Business processes and flow. Let's firstly have a talk about process thinking. A business process, which is called the value stream in lean terminology, runs right from the customers through to suppliers without departmental or functional barriers or boundaries, and improving the process as a whole is the best and most sustainable way of improving the profitability of the process. Why does the Theory of Constraints and the lean philosophy encourage us to think about processes? Well processes tell us where customer value is created. We can map the process steps to identify the steps that create value and the steps of which are wasteful or inefficient.

If we remove obstacles to flow, then we have the opportunity to increase sales. Although departments can be optimized, we need to maximize the flow through the entire process. In order to be able to improve profitability, let's talk about processes and cost reduction. We cannot cost reduce products only processes. And there are only three ways of reducing the production cost of a product, we can redesign the product, we can improve the production process, so that it can do more in a given timescale. And we can remove capacity that is assets and people that are no longer needed.

Product costs are reduced by increasing the throughput or flow of the process in a given timeframe. And we can improve the process by taking out waste which will increase throughput. This increases the capacity of the process for all the products that flow through it. So the concept of product cost is irrelevant in cost reduction. What matters is that the whole business process cost and in particular, constrained resources or activities. We're going to look at a couple of examples now.

So let's have a quick reminder of the throughput accounting measures and ratios. Firstly, throughput contribution is defined as net sales less total variable cost. investment is defined as money tied up in equipment, inventory, facilities, buildings and other assets and liabilities that form the process. And it's valued at variable cost only without labor or overhead. operating expense is other direct costs associated with the process excluding any allocations or external overheads. And the four ratios of throughput accounting, well, their net profit, which is te throughput minus e operating expenses, return on investment, which is net profit over investment as a percentage productivity which is throughput divided By operating expense as a percentage, and investment turns, which is throughput, divided by investment as a ratio.

So here's a quick example of the calculations before we move on to a more detailed example. And in this slide, we have a current state of a business process. And then option one for improvement. And option two for improvement. We can see that both improvement options improve sales, but they also have an increase in material costs. Both options reduce labor costs.

So let's look at the calculations and the ratios. We see the calculation for throughput there a sales less variable costs, which in this case is material costs only. And both options improve the throughput of this process. As I said, labor costs are reducing under the two improvement options. Other direct costs remain the same and All three alternatives. So net profit in the throughput accounting sense is shown there for the current state.

And for the two improvement options, and we have the number they're given for the level of investment under each of the options. Both options, as we see require a lower level of investment overall than the current state, presumably because we're able to reduce inventory, and perhaps some other equipment costs. From the throughput accounting KPIs, we see productivity there, and improvement option number one has a 206% productivity compared to the current state of 150%. Option number two is calculated at 208%. Productivity return on investment is 4% in the current state 8% under option one, and 9% under option two, and the investment turns metric is zero. point one, two in the current state 0.16 under option one, and 0.17 and the option two.

All of these metrics suggest that we should take option two over option one for our improvement to the current state. And this data these measures show that throughput accounting is easy to understand and provides useful tools for understanding and improving the flow through the process of value stream. How then can you move towards using throughput accounting for your management accounts and your decision making? Well, you need to align your cost centers with value streams or processes. You need to avoid the allocation of corporate overheads. And then you're ready to work out the ratios identified to support process improvement.