TOC and Throughput Accounting PDF

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Management Accounting (07 33932)...

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MANAGEMENT ACCOUNTING

LECTURE 7 (No blank pages)

THE THEORY OF CONSTRAINTS & THROUGHPUT ACCOUNTING

YEAR 2 MANAGEMENT ACCOUNTING

OBJECTIVES By the end of this session students should be able to: (i) (ii) (iii) (iv) (v) (vi)

Explain the principle of the Theory of Constraints (TOC) Describe the five step process suggested by the TOC Explain the problems with traditional management accounting that are suggested by the TOC Identify the bottleneck in a process Explain the principle of Throughput Accounting and its links to the TOC Calculate and interpret the Throughput Accounting ratio

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1

The Theory of Constraints

(i)

The concept of the Theory of Constraints (TOC) was introduced by Goldratt and Cox (1984) in their book The Goal.

(ii)

It was argued that many of the performance measures employed in organisations did not help them achieve their ultimate goal. This goal must be set by the owners of the business, but it was initially assumed that it was to make money (maximise profit).

(iii)

At a later point Goldratt amended his position to recognise that the needs of other stakeholders, in particular employees and customers, need to be taken into account.

(iv)

However, there will always be some bottleneck or constraint that limits an organisation’s ability to generate profit.

(v)

The TOC suggests (Goldratt and Cox, 1992) that there are five steps to maximise profit in the presence of a bottleneck/binding constraint: 1) Identify the system’s bottleneck/constraint 2) Decide how best to exploit the bottleneck/constraint 3) Subordinate all other operations to help support step 2 4) Elevate the system’s bottleneck/constraint – i.e. increase its capacity 5) If a bottleneck has been broken in a previous step then return to step 1

(vi)

There are several consequences arising from the above steps: • A buffer of work-in-progress should be kept in front of the bottleneck resource to ensure that it is never prevented from operating by a shortage of material. •

Strict quality control is needed for the parts being supplied to the bottleneck resource to ensure bottleneck time is not wasted processing rejects.

•

Attempts should be made to find alternative production processes that allow products to be made without the use of the bottleneck.

•

Non-bottleneck resources do not need to be run at full capacity. They should instead be run to support the requirements of bottleneck.

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•

The level of inventory elsewhere in the organisation (i.e. not in front of the bottleneck) should therefore fall.

Example 1 Blockage Ltd produces and sells plumbing equipment. Its factory in Bath manufactures three products – the Flowmaster (F) the DrainKing (D) and the SprayStop (S). The products are made using a wide variety of components, but there are two machines that are common to the manufacture of all three products. Machine K was installed 20 years ago. It is notionally operational for 168 hours per week, but due to its age it is out of service for 10% of this time. Its output is still of a high quality but the production manager is keen to replace it with a newer model that can process a much higher volume of products per hour and would have very little downtime. The output from machine K is then processed by machine T. Machine T was purchased 6 months ago to replace 3 old inefficient machines. It is also notionally operational for 168 hours per week but is only out of service for 3% of this time. Summary details for the three products are as follows:

Minutes per unit Direct labour Machine K Machine T Weekly demand (units)

Flowmaster (F)

DrainKing (D)

SprayStop (S)

0.9 0.2 0.1

0.3 0.1 0.4

0.7 0.4 0.2

6,500

25,000

12,000

Direct labour costs £15.75 per hour and the company is able to meet any increase in demand through the use of agency workers. Required (a)

Identify the bottleneck (if any) in the process.

(b)

Advise the Production Manager on how he can increase profitability including whether he should prioritise the replacement of machine K.

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2

The impact of the TOC on accounting

(i)

The TOC raises a number of criticisms of traditional accounting performance measures:

(ii)

•

Machine efficiency measures are misleading as they suggest that all machines should be working at full capacity, but this will not lead to the achievement of the overall goal of the organisation.

•

Traditional accounting treats work-in-progress as an asset and includes direct labour and overhead in its value. This encourages production and punishes managers who take action to reduce inventory levels as they will report lower profits.

•

There is a temptation to use too many performance measures that can obscure the achievement of the overall goal.

