Why throughput accounting is important

According to Goldratt , the theory of constraints is summarized into five-step approach as follow:. Step 1: Identification of Constraints Bottleneck Resource. The bottleneck or constraint can either be an internal issue i. The first step is to identify the constraints in the system. Once we have identified the bottleneck or constraint, the management must make sure to maximize that scarce resource. For example, if the bottleneck is raw material the machine and labor force will sit idle.

Step 3: Subordinate and Synchronize everything else to the decision made in Step 2. Steps must be taken to elevate the bottlenecks, for example, if there is key machinery in the manufacturing facility and it runs out of date then there is no alternative but to purchase a new one. Step 5: If the constraint has shifted during the above steps, go back to step 1. In this step, we also call continuous improvement. Once a bottleneck is removed from the system, the new bottleneck must be identified and the process continues.

Suppose ABC Co is a manufacturing company and has two types of machine. Machine X and Machine Y. Machine X can process 1, kg of raw material per hour. Machine Y has the capacity to process 1, kg per hour. After material processed machine X, it need to go through another process in Machine Y. However, machine Y can only process up to 1, kg; thus kg must be wait until machine Y process the 1, kg.

The current maximum output capacity of each types of machine per week is as follow:. The company is considering the purchase of additional machine type C since the existing one can produce only up to 1, units. This would increase the additional output of units per week. Have you ever seen a person drawing lower salary or rental of a building reduced because of a product being sourced out?

With the outsourcing decision, the payouts increase by more than the raw material costs. So the net result is extra payouts by the company. Machine investment decisions are usually made based on comparisons of reduction in cost per part as compared with the investment, to calculate the payback period. The reduction in cost per part is almost a myth, if the equipment is a non-bottleneck machine.

While for a bottleneck machine, the actual payback period is much less than what is calculated using the traditional method. It is interesting to know that many loss making companies actually do not take loss making orders.

However they still make losses at end of the year! Of late, cost accounting has been criticized by many. In fact cost accountants have been advising against the blind use of numbers for decision making.

Activity Based Costing was invented to take care of the problems with cost accounting. They argue that the allocation method is incorrect when different product use resources in varying ways. So they argue, the resource cost allocation, should be based on how much the product has actually used the resource. ABC advocates a better allocation method. Allocation of what are essentially period costs can lead to erroneous decisions like the examples discussed.

The Theory of constraints advocates argue that bulk of the manufacturing expenses are actually period expenses. So it makes sense only to allocate what is truly variable with a unit of sales. For example raw material costs, sales incentives etc. At the product level, what needs to be measured is only throughput Sales-Truly variable expenses. Since the period expenses are allocated to the product, the inventory is only valued as per the truly variable expenses.

It includes all expenses, other than the truly variable expenses. It is the company which makes profit so the profit has to be calculated only at the company level.

Products bring thru-put and the total thru-put from all products should be more than enough to cover the total period expenses and give the desired profits.

As already discussed, many cost accounting decisions at a local level can actually cause damage to the company at the global level. So now we need a tool which helps connect the local decisions with the global objective making more profits for the company. Any business decision like outsourcing, investments in new equipments, accepting a large order can impact either the throughput, or the operating expense at organization level , or the total inventory.

So it makes sense to analyze the impact on these 3 variables. The change in throughput because of the decision should be compared with the change in total operating expense because of the decision. This will provide us with the change in profits which in turn can be compared with the change in investments to determine the ROI. Throughput accounting does not assume operating expenses to be fixed. It assumes it is not truly variable.

So any decision for any time horizon has to check the changes in the 3 variables to arrive at a correct decision for the company as a whole.

The above analysis can only be done if one understands the relationship between the constraint of the organization, the non constraints and the output of the company. The focusing steps of TOC have to be used to analyze the company before one can measure the impact of a local decision on global impact using the 3 questions. The focusing Steps:. It is already established at that point that performance problems are inevitable. All we are doing from that point on is, validating their existence in detail and in scale,.

Cost Accounting data is treated as entirely legitimate by most managers — and if you don't believe me, ask yourself just one question: does anyone in senior management in your company pay any attention to the margins on different products or the margins on different orders, if you don't have standard products?

No, "margin" wasn't handed down by Moses on a tablet — it's a man-made concept, and it's mathematically absurd. Corbett's book called "Throughput Accounting," is one of several useful publications that provides detailed numerical examples to accompany an explanation. It rigorously examined manufacturing businesses in US and Europe who had been using Theory of Constraints for some time to demonstrate the effectiveness of the Throughput Accounting approach.

A Book "The Management Nightmare" by Debra Smith provides probably the best picture of the whole topic because she devotes a whole chapter to the type of profit-killing behaviors that the Cost Accounting mind-set creates in companies. And Debra is one of the best qualified Accountants you'll ever encounter - with a history as an auditor, Controller of a division of a Fortrune company, and Visiting Professor at Washington State University. So, just for the moment giving us the benefit of the doubt, assuming we and many others are right That's why Throughput Accounting was developed — to provide managers with a basis for accurately predicting the bottom-line impact of their decisions and actions.

Throughput Accounting usually makes intuitive sense to everyone at all levels and in all functions of a manufacturing organization - it is simple, and logical. It demands less data than conventional Management Accounting, and it is far more tolerant of inaccurate or incomplete data. Its principal value, though, is simply that it supports better and faster decision-making. Step 3: Subordinate everything else to the decisions made in Step 2 The main point here is that the production capacity of the bottleneck resource should determine the production schedule for the organisation as a whole.

Remember how, in the previous article, I talked about how new bottlenecks seemed to be appearing at the UniCo plant, because non-bottleneck machines were producing more parts than the bottleneck resources could absorb?

Idle time is unavoidable and needs to be accepted if the theory of constraints is to be successfully applied. To push more work into the system than the constraint can deal with results in excess work-in-progress, extended lead times, and the appearance of what looks like new bottlenecks, as the whole system becomes clogged up.

By definition, the system does not require the non-bottleneck resources to be used to their full capacity and therefore they must sit idle for some of the time. Jonah made him and his team think about the fact that, while the NCX 10 alone performed the job of three of the old machines, and was very efficient at doing that job, the old machines had still been capable of producing parts.

Admittedly, the old machines were slower but, if used alongside the NCX 10, they were still capable of elevating production levels. This example of elevating a bottleneck without cost is probably unusual.

Normally, elevation will require capital expenditure. However, it is important that an organisation does not ignore Step 2 and jumps straight to Step 4, and this is what often happens. There is often untapped production capacity that can be found if you look closely enough.

Elevation should only be considered once exploitation has taken place. This could be in the form of another machine that can now process less units than the elevated bottleneck.

Eventually, however, the ultimate constraint on the system is likely to be market demand. Whatever the new bottleneck is, the message of the theory of constraints is: never get complacent. The system should be one of ongoing improvement because nothing ever stands still for long. In practice, there may be lots of options open to the organisation such as the ones outlined in The Goal.

In the context of an exam question, however, you are more likely to be asked to show how a bottleneck can be exploited by maximising throughput via the production of an optimum production plan.

This requires an application of the simple principles of key factor analysis, otherwise known as limiting factor analysis or principal budget factor. Once an organisation has identified its bottleneck resource, as demonstrated in Step 1 above, it then has to decide how to get the most out of that resource.

Given that most businesses are producing more than one type of product or supplying more than one type of service , this means that part of the exploitation step involves working out what the optimum production plan is, based on maximising throughput per unit of bottleneck resource.

In key factor analysis, the contribution per unit is first calculated for each product, then a contribution per unit of scarce resource is calculated by working out how much of the scarce resource each unit requires in its production.