THEORY OF CONSTRAINTS
Throughput accounting is a product management system which aims to maximise throughput, and therefore cash generation from sales, rather than profit. A just in time (JIT) environment is operated, with buffer inventory kept only when there is a bottleneck.
The Theory of Constraints (TOC) is an approach to production management. Its key financial concept is to turn materials into sales as quickly as possible, thereby maximising the net cash generated from sales. This is achieved by striving for balance in production processes, and so evenness of production flow is also an important aim.
Theory of constraints (TOC) is an approach to production management which aims to maximise sales revenue less material and variable overhead cost. It focuses on factors such as bottlenecks which act as constraints to this maximisation.
Bottleneck or binding constraint – an activity which has a lower capacity than preceding or subsequent activities, thereby limiting throughput.
One process will inevitably act as a bottleneck (or limiting factor) and constrain throughput – this is known as the binding constraint in TOC terminology. Steps should be taken to remove this by buying more equipment, improving production flow and so on. But ultimately there will always be a binding constraint, unless capacity is far greater than sales demand or all processes are totally in balance, which is unlikely.
Output through the binding constraint should never be delayed or held up otherwise sales will be lost. To avoid this happening a buffer inventory should be built up immediately prior to the bottleneck or binding constraint. This is the only inventory that the business should hold, with the exception of possibly a very small amount of finished goods inventory and raw materials that are consistent with the JIT approach.
Operations prior to the binding constraint should operate at the same speed as the binding constraint, otherwise work in progress (other than the buffer inventory) will be built up. According to TOC, inventory costs money in terms of storage space and interest costs, and so inventory is not desirable.
The overall aim of TOC is to maximise throughput contribution (sales revenue – material cost) while keeping conversion cost (all operating costs except material costs) and investment costs (inventory, equipment and so on) to the minimum. A strategy for increasing throughput contribution will only be accepted if conversion and investment costs increase by a lower amount than the increase in contribution.
THROUGHPUT ACCOUNTING
The concept of throughput accounting has been developed from TOC as an alternative system of cost and management accounting in a JIT environment.
Throughput Accounting (TA) is an approach to accounting which is largely in sympathy with the JIT philosophy. In essence, TA assumes that a manager has a given set of resources available. These comprise existing buildings, capital equipment and labour force. Using these resources, purchased materials and parts must be processed to generate sales revenue. Given this scenario the most appropriate financial objective to set for doing this is the maximisation of throughput (Goldratt and Cox, 1984) which is defined as: sales revenue less direct material cost.
(Tanaka, Yoshikawa, Innes and Mitchell, Contemporary Cost Management)
TA for JIT is said to be based on three concepts.
Concept 1
In the short run, most costs in the factory (with the exception of materials costs) are fixed (the opposite of ABC, which assumes that all costs are variable). These fixed costs include direct labour. It is useful to group all these costs together and call them Total Factory Costs (TFC).
Concept 2
In a JIT environment, all stock is a ‘bad thing’ and the ideal stock level is zero. Products should not be made unless a customer has ordered them. When goods are made, the factory effectively operates at the rate of the slowest process, and there will be unavoidable idle capacity in other operations.
Work in progress should be valued at material cost only until the output is eventually sold, so that no value will be added and no profit earned until the sale takes place. Working on output just to add to work in progress or finished goods inventory creates no profit, and so should not be encouraged.
Concept 3
Profitability is determined by the rate at which ‘money comes in at the door’ (that is, sales are made) and, in a JIT environment, this depends on how quickly goods can be produced to satisfy customer orders. Since the goal of a profit-oriented organisation is to make money, inventory must be sold for that goal to be achieved. The bottleneck slows the process of making money.
Bottleneck.
The aim of modern manufacturing approaches is to match production resources with the demand for them. This implies that there are no constraints, termed binding constraint in TA, within an organisation. The throughput philosophy entails the identification and elimination of these bottlenecks by overtime, product changes and process alterations to reduce set-up and waiting times.
Where throughput cannot be eliminated by say prioritising work, and to avoid the build-up of work in progress, production must be limited to the capacity of the bottleneck but this capacity must be fully utilised. If a rearrangement of existing resources or buying-in resources does not alleviate the bottleneck, investment in new equipment may be necessary.
The elimination of one bottleneck is likely to lead to the creation of another at a previously satisfactory location, however. The management of bottlenecks therefore becomes a primary concern of the manager seeking to increase throughput.
There are other factors which might limit throughput other than a lack of production resources (bottlenecks) and these need to be addressed as well.
The existence of an uncompetitive selling price
- The need to deliver on time to particular customers
- The lack of product quality and reliability
- The lack of reliable material suppliers
- The shortage of production resources
Is it good or bad?
