Topic Gateway Series
Theory of constraints and throughput accounting
Theory of constraints and
throughput accounting
Topic Gateway Series No. 26
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Prepared by John Freeman and Technical Information Service
March 2007
Theory of constraints and throughput accounting
Topic Gateway Series
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Topic Gateway Series
Theory of constraints and throughput accounting
Definition
‘A technique where the primary goal is to maximise throughput while
simultaneously maintaining or decreasing inventory and operating costs.’
CIMA Official Terminology 2005
Context
Part of CIMA’s remit is to review academic research and to highlight the benefits
stemming from that research. This recognises the need to support the twin goals
of management accountants, namely to create value by reporting financial
performance, and by driving financial performance. Experience dictates the latter
is much more difficult than the former and is the focus of this report.
In the current syllabus, CIMA students will learn and may be examined on this
topic in Paper P1, Management Accounting, Performance Evaluation.
Overview
Managers use cost accounting to help make decisions to reduce a company’s
costs and improve profitability. For the sake of completeness, it should be noted
that the theory of constraints and throughput accounting (TOC/TA) is not the
only approach used in decision making. Other methods are:
•
standard cost accounting
•
activity based costing
•
marginal costing.
The general hypothesis of TOC/TA is that constraints are impediments to
achieving a firm’s goal and their impact reduces profits. Additionally, the
hypothesis is based on the supposition that most businesses have very few
constraints, often just one. A constraint can be a resource, a company policy or
management mindset. This hypothesis has similarities with limiting factor
analysis, which is defined as a factor or condition that impedes meeting goals.
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The broad concepts
Goldratt’s ideas on TOC indicate a criticism of traditional accounting
measurement. They focus on working optimally instead. TOC is predicated on
there being a finite capacity at certain critical points in any production schedule.
By eliminating bottlenecks, TOC increases the velocity of products moving
through an organisation and therefore profit is maximised.
TOC is not ‘costing’ as it does not allocate costs to products and services. The
TOC approach calculates the product throughput as the product’s sales price
minus its material costs. All other costs are taken into account separately as
operating costs and are not allocated directly to the products.
However, some papers define throughput as the sales price minus all variable
costs. Examples include Noreen et al. (1995) and Gupta (2003). Balderstone and
Keef (1999) provide a comprehensive overview of different definitions.
Currently, no specific accounting practices are advocated by Goldratt. Instead,
accountants are encouraged to learn TOC ideas and to apply them to accounting
in ways which suit them.
The concept of TA was created by management consultants David Galloway and
David Waldron. They wished to replace traditional concepts such as direct/indirect
cost allocation, economic batch size and treating inventory as an asset. In their
view accounting should monitor the rate at which businesses make money. With
this crucial goal in mind, they focused on the return per product per bottleneck
hour.
Application
Goldratt’s five steps in the TOC methodology
TOC analyses production through a series of steps.
Identify the system constraint
Is the constraint internal, for example, in production, engineering or planning? Is
it external, for example, in the market? Is it a resource or is it a policy?
Decide how to maximise the output from the constraint
Prepare to subordinate all other activities to this decision. Non-constraints must
be subordinate to the needs of the constraint.
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Theory of constraints and throughput accounting
Once the resource constraint has been identified, consideration can be given to
deploying the appropriate level of resources. As a consequence, the constraint's
capacity is increased.
Identified policy constraints can be more easily eliminated
Once a constraint has been rectified, go back to step one to identify the next
most serious constraint and repeat.
In practice – reported benefits
Standard cost accounting has lost some of its usefulness recently. Standard cost
accounting aims to identify the variation between actual cost and standard cost.
The latter includes volume variation, material cost variation and labour cost
variation.
Traditionally managers took action to correct costs different from planned
through its use. However, cost allocation has become arbitrary and capricious for
several reasons and its applicability is now dubious. One reason is that more
companies today have common processes for a range of products.
The TOC concept avoids cost allocation semantics and restructures the financial
control system from one based on reporting entities, such as departments, to a
company wide overview of value streams.
TOC recognises that some non-critical machines or production facilities will not
be used to capacity. Its proponents believe simple recognition is very
advantageous because TOC prevents non-critical machines being run to capacity
for no purpose if not all their total output can be used.
