Throughput
Throughput
Throughput
accounting
Introduction
Throughput accounting is the fourth management accounting technique in
Section A of the syllabus. It has developed in response to the use of just-in-
time and uses the theory of constraints. An objective for an organisation is to
maximise throughput by identifying and eliminating bottlenecks.
49
Study guide
Intellectual level
A4 Throughput accounting
(a) Calculate and interpret a throughput accounting ratio (TPAR) 2
(b) Suggest how a TPAR could be improved 2
(c) Apply throughput accounting to a multi-product decision-making problem 2
Exam guide
Questions on this topic are likely to be a mixture of calculation and discussion. You may be required to
use your knowledge of limiting factors from previous studies.
1 Theory of constraints
FAST FORWARD
Throughput accounting is a product management system which aims to maximise throughput, and
therefore cash generation from sales, rather than profit. A just in time (JIT) environment is operated, with
buffer inventory kept only when there is a bottleneck resource.
The theory of constraints (TOC) is an approach to production management formulated by Goldratt and
Cox in the USA in 1986. Its key financial concept is to turn materials into sales as quickly as possible,
thereby maximising the net cash generated from sales. This is achieved by striving for balance in
production processes, and so evenness of production flow is also an important aim.
Key terms Theory of constraints (TOC) is an approach to production management which aims to maximise sales
revenue less material and variable overhead cost. It focuses on factors such as bottlenecks which act as
constraints to this maximisation.
Bottleneck resource or binding constraint – an activity which has a lower capacity than preceding or
subsequent activities, thereby limiting throughput.
One process will inevitably act as a bottleneck (or limiting factor) and constrain throughput – this is
known as the binding constraint in TOC terminology. Steps should be taken to remove this by buying
more equipment, improving production flow and so on. But ultimately there will always be a binding
constraint, unless capacity is far greater than sales demand or all processes are totally in balance, which is
unlikely.
Output through the binding constraint should never be delayed or held up otherwise sales will be lost. To
avoid this happening a buffer inventory should be built up immediately prior to the bottleneck or binding
constraint. This is the only inventory that the business should hold, with the exception of possibly a very
small amount of finished goods inventory and raw materials that are consistent with the JIT approach.
Operations prior to the binding constraint should operate at the same speed as the binding constraint,
otherwise work in progress (other than the buffer inventory) will be built up. According to TOC, inventory
costs money in terms of storage space and interest costs, and so inventory is not desirable.
50 2d: Throughput accounting ⏐ Part A Specialist cost and management accounting techniques
Goldratt devised a five-step approach to summarise the key stages of TOC.
Step 1 Identify the constraint.
Step 2 Decide how to exploit the constraint.
Step 3 Subordinate and synchronise everything else to the decisions made in step 2.
Step 4 Elevate the performance of the constraint.
Step 5 If the constraint has shifted during any of the above steps, go back to step 1. Do not allow
inertia to cause a new constraint.
The overall aim of TOC is to maximise throughput contribution (sales revenue – material cost) while
keeping conversion cost (all operating costs except material costs) and investment costs (inventory,
equipment and so on) to the minimum. A strategy for increasing throughput contribution will only be
accepted if conversion and investment costs increase by a lower amount than the increase in contribution.
The traditional view is that machines should be working, not sitting idle. So if the desired output from
the above process were 8,100 kgs, machine X would be kept in continual use and all 8,100 kgs would be
processed through the machine in nine hours. There would be a backlog of 900 kgs [8,100 – (9 hrs ×
800)] of processed material in front of machine Y, however. All this material would require handling and
storage space and create the additional costs related to these non-value added activities. Its
processing would not increase throughput contribution.
2 Throughput accounting
The concept of throughput accounting has been developed from TOC as an alternative system of cost and
management accounting in a JIT environment.
Key term Throughput accounting (TA) is an approach to accounting which is largely in sympathy with the JIT
philosophy. In essence, TA assumes that a manager has a given set of resources available. These
comprise existing buildings, capital equipment and labour force. Using these resources, purchased
materials and parts must be processed to generate sales revenue. Given this scenario the most
appropriate financial objective to set for doing this is the maximisation of throughput (Goldratt and Cox,
1984) which is defined as: sales revenue less direct material cost.
(Tanaka, Yoshikawa, Innes and Mitchell, Contemporary Cost Management)
Part A Specialist cost and management accounting techniques ⏐ 2d: Throughput accounting 51
TA for JIT is said to be based on three concepts.
