It took me a lot of time to understand the sources of disagreement and gap in understanding approaches to cash flow evaluation in decision making. I couldn’t realize why formula CF=T-OE-∆I is not obvious.
Now I realize that it’s not used in TOC. What a surprise to me! Let me explain why.
I started studying TOC in 2011 from the Russian edition of William Detmer’s book “Goldratt’s Theory of Constraints. A system Approach to Continuous Improvement” not from the “Goal”. In the chapter devoted to T, OE and I concept there was a footnote about relations between T, OE and I with the above formula. The formula is so natural and obvious to anybody who is related with financial accounting, it’s so simple, logical, practical and graceful if we are speaking about the goal “to make money now and in the future” that I even didn’t mentioned that the footnote was written by scientific editor not by author and focused on T/CU concept admiring and enjoying simplicity and usability. The formula is taken from The Complete Guide to CQM (Quality America, 2000).
When I started my discussion about the purpose not to consider material costs as a TVC in some cases I was sure that the formula is usual in TOC (because it’s obvious as I thought) and when you didn’t understand me I was puzzled. So, I took all my books were is this issue: William Detmer’s I’ve mentioned above , Thomas Corbett’s “Throughput Accounting” and found the reason.
Thus, let start from the very beginning.
First, let’s agree about the goal. It’s generally accepted that the goal of any commercial organization is to get profit. But is it a goal of owner? Will any owner be satisfied when his organization has profit but can’t give him any cash? “Common sense is not common” What is profit? It’s just a figure in accountant’s books. It can be related with your money in bank or in cash or it may be dissipated in inventories, investments and deferred client’s payment. I didn’t see correct Goldratt’s quotation but I clearly know that “make money now and in the future” and “make profit now and in the future” is not the same. And the vast majority of entrepreneurs and owners I’m acquainted with will prefer to have more money with less profit than the reverse. And if it’s so that the top-level measurement is cash-free. There are different definitions of FCF (Free Cash Flow), I prefer to define it like “money which owner can use to any projects and purposes without any harm to organization functionality, liabilities and development plans”. Profit is necessary condition to make money in future but it’s not sufficient.
TOC solutions for supply chain management do not only improve ROI but also free money from the stock from surpluses. Let say we have about 20% increasing of T due to better availability ($20 000 – for example) and decreasing stock minus 30% ($10 000). In this case we have increased cash-free for $30 000 – not bad to invest in entrepreneurs experiment.
When we make any decision it impacts on all three elements. For example, we sell product for $100, TVC is $50, ∆OE for one sale is zero. If we use buffer management and replenish according to consumption ∆I is to be zero: when we sell it decreases for $50 and we replenish it for $50. What we’ll see in CF? Throughput is $50, ∆OE = 0, NP = $50, CF=$50-0-($50-$50)=50. No difference between NP and CF. But what happens when we sell to deferred payment? Where would we see accounts receivable? I think it’s investment in client’s relationship, so we have to account it ∆I.
And here is a question which sum we have to account? Usually it is revenue but… We have invested our own money only equal to TVC. To my mind ∆I is (-$50) (decreasing by shipping goods) plus replenishment for $50 plus $50 (money invested in accounts receivable) = ($50)+$50+$50=$50.
So NP didn’t changed, it’s $50 but CF = $0. Now we have profit but have no money. Good business!
Of course, we have to look it not only in short time but and in long time interval. May be we have to buffer accounts receivable, who knows? We make buffers for our clients accounts receivable in two dimensions: time and money.
That’s why I’m torturing you with questions.
You say that it may take a lot of time between the moment we buy the material and the moment we decide to stop its production. Yes, it’s obvious but the formula is working at any time interval not only for single sale but for whole organization slightly modified.
All variables are sum for T, OE and I for the whole organization. If we are making decision for some scenarios we should use Deltas.
It’s not something special. It’s trivial calculation of cash flow indirect way from P&L and BS report. It links Net Profit with changes in Balance sheet. Usually it is used to check cash flow accounting in order to be sure that every movement of cash is accounted and nothing left unaccounted. So , there are different approaches what to consider as “I” – it may be total assets, current assets if we are talking about all money stuck in organization or net assets (I’m not sure it is correct translation: it means total assets minus all debts in liabilities) if we are talking about our own money. So the impact of TOC supply chain logistics application on a cash flow was obvious from the very beginning.
That’s why I even didn’t pay any attention that it’s not Detmer’s or Goldratt’s formula so obvious it was if we are talking about money. I even admired how easy physician understood the nature of money management without any complexity just taking out the core of it. All thoughts in Haystack Syndrom, all definitions of T, OE and I never caused me doubt that this calculation of cash flow is obvious to everyone.
That’s why I claim that it’s no reason don’t to treat material costs as TVC because if we don’t replenish it even selling below TVC have positive impact on our goal units – money. And in regular cases it have negative impact due to replenishment.
Let’s see: selling price is $40, TVC — $50, and we replenish (OE we put out of consideration). CF = 40 (TS) – 50 (TVC) – (50-50) (∆I) = (10) – minus ten dollars – bad decision.
But if we don’t replenish situation changes: CF = TS – TVC — ∆I = 40 – 50 – (-50) = 40. Good decision in spite of negative NP.
That’s why I don’t see any reason to multiply entities. Let’s use Occam’s razor. We already have all necessary data to make good enough decision if we’ll not substitute the goal – make MONEY now and in the future. “Information is an answer to the question” if I’m not mistaken.