Management Accounting:
A Road of Discovery
Management Accounting:
A Road of Discovery
James T. Mackey
Michael F. Thomas
Presentations by:
Roderick S. Barclay
Texas A&M University - Commerce
James T. Mackey
California State University - Sacramento
© 2000 South-Western College Publishing
Chapter 12
Which process should we improve
first?
Decision-focused
management using the theory
of constraints
Key Learning Objectives
1. List TOC’s continuous
improvement steps and relate
them to Pareto management
using drum-buffer-rope
scheduling.
2. Maximize profits by using
throughput to schedule
production.
3. Calculate the minimum sales
price to break even when a
constraint exists.
4. Show how to eliminate a
constraint by using throughput
with the payback period and
make-buy analyses..
5. Demonstrate four ratios for
continuous improvement
management.
Part I
The Theory of Constraints (TOC)
Way to Continuous Improvement
Overview

Consider a company that processes and sells
peanuts. It has these characteristics:
Traditional management
Functional areas of specialization
Areas of responsibility
‘One best way’ work standards
Cheap labor, easy to learn activities
Cost centers
‘Each manager has their own budget’
Overview




(Continued)
The company has three functional departments.
Husk
Pack
Sales
&
&
Bake
Ship
Each department is like a ‘silo’ surrounded by walls of
inventory or time buffers.
Each department has separate budgets, responsibility
centers, and variance reports that promote a strategy
to optimize each individual department.
Coordination using budgets creates and maintains
the value of the whole company.
Creating a Cost World



You are the manager of the ‘husk and bake’
department.
Your objective as a good manager is to create
and maintain value.
Your problem:



You have no influence on the ‘Sales’ or ‘Pack&Ship’
departments.
You can only influence your costs.
How does this fit into your TQM efforts?
TQM Says:
DO IT RIGHT THE FIRST TIME
CONTINUOUS IMPROVEMENT
ELIMINATE NONVALUE ADDING ACTIVITIES
FIX ‘ALL’ ACTIVITIES NOW
What Can I Do?

What can you as the manager of the ‘Husk &
Bake department do under TQM? The only
thing you control is costs.



You can only decrease costs while providing the
same level of production or service.
The objective is to increase productivity or ‘do the
same for less’.
TOC argues that accounting systems create a ‘cost
world’ approach to improvement.
The Problem


The problem is that in most cases the largest
cost savings to improve productivity is to
reduce labor content.
‘Just-in-Time’ becomes interpreted by workers
as ‘Jobs-in-Trouble’.
Creating a Value World


TOC supporters argue that this cost world
emphasis is inefficient, wasteful and
undermines support for continuous
improvement.
Managers need to focus on creating value for
the company and not necessarily decreasing
costs.
How Can This be Done?




Pareto management, or the 80:20 rule, claims that
only a few activities are responsible for most of a
company’s profits.
The TOC version is that there is always some activity
that limits or constrains increasing value.
Continuous improvement with TOC management
focuses on increasing value by finding and improving
constraints limiting throughput.
 Throughput is defined as sales revenue less direct
materials.
Constraint activities limit short-term value. Thus
removing constraints converts us from a ‘cost world’
to a ‘value world’.
TOC
TOC ARGUES THAT ‘SILO’ MANAGEMENT
ACTUALLY LEADS TO CONSTRAINTS,
ESPECIALLY WHEN PRODUCTION
PROCESSES VARY FOR DIFFERENT
PRODUCTS.
Part II
An Illustration
Our Peanut Company



Remember we fist ‘husk&bake’, then we
‘pack&salt’ and finally we ‘sell’ our peanuts.
We must complete one activity before we can
start the next activity.
TOC assumes there is always one activity that
constrains value.
Husk & Bake
Capacity of
200 lbs per day
Pack & Ship
Capacity of
150 lbs per day
Sales
Capacity of
100 lbs per day
Question and Answer

Question.


Answer.


