are making money or losing money.
How throughput accounting and Profit First could have helped contractors make better decisions during the recession
[00:19:09] Wade Carpenter: One of the things I hear all the time from contractors that don’t have a good job costing system: I know in my gut how I did my on my job. And you probably do. But I also see all the time where people say, I’m using the industry standard labor rate or the industry standard overhead rate. We’ve said many times, a lot of times, whatever that rate is for whatever the so-called “industry standard”, or what you had at the previous company you worked at has nothing to do with your own internal books.
What Rob said about the time tracking. Yeah, they have all these apps right now, and we work with a lot of contractors where it is still a struggle, even though they can do it on their phone, they don’t do it.
And the problem like Rob was saying, well, if we can walk next door from one job to the other, or a job is named very similar, so many times that job costing gets jumbled up. So again, especially if we have fixed labor, we may look at it very differently.
Rob made another good point about, I said a while ago, if we rent the equipment. I should have said a monthly type rental. Turn it in when you’re done, versus an operating lease where we’ve got to pay that for five years or something.
So some great points there guys, but to bring this back to, would we make different decisions? One of the things I’ve constantly done in the last five years or so is, would we have made different decisions back in 2008, when to shut down?
A lot of these heavy yellow iron guys, I keep coming back to them. But you know, they had so much overhead they couldn’t survive it. And a lot of them did not. And they should have possibly shut down earlier.
So I asked the question, would you have made a different decision? If you’re doing basically bank balance, what’s in my bank account, my gut feel versus having a traditional job costing, versus having a throughput accounting system.
And the fourth one, what we talk about on here all the time is the Profit First system of cash flow management. And quite honestly, the Profit First system might have made us make a different decision faster than any of them.
But my conclusion about what we think about as fixed cost with throughput accounting, I think people would’ve made some different decisions and maybe made them earlier and not gone and ruined their credit and had all these bankruptcies.
[00:21:34] Stephen Brown: Unfortunately our clients that end up defaulting on projects and going out of business, they just didn’t see it. And it was like, oh, if you only knew this, if you’d only done this.
[00:21:46] Wade Carpenter: Well, it’s easy to say, Monday morning quarterback, I–
[00:21:48] Stephen Brown: Sure. I know that. But in these situations that information in their systems just totally failed. So.
[00:21:54] Rob Williams: Stephen, you asked me earlier, how would you decide which system to make? When I’m talking to people, and I’ve had different partners in different situations, a lot of it depends on their availability to cash and how they’re doing business. Whether you want a lot of fixed costs. I think a lot of the Eli Goldratt assumptions of this throughput are assuming that there’s unlimited cash flow in these downtimes.
In the real world, what does that mean for contractors? Well, there’s some contractors that have $10 million of cash sitting in some checking accounts. Literally I’ve seen it. They’ve got years worth of downtime and they’re looking forward to the bad times because they’re gonna make a fortune buying up everything. It would make more sense for them to buy and do some more of that throughput stuff because they don’t have that cash flow concern. They may be concerned about it, but it may not be a need. It may be a want.
But where your typical guy that’s starting and running his company, he needs short-term cash flow all the time to operate his company. And he’s putting on there. In that case, it would be a lot more of the variable costs like what we were talking about, and maybe a little less throughput, because you don’t have the flexibility in cash flow. You may have to have a little bit more… well, I don’t even know if that’s throughput, Wade. Can you comment on that some, because it’s just a cash flow. Your main concern is how much gross profit can you pull through with that cash flow? And if you’re not planning a lot of variability in your costing structure so you don’t go broke when things– you’re gonna go broke at some point, because every few years there’s some kind of turn.
[00:23:34] Wade Carpenter: Well, I hope we don’t go broke every few years, but anyway to–
[00:23:38] Rob Williams: Well, well if you’re on the edge, I mean there, there are a lot of people that, just don’t last. They may not be getting bonded. Stephen may not give those guys a bond, but.
You have to have a traditional accounting system with job costing to do throughput accounting
[00:23:46] Wade Carpenter: To answer your question, number one, everybody needs a job costing system, in my opinion. But there is no such thing as you can go out and purchase a, Sage, or Peachtree, Timberline, QuickBooks. There is no throughput accounting system. You have to have a traditional accounting system that has some job costing for you to be able to do throughput accounting. So I think it just adds an additional dimension where we can make some smarter decisions. That’s one thing I wanted to clarify.
If nothing else, I hope we made some listeners think about how they evaluate jobs. I just finished a two hour presentation to a trade association on all these concepts. And it’s been enlightening for me to think about it from a construction standpoint. So, wrap up guys? Any thoughts?
[00:24:32] Stephen Brown: Thanks Wade for bringing this up. I think it’s very topical right now.
[00:24:37] Rob Williams: I just keep reading the title, what cost accounting systems don’t tell you. There’s so much in there about efficiency and then downtime and the cost and that throughput. If your business is in a position where you will really benefit from efficiencies, like maybe you have a specialty, then the throughput stuff can really help you have those lean manufacturing type efficiencies. You can really improve on it if you’re not doing that. But if you’re just allocating everything, you may not really have the opportunity to be pushed to make those.
[00:25:09] Wade Carpenter: I use the analogy of bath fitters. I mean, you get in and out in a day on redoing a bath. Speed is what it’s all about, and how fast can we turn profit? So I guess we need to wrap it up.
[00:25:23] Rob Williams: Okay. That was great.
[00:25:24] Stephen Brown: Hey and listeners, if you hadn’t heard our podcast on the theory of constraints, you might wanna listen to it. Might make this podcast a little clearer to you. But Wade, that was a good analogy of the bath fitters getting in and out. Who would’ve thought, 20 years ago, that someone could get out and do a bathroom in a day? But thanks guys.
[00:25:44] Rob Williams: Yeah. So everybody go ahead and comment, ask us questions. Look us up, ContractorSuccessForum.com and Contractor Success Forum on LinkedIn. Ask us questions, propose any new topics. Is there something that you would rather not pay some consultant for when you can get the three of us just talking about it? So give us some good suggestions.
[00:26:04] Stephen Brown: Well, you get what you pay for it.
[00:26:06] Rob Williams: Yeah, that’s right. That’s right. All right. Well, thanks for joining the Contractor Success Forum today. We have Stephen Brown, McDaniel Whitley bonding and insurance agency, Wade Carpenter, Carpenter and Company CPAs, and Rob Williams with IronGate Entrepreneurial Support Systems.
Have a great day.