(a) Concept 1
In the short run, most costs in the factory (with the exception of materials costs) are fixed (the
opposite of ABC, which assumes that all costs are variable). These fixed costs include direct
labour. It is useful to group all these costs together and call them Total Factory Costs (TFC).
(b) Concept 2
In a JIT environment, all inventory is a 'bad thing' and the ideal inventory level is zero. Products
should not be made unless a customer has ordered them. When goods are made, the factory
effectively operates at the rate of the slowest process, and there will be unavoidable idle capacity in
other operations.
Work in progress should be valued at material cost only until the output is eventually sold, so that
no value will be added and no profit earned until the sale takes place. Working on output just to add
to work in progress or finished goods inventory creates no profit, and so should not be
encouraged.
(c) Concept 3
Profitability is determined by the rate at which 'money comes in at the door' (that is, sales are
made) and, in a JIT environment, this depends on how quickly goods can be produced to satisfy
customer orders. Since the goal of a profit-orientated organisation is to make money, inventory
must be sold for that goal to be achieved. The bottleneck resource slows the process of making
money.
How are these concepts a direct contrast to the fundamental principles of conventional cost accounting?
Answer
Conventional cost accounting Throughput accounting
Inventory is an asset. Inventory is not an asset. It is a result of
unsynchronised manufacturing and is a barrier to
making profit.
Costs can be classified either as direct or Such classifications are no longer useful.
indirect.
Product profitability can be determined by Profitability is determined by the rate at which money
deducting a product cost from selling price. is earned.
Profit can be increased by reducing cost Profit is a function of material cost, total factory cost
elements. and throughput.
52 2d: Throughput accounting ⏐ Part A Specialist cost and management accounting techniques
The elimination of one bottleneck is likely to lead to the creation of another at a previously satisfactory
location, however. The management of bottlenecks therefore becomes a primary concern of the manager
seeking to increase throughput.
There are other factors which might limit throughput other than a lack of production resources
(bottlenecks) and these need to be addressed as well.
(a) The existence of an uncompetitive selling price
(b) The need to deliver on time to particular customers
(c) The lack of product quality and reliability
(d) The lack of reliable material suppliers
(e) The shortage of production resources
Part A Specialist cost and management accounting techniques ⏐ 2d: Throughput accounting 53
as overheads. These characteristics make throughput accounting a good complement for ABC, however,
since ABC focuses on labour and overhead costs.
TA attempts to maximise throughput whereas traditional systems attempt to maximise profit. By
attempting to maximise throughput an organisation could be producing in excess of the profit-maximising
output. Production scheduling problems inevitably mean that the throughput-maximising output is never
attained, however, and so a throughput maximising approach could well lead to the profit-maximising
output being achieved.
TA helps to direct attention to bottlenecks and focus management on the key elements in making profits,
inventory reduction and reducing the response time to customer demand.
This enables businesses to take short-term decisions when a resource is in scarce supply.
(b) Throughput accounting ratio
Again factory hours are measured in terms of use of the bottleneck resource. Businesses should
try to maximise the throughput accounting ratio by making process improvements or product
specification changes.
This measure has the advantage of including the costs involved in running the factory. The higher
the ratio, the more profitable the company. (If a product has a ratio of less than one, the
organisation loses money every time it is made.)
Here's an example.
Product A Product B
$ per hour $ per hour
Sales price 100 150
Material cost (40) (50)
Conversion cost (50) (50)
Profit 10 50
TA ratio 60 100
= 1.2 = 2.0
50 50
Profit will be maximised by manufacturing as much of product B as possible.
Growler manufactures computer components. Health and safety regulations mean that one of its
processes can only be operated 8 hours a day. The hourly capacity of this process is 500 units per hour.
The selling price of each component is $100 and the unit material cost is $40. The daily total of all factory
costs (conversion costs) is $144,000, excluding materials. Expected production is 3,600 units per day.
54 2d: Throughput accounting ⏐ Part A Specialist cost and management accounting techniques
Required
Calculate
(a) Total profit per day
(b) Return per factory hour
(c) Throughput accounting ratio
Answer
(a) Total profit per day = Throughput contribution – Conversion costs
= (3,600 × (100 – 40) – 144,000)
= $72,000
Sales – direct material costs
(b) Return per factory hour =
Usage of bottleneck resource in hours (factory hours)
100 − 40
=
1/500
= $30,000
Return per factory hour
(c) Throughput accounting ratio =
Total conversion cost per factory hour
30,000
=
144,000/8
= 1.67
The TA ratio can be used to assess the relative earning capabilities of different products and hence can
help with decision making.
Part A Specialist cost and