What is the company’s maximum daily production
and sales?
Sales sets the capacity for the company at 100 lbs
per day. Sales is the constraint. The constraint sets
the capacity (short-term value) for the entire
company.
Discussion.


The first steps for TOC continuous improvement is to
identify the activity that is the constraint to
increasing immediate value (not necessarily longterm value).
Improving this constraint is the only way to
guarantee immediate value improvement.
Let’s Improve the Constraint



If peanuts sell for $10 per pound, then what
is the maximum daily revenue?
100 lbs @ $10 per lb = $1,000 per day.
Suppose that for spending $1,000 for training
in each department, we can increase
productivity by 10%.
How much money should we spend to
maximize short term value, $3,000, $2,000,
or $1,000?
The Improvement
Husk & Bake
200 lbs
Increases 10% to
220 lbs
Pack & Salt
150 lbs
Increases 10% to
165 lbs
Sales
100 lbs
Increase 10% to
110 lbs
Rather than spending $3,000, TOC says only spend $1,000.
The extra $2,000 is wasted in the short-term.
 Using TQM logic, we would improve all three departments
for $3,000 and justify this based upon long-term value
creation.
TOC Rule: only increasing capacity at the constraint
will guarantee short-term value increases.
TQM Rule: Long-term value improvements will justify
all $3,000.
Both are correct!

Results

If we spend the $1,000, how much value
have we added daily?


10 extra pounds x ($10 - $2) = $80 per day.
What is the appropriate value added per unit
of production?
Value Added
GAAP
Contribution
Margin
Throughput
$10
$10
$10
$ 2
$ 2
$ 2
Direct labor
1
1
Fixed overhead
2
Selling price
Less:
Direct material
Gross margin
Contribution margin
Throughput
$ 5
$ 7
$ 8
‘Different costs for different purposes’. Which cost is correct?
Which best reflects the change in value from our productivity
improvements?
Explanation
Gross Margin per unit
This is the GAAP inventory valuation for
financial statements. This is absorption
costing. In the long run all the costs necessary
for production must be recovered.
Contribution Margin
This is the incremental cash available to cover
fixed costs and profit within the relevant
range for the current capacity.
Throughput
This is the cash available from productivity
improvements. Producing more products with
the same level of labor and overhead.
Throughput is defined as Sales revenue less
the costs of materials and any additional
power, etc.
Results


Throughput from the productivity
improvement = 10 lbs x $8 = $80 per day.
Should we make the productivity
improvement at the constraint?



The cost of the productivity investment is $1,000.
How long will it take to recover or payback the
investment?
Payback period = $1,000/$80 per day = 12.5 days
Part III
TOC’s Five Step Process to
Continuous Improvement
TOC’s Five Steps for Continuous
Improvement





Identify the most important constraint.
Exploit it by optimally using the current
constraint to maximize profits (drum-bufferrope management).
Don’t worry too much about the nonconstraints.
Eliminate the constraint.
A new constraint will exist, so start all over.
Part IV
Managing the Constraint with DrumBuffer-Rope Scheduling
Definitions



The constraint activity is the DRUM that
sets the pace for all operations.
The BUFFER is the inventory maintained in
front of the constraint to insure all available
capacity will be utilized.
The ROPE is the schedule for work activity
that is based upon the needs of the
constraint. Thus, the pace of the constraint
pulls work through the activities in front of
it.
Control: What Do We Want People to Do?
Traditional Management
TOC
Minimize costs in each
department
 Maintain current expenses in
every non-constraint.
Don’t have unfavorable cost
variances
 Focus on increasing constraint
capacity to increase firm value.
Maximize the output of every
department to minimize the
average cost per unit.
 Meet the production needs of the
constraint.
Note:
Means thinking within the box.
(Functional silo management —
maximizing each department’s
output will optimize overall
value.)
 Means think outside the box.
(Constraints management —
maximizing the constraint’s
output will optimize overall
value.)
Part V
TOC Decisions and Cost Categories
TOC Decisions and Cost Categories



