Theory_of_Constraints_and_Throughput_Accounting.pdf

Theory of constraints and throughput accounting

Topic Gateway Series

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Topic Gateway Series No. 26

Prepared by John Freeman and Technical Information Service March 2007


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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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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

http://www.cimaglobal.com/mycima



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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.



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]

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First published in 2007 by:

The Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP United Kingdom

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http://www.goldratt.com/

https://toc-goldratt.com/store/home.php

http://www.goldrattconsulting.com/

http://www.tcorbett.com/

Theory_of_Constraints_and_Throughput_Accounting.pdf

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