It was proposed that fundamentally only three key measures were necessary: •

Throughput: Sales revenue minus any material purchases

•

Operational expense: All operating costs excluding material

•

Inventory: The total of inventories, plant and equipment and other assets

(iii)

Managers should aim to increase throughput whilst at the same time reducing operational expense and inventory. However the scope to reduce these measures is limited and therefore top priority should be given to increasing throughput.

(iv)

The TOC did not recommend specific accounting techniques but instead suggested that accountants should develop information systems that matched the TOC approach and their organisation’s needs.

(v)

However a number of standard accounting measures were developed that applied TOC principles and this approach became known as “Throughput Accounting”

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YEAR 2 MANAGEMENT ACCOUNTING

3 (i)

Throughput Accounting Throughput Accounting is consistent with TOC in that it suggests that: •

All costs are fixed in the short run except for material

•

It is the rate at which products generate throughput that determines profitability

•

Inventory should be valued at material cost only as its production does not increase profitability.

(ii) Waldron and Galloway (1988) developed measures that allowed products to be ranked on a Throughput Accounting basis: Return per factory hour =

. Sales – material cost Time on the bottleneck resource

Cost per factory hour =

. Total factory cost Total time available on the bottleneck resource

TA ratio

=

Return per factory hour. Cost per factory hour

(iii) “Total factory cost” includes all costs incurred except for materials (iv) A product is viable if it has a TA ratio greater than one.

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Example 2 YKR Ltd is a manufacturer and retailer of self-assembly furniture. Their factory in Worcester produces three of their most popular products. Although the final production and packing processes are different, components for all three products are made on one set of machines that has been identified as a bottleneck resource. The total time available on this bottleneck resource is 115,000 minutes per month. Details of the products from the company’s current accounting system are shown below: Product

Malm £ 250 65 45 15 50 75 12 5,000

Selling price Direct material Direct labour (@£15/hour) Variable production overhead Fixed production overhead Profit Time on bottleneck resource (minutes) Customer demand (units per month)

Holm £ 160 45 40 15 30 30 7 6,000

Burg £ 90 25 15 5 20 25 5 10,000

The company’s Management Accountant and Production Manager are now investigating whether they should implement a Throughput Accounting approach. The Management Accountant has calculated that using Throughput Accounting cost classifications the Total Factory Cost is £1,460,000 per month Required a) Calculate and state the optimum production plan using throughput accounting principles b) Briefly explain how the approach taken in part a) differs from traditional marginal costing c) Calculate the throughput accounting ratio for each of the products and briefly explain the significance of the calculated ratios

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YEAR 2 MANAGEMENT ACCOUNTING

4

Criticisms of TOC and Throughput Accounting

(i)

The assumption that organisations have a single goal does not reflect real life complexity.

(ii)

Assuming that all costs other than material are fixed is simplistic.

(iii)

The TA ratio is only useful as a short term decision tool and can be seen as only a minor adjustment to a traditional marginal costing approach.

(iv)

Developing accounting measures that apply TOC principles has been difficult in practice. (Although remember that TOC is not an accounting technique).

(v)

For a much more thorough analysis of the TOC and Throughput Accounting you should refer to Jones and Dugdale (1998) and Dugdale and Jones (1998).

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Lecture summary

In this lecture we have: (i) (ii) (iii) (iv) (v) (vi)

Explained the principle of the Theory of Constraints (TOC) Described the five step process suggested by the TOC Explained the problems with traditional management accounting that are suggested by the TOC Identified the bottleneck in a process Explained the principle of Throughput Accounting and its links to the TOC Calculated and interpreted the Throughput Accounting ratio

References Dugdale, D. & Jones, T. C. (1998) 'Throughput accounting: Transforming practices?', The British Accounting Review, 30, pp. 203-220. Goldratt, E. M. & Cox, J. (1984) The Goal. London: Gower. Goldratt, E. M. & Cox, J. (1992) The Goal. 2nd ed. London: Gower. Jones, T. C. & Dugdale, D. (1998) 'Theory of constraints: Transforming ideas?', The British Accounting Review, 30, pp. 73-91. Waldron, D. & Galloway, D. (1988) 'Throughout Accounting Part 2: Ranking Products Profitably', Management Accounting, 66, pp. 34.

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