The advantage lies in avoiding the accumulation of the associated excess stocks
and work in progress. It also addresses the weakness of managers seeking to
optimise production on particular machines if this is sub-optimal for the firm.
Markets and customer requirements are constantly changing and the business
model must respond quickly. Goldratt’s fifth step recognises this requirement.
As a pure optimisation tool, TOC can never be better than a correctly formulated
linear programming (LP) approach. However, the TOC-based approach has
significant advantages over LP. It is easier to use, particularly for managers who
are not familiar with operational research methods.
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TA is an important development in modern accounting that allows managers to
understand the contribution of constrained resources to overall profitability. It
also refocuses away from cost accounting’s reliance on efficiencies. TA improves
profit performance through better analytical decisions based on three critical
monetary variables, namely throughput, inventory and operating expense. It is
sometimes referred to as throughput contribution and is similar to the concept of
‘contribution’ in marginal costing i.e. sales revenue less ‘variable’ costs.
Supply chains transform components into a finished product that is delivered to
the end customer. Goldratt’s fundamental rethinking of chain management is
best described as a shift from the ‘cost world’ to the ‘throughput world’.
Reported drawbacks
TOC and TA detractors' summary of criticisms
Specific criticisms have been levelled at TOC and TA and are discussed below:
1. They are short-term decision tools.
2. They may only be valid concepts if applied to the totality of the supply chain
including management, production, resources and support.
3. Dependent on circumstances, operating expenses under TOC/TA are regarded
as fixed, which is simplistic in the view of detractors. Therefore TOC and TA
are basically the same thing as variable costing.
Detracting developments
The credibility of TOC was seriously debased when Galloway and Waldron
discovered a number of difficulties with their TA formulation. They amended their
TA departmental performance measures and withdrew TA product costing in
favour of an activity based costing (ABC) approach. Since then ABC has been
strongly attacked by Goldratt as a fruitless attempt to save the old ‘cost world’
thinking.
Following this spat, it is uncertain where commercial advantage lies. Over the last
decade, several papers have been published commenting on the contributions of
TOC and TA. Despite complex worked examples, the assessment results of the
TOC/TA-based approach in generating optimal work flows are disparate. There is
a lack of clarity as to whether TOC/TA is appropriate to provide competitive
advantage in a complex and rapidly changing environment.
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Regulatory financial reporting
Traditional costing is premised on accounting concepts that were designed to
satisfy the needs of external and regulatory financial reporting. One example is
that the cost of stock is the lower of cost or NRV (net realisable value).
Accounting systems for decision making under TOC/TA must have the flexibility
to meet these standards.
Supply
There is little reference to supply network strategies and the sophisticated roles of
the purchasing department. Competition is now defined as ‘supply chain vs.
supply chain’ (Christopher, 1998). New configurations of supply chains are
required for evolving market places to cope with rapidly changing demand
patterns. One example is the use of e-trading, which is often associated with
high volume retail and manufacturing supply chains.
The main characteristics (Hughes et al., 1998) of an agile supply chain are:
•
integration of capabilities with trading partners
•
manufacturing systems that can be customised
•
scheduling synchronised with final demand
•
concurrent product development
•
‘pipeline’ cost improvements.
If supply partners work closely together to identify supply chain bottlenecks, the
TOC/TA concepts are credible.
Human capital
TOC and TA are an accounting approach which does not adequately address the
benefits to productivity through involving people. It is suggested that human
performance as well as mechanical performance should be addressed when
assessing a perceived constraint.
A study at Bell Labs (Kelley & Caplan, 1993) noted a potential eight to one
difference between the productivity of ‘stars’ and ‘average performers’. Kelley
and Caplan demonstrated that ‘star performers’ were not differentiated by ability
or personality traits or by high-level reasoning. Work behaviour is the result of a
process of interaction. People shape the role to reflect their own preferences, as
well as responding to what they believe the role requires. This shaping sometimes
leads to sub-optimal performance.
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Conclusions
Managers in successful companies must differentiate between theories that will
have a lasting value and the froth of impractical ideas which will have a
deleterious effect on profitability.
From a theoretical viewpoint, it is clear TOC and TA do not contribute original
methodologies to the product mix decision. However, this is academic and what
is important is the theory’s effect on profitability. There is some evidence a
TOC/TA-based approach may be used within a wide range of product mix
decisions and can lead to acceptable solutions, sometimes with slight variations.