TA is seen by some as too short term, as all costs other than direct material are regarded as fixed. Moreover, it concentrates on direct material costs and does nothing for the control of other costs such as overheads. These characteristics make throughput accounting a good complement for ABC, however, since aspects of ABC focus on labour and overhead costs.
TA attempts to maximise throughput whereas traditional systems attempt to maximise profit. By attempting to maximise throughput, an organisation could be producing in excess of the profit-maximising output. Production scheduling problems inevitably mean that the maximising of throughput is never attained, however, and so a throughput maximising approach could well lead to the profit-maximising output being achieved.
TA helps to direct attention to bottlenecks and focus management on the key elements in making profits, inventory reduction and reducing the response time to customer demand.
BLANK
PERFORMANCE MEASURES IN THROUGHPUT ACCOUNTING
Performance measures in throughput accounting are based around the concept that only direct materials are regarded as variable costs.
Return per factory hour
Sales−directmaterialcosts
Usageofbottleneckinhours(factoryhours)
This enables businesses to take short-term decisions when a resource is in scarce supply.
Throughput accounting ratio
Return perfactory hour
Total conversioncost perfactory hour
Again factory hours are measured in terms of use of the bottleneck. Businesses should try to maximise the throughput accounting ratio by making process improvements or product specification changes.
This measure has the advantage of including the costs involved in running the factory. The higher the ratio, the more profitable the company. (If a product has a ratio of less than one, the organisation loses money every time the product is made.)
THROUGHPUT AND DECISION MAKING
In a throughput environment, production priority must be given to the products best able to generate throughput, that is those products that maximise throughput per unit of bottleneck.
The TA ratio can be used to assess the relative earning capabilities of different products and hence can help with decision making.
How can a business improve a throughput accounting ratio?
| Measures | Consequences | ||
| • | Increase sales price per unit | • | Demand for the product may fall |
| • | Reduce material costs per unit, eg change materials and/or suppliers | • | Quality may fall and bulk discounts may be lost |
| • | Reduce operating expenses | • | Quality may fall and/or errors increase |
Limitations of the throughput accounting ratio
As we have seen, the TA ratio can be used to decide which products should be produced. However, the huge majority of organisations cannot produce and market products based on short-term profit considerations alone. Strategic-level issues such as market developments, product developments and the stage reached in the product life cycle must also be taken into account.
Throughput and limiting factor analysis
The throughput approach is very similar to the approach of maximising contribution per unit of scarce resource, which you will have covered in your earlier studies.
Knowledge brought forward from previous studies
Limiting factor analysis
- An organisation might be faced with just one limiting factor (other than maximum sales demand) but there might also be several scarce resources, with two or more of them putting an effective limit on the level of activity that can be achieved.
- Examples of limiting factors include sales demand and production constraints.
- The limit may be either in terms of total quantity or of particular skills.
- There may be insufficient available materials to produce enough units to satisfy sales demand.
- Manufacturing capacity. There may not be sufficient machine capacity for the production required to meet sales demand.
- It is assumed in limiting factor analysis that management would make a product mix decision or service mix decision based on the option that would maximise profit and that profit is maximised when contribution is maximised (given no change in fixed cost expenditure incurred). In other words, marginal costing ideas are applied.
- Contribution will be maximised by earning the biggest possible contribution per unit of limiting factor. For example if grade A labour is the limiting factor, contribution will be maximised by earning the biggest contribution per hour of grade A labour worked.
- The limiting factor decision therefore involves the determination of the contribution earned per unit of limiting factor by each different product.
- If the sales demand is limited, the profit-maximising decision will be to produce the top-ranked product(s) up to the sales demand limit.
- In limiting factor decisions, we generally assume that fixed costs are the same whatever product or service mix is selected, so that the only relevant costs are variable costs.
- When there is just one limiting factor, the technique for establishing the contributionmaximising product mix or service mix is to rank the products or services in order of contribution-earning ability per unit of limiting factor.
Throughput is defined as sales less material costs whereas contribution is defined as sales less all variable costs. Throughput assumes that all costs except materials are fixed in the short run.
CHAPTER ROUNDUP
- Throughput accounting is a product management system which aims to maximise throughput, and therefore cash generation from sales, rather than profit. A just in time (JIT) environment is operated, with buffer inventory kept only when there is a defined bottleneck .
- Performance measures in throughput accounting are based around the concept that only direct materials are regarded as variable costs.
- In a throughput environment, production priority must be given to the products best able to generate throughput, that is those products that maximise throughput per unit of bottleneck.
