Theory of Constraints: Throughput Cost Accounting

by Richard J. Lukesh

Jan 1, 1999

(TMA Global)

This article is the second in a two-part series outlining the managerial philosophy, Theory of Constraints. Part one appeared in the 1998 November/December issue of The Journal of Corporate Renewal.

Renowned author Eliyahu Goldratt’s Theory of Constraints (TOC) includes the concepts of Throughput Cost Accounting, Drum-Buffer-Rope and the Thinking Process. The core idea behind TOC is that every system must have at least one constraint and that constraint must be properly managed for the system achieve more of what it strives to produce. Goldratt maintains that the biggest problem in managing the constraint is the erroneous assumption that maximizing throughput on every resource (machines and manpower) will decrease costs and improve profits throughout the global system. This assumption is supported by Full Absorption Cost Accounting (FACA) and its related cost variance reports. In truth, attempting to maximize productivity and efficiency at each resource (Local Optimization) actually increases costs globally.

Full Absorption Cost Accounting

FACA computes Cost of Goods Sold (CGS) by adding: 1) direct material costs; 2) direct labor and 3) factory overhead. Overhead is typically calculated as a mark-up to direct labor. Table A shows the Cost Per Widget of a 100 widget batch and a 50 widget batch. For this example, material cost is $1 per widget; labor cost is $12 per hour ($.20 per minute) and production time per widget is five minutes.

The cost per widget (contribution margin) increases with a smaller batch because FACA spreads the direct cost of labor over a smaller number of units. The assumption is that all workers are fully utilized. Therefore, to do more set-ups, the plant would need to hire more workers. In reality, the actual expenses of the plant have not increased.

On the balance sheet, CGS information is reported under the general heading of inventory (finished goods + work-in-process {WIP} + raw material). A build-up of finished goods, WIP and raw material increases assets due to the increase in inventory.

On the income statement, CGS is reported as an expense from sales to determine gross profit margin. By including factory overhead in CGS, the factory overhead is spread over more units and the cost of the product decreases whenever production (build-up of finished goods and WIP) exceeds sales. On the income statement, a build-up of inventory will tend to reduce the average CGS and show a larger profit. If a company tried to reduce the components of inventory to conserve cash, the short-term effect would be a reduction in gross profit margin. (See Table B.)

What most companies have not realized is that FACA guidelines, when strictly applied in a production setting, can contribute to a lack of competitiveness, and in some cases, the potential failure of a business. This is due to the fact that accounting variance reports encourage local optimization. Maximizing output of every machine and person is appropriate if every item produced at each step was sold immediately to customers. Unfortunately, one cannot take a component, that is part of a process, and sell it directly to customers.

However, within a given system, there is one process that determines output of the entire system. This one process controls the total amount of goods that can be sold to customers on a given day. This process is called the capacity-constrained resource, or the bottleneck.

If accounting rules and regulations applied efficiency and utilization statistics to the bottleneck operation only, the other steps of the process can be regulated to produce just enough product to feed the next downstream function based on predetermined inventory buffer sizes.

Throughput Cost Accounting

Throughput Cost Accounting (TCA), as developed by Goldratt, is a variation of Variable Cost Accounting (VCA) in which TCA assumes that direct material is the only variable cost. All other costs are considered fixed costs.

The nuances of FACA, VCA and TCA can been seen in the following examples.

Full Absorption Cost Accounting:
Selling Price
Less Material Cost
Less Direct Labor
Less Overhead
Contribution Margin
Less Fixed Expenses

Variable Cost Accounting:
Selling Price
Less Material Cost
Less Direct Labor
Less Variable Overhead
Contribution Margin
Less Fixed Expenses

Throughput Cost Accounting:
Selling Price
Less Material Cost (variable cost)
Contribution Margin (throughput)
Less Fixed Expenses (operating expenses)

By assuming that the only variable cost is material, TCA does not create incentives for the perpetuation of local optimization. Under TCA there are only 3 ways to increase profits: increase throughput (sales), decrease operating expenses (fixed costs) and decrease investment (particularly in inventories).

The above three goals can be accomplished by the way jobs are scheduled through the bottleneck operation (the capacity-constrained resource) using the TOC scheduling technique, Drum-Buffer-Rope (DBR).

TCA forces management to follow a global plan for operations which is centered on shipping specific orders by specific dates using no more than a specific level of operating expenses, a specific level of capacities (current expenses and machine capacities) and a specific level of inventories. This forces management away from local optimization techniques, which distinguish FACA.

Implementation of TCA and DBR will create a situation where excess capacity and surplus resources are quickly exposed. The natural managerial tendency is to layoff employees when excess labor capacity is revealed. This is certainly an important strategy for a financially distressed company. However, for a company interested in moving into a world-class competitive arena, layoffs can send the wrong message to the remaining employees about the effects of improvement programs. The preference in TOC companies is to find new products and enter new markets when excess capacity is exposed rather than layoff employees.

The initial calculations of contribution margins under TCA will normally reveal significant opportunities to cut prices. Adjustments in pricing may be necessary if a company is significantly out of line with industry pricing. Cutting prices below industry standards will certainly provide a short-term boost to sales. It will also, however, ignite a price war that nobody will win.

TCA data should be used to provide greater flexibility in pricing decisions. Generally, if there is idle capacity on a bottleneck, then accepting a job at any price above direct material cost plus direct/out-of-pocket costs is acceptable. Under TCA, a company may give price breaks for longer lead times, guaranteed orders over the course of the year, orders during the production off-season, etc. Such strategies do not destroy a company’s standard pricing, which is a function of market conditions, customer demands and competition. Under FACA, price breaks are primarily given to keep everyone busy or clear out inventory for the next round of overproduction.

TOC has value in a number of areas. It can provide opportunities for “outside the box” thinking by employees and management. TOC can help the company achieve its goal of larger profits and greater cash flow, and also can be a powerful tool for releasing the creative and productive energies of a company. However, the concepts of TOC will never replace GAAP financial reports. At best, a company will utilize TOC concepts internally for tracking efficiency, improving productivity, planning product line expansion and measuring management, while utilizing GAAP financial reports for distribution to the outside world. The extra effort in keeping two sets of books will be well worth the payoff.

Throughput Cost Accounting Definitions:

Throughput is defined as the rate at which a company generates money through sales.

Assets are accounted for in the traditional manner on the TCA balance sheet with the exception of inventories. Inventories are recorded at their direct material cost only. Under TCA, labor is not capitalized in inventories.

Operating expenses (fixed expenses) include all expenses except total variable costs, which in most cases are direct material costs.

Profitability is a variation of the return on assets (ROA) formula. Profitability declines as assets increase in value. As such, a company must control operating expenses and assets while trying to increase throughput.

Throughput dollar days is a measure of due date performance, which identifies the failure to ship a specific order by a specific date.

Throughput (contribution margin) per unit of constrained resource is a key financial measure that is critical to prioritizing use of the constraint and deciding whether or not to elevate the constraint. Products with the smallest contribution margin per unit would typically receive the lowest priority because they are the least valuable use of the bottleneck.

Opportunity cost is the amount of income that results from the best use of a bottleneck. Under TCA, the selling price of a product should at least be equal to the direct material cost + opportunity costs (the additional, direct, out-of-pocket expenses such as sales commission, shipping costs, subcontractor fees, overtime, additional employees, etc.). As such, the benefit (contribution margin) must exceed the direct material costs + opportunity costs. This calculation is especially important in making strategic decisions about entering new markets, accepting orders below standard pricing, adding new products, etc.


Richard J. Lukesh
Regional Services, Inc.


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