In summary, the TOC/TA-based approach as a direct costing approach may be
more suitable for short-term product mix decisions. It is clearer than approaches
that allocate indirect costs more or less arbitrarily (Boyd and Cox, 2002).
On balance, it may be considered that TOC should not be ignored due to the
comprehensibility of the approach. TOC may be best described as a ‘tool in the
bag’ rather than a total philosophy.
Further information
Articles
Full text article is available from Business Source Corporate
www.cimaglobal.com/mycima
[Accessed 13 March 2008]
Dugdale D. and Jones T.C. Direct versus absorption costing: a reply. Accounting
Business and Financial History, March 2005, Volume 15, Issue 1, pp 93-95
Other recommended articles
Abdel-Maksoud A., Dugdale D. and Luther R. Non-financial performance
measurement in manufacturing companies. British Accounting Review,
September 2005, Volume 37, pp 261-297
Coughlan, P. and Darlington, J. As fast as the slowest operation: the theory of
constraints. Management Accounting, June 2003, pp 14-17
Darlington, J. et al. Throughput accounting: the Garrett automotive experience.
Management Accounting, April 1992, pp 32-33 and 35-38
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Galloway, D. and Waldron, D. Throughput accounting – 1: The need for a new
language for manufacturing. Management Accounting, November 1988,
pp 34-35
Galloway, D. and Waldron, D. Throughput accounting – 2: ranking products
profitably. Management Accounting, December 1988, pp 34-35
Galloway, D. and Waldron, D. (1989a). Throughput accounting – 3: a better way
to control labour costs. Management Accounting, January 1989, pp 32-33
Galloway, D. and Waldron, D. Throughput accounting – 4: moving on to
complex products. Management Accounting, February 1989, pp 40-41
Books
Drury, C. et al. (1993). A survey of management accounting practices in UK
manufacturing companies. London: ACCA
Dugdale D., Jones T.C. and Green S. (2006). Contemporary management
accounting practices in UK manufacturing. Oxford: Elsevier/CIMA
Goldratt, E.M. (1990). The Haystack syndrome. New York: North River Press
Goldratt, E.M. (1990). Theory of Constraints. New York: North River Press
Goldratt, E.M. (1994). It’s not luck. London: Grover
Goldratt, E.M. and Cox, J. (1984). The goal. London: Grover
Goldratt, E.M. and Cox, J. (1993). The goal. 2nd ed. London: Gower
Goldratt, E.M. and Fox, R. (1986). The race. New York: North River Press
Jones T.C. and Dugdale D. (2005). ‘The concept of an accounting regime’ in N.B.
Macintosh and T. Hopper (eds.) Accounting the social and the political: classics,
contemporary and beyond. Oxford: Elsevier, pp 267-284
Noreen, E., Smith, D. and Mackey, J.T. (1995). The Theory of Constraints and its
implications for management accounting. Great Barrington, M.A.: North River
Press
Case study
Souren, R., Ahn, H. and Schmitz, C. Optimal production mix decisions based on
the Theory of Constraints?: exposing rarely emphasised premises of throughput
accounting. International Journal of Production Research, 15/1/2005, Volume 43,
Issue 2, pp 361-374. Abstract available from Business Source Corporate.
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Theory of constraints and throughput accounting
Other
Goldratt, E.M. (1993). Introduction to the Theory of Constraints:
through application to marketing and sales. Presentation at Excelsior
Hotel Heathrow, 17-18 November, 2003
Lewis, D. The Theory of Constraints in accounting. 71st branch
meeting, November 1993, Swindon, Wilts.
Websites
AGI – Goldratt Institute
The web home of the Theory of Constraints. www.goldratt.com
[Accessed 13 March 2008]
Goldratt’s Marketing Group website
Learning products for the Theory of Constraints and a list of TOC.
practitioners https://toc-goldratt.com/store/home.php
[Accessed 13 March 2008]
Goldratt Consulting website
Explains the 'viable vision' and how it can be applied to business.
www.goldrattconsulting.com
[Accessed 13 March 2008]
Thomas Corbett’s website
Explains the concepts of throughput accounting and TOC.
www.tcorbett.com
[Accessed 13 March 2008]
First published in 2007 by:
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