Decisions are limited to the comparison of
Throughput against the cost of increasing the
Throughput. Positive Throughput dollars will
increase value. Projects are ranked by Throughput
value.
Costs that will continue are grouped together as
‘Operating Expenses’. If Throughput is greater
than the Operating Expenses then value will
increase.
Costs that will not continue are grouped together as
‘Investments’ (sometimes called ‘Inventories’).
The Payback period will determine how long it
takes for the increase in Throughput to recover the
investment.
Part VI
Performance Evaluation and Control
Measures
Goals for the TOC Accounting System
(Keep your eye on the ball.)

Measure how well we use the constraint.



Don’t emphasize efficiency measures in the
bottlenecks.



Management goal — maximize constraint output.
TOC accounting provides information for improving
the constraint’s value only.
Management goal — non-constraints should work
only to the beat of the drum, not at their own
maximum rates.
Accounting provides overall budget-to-actual
department costs only.
WIP information should be for the buffer inventory in
front of the constraint

Management goal — monitor the buffer and minimize
WIP at the non-constraints.
Cost Organization in Different Income
Statements


Exhibit 12-9, p. 444, provides a
comprehensive illustration of the relationship
of TOC, Functional, and Activity-based
Income Statements.
Review and assure an understanding of the
different structure of the statements and how
they contain essentially the same information,
structured and formatted differently.
Payback Period for Nailing Machine
Improvement
Throughput
$3,687.50 per truss
- Incremental variable costs
(7.50)
=Throughput from investment
$3,680.00 per truss
x Increased capacity
x 8 trusses per month
= Additional contribution margin
$29,440 per month
- Incremental operating expenses
= Cashflow generated
$29,000 per month
Investment cost
Payback period =
(440) per month
$350,000
=
Cashflow generated
= 12.07 months
$ 29,000
TOC Continuous Improvement Ratios
Constraint
utilization rate
Throughput
efficiency
Improvement
efficiency
Product
mix
Constraint run
time
Time available
Throughput
Constraint run
time
Standard homes
Custom homes
7 hrs. per day
8 hrs. per day
$700 per day
7 hrs. per day
D (Variable costs
+ operating
expenses
DConstraint
capacity
$440 per month
8 extra trusses
90 houses
20 houses
$55.00 per truss
+ 7.50 var. cost
= 88%
efficiency
= $100 per hour
= $62.50 each
= 4.5 to 1
TOC Performance Ratios —
Short-Term Measures
Performance Measure
Criteria
Constraint Utilization
Rate
Throughput Efficiency
Value — Does a change
in the measure
correlate with changes
in company value?
As utilization of the
constraint increases,
profits and cashflow
increase.
The greater the return
for each hour of
operations, the larger
the profits and cashflow.
Direction — Does the
measure identify or
guide workers to
actions that will
increase value?
The action directed is
to keep the constraint
running as much as
possible.
For workers— move
materials through the
constraint faster. For
management— obtain
better prices for
constraint capacity.
Controllability — Can
the workers
significantly influence
the activities that
change the measure?
Only to the extent the
workers can influence
activities that keep
the constraint
running.
This is controlled by the
workers and by
management.
TOC Performance Ratios —
Long-Term Performance Measures
Performance Measure
Criteria
Improvement
Efficiency
Product Mix
Value — Does a change
in the measure
correlate with changes
in company value?
The relative efficiency
of any added capacity
will influence longterm competitiveness.
The strategic plan is to
maximize long-term
value. If the product mix
changes, it will not.
Direction — Does the
measure identify or
guide workers to
actions that will
increase value?
Workers need to
increase capacity at
the constraint, but not
at any cost. Payback
period may need to be
considered as well.
Management — Maintain
long-term value and
current cashflow. They
must assure the mix of
orders matches these
goals.
Controllability — Can
the workers
significantly influence
the activities that
change the measure?
The workers are
empowered to
continuously improve.
Managers set the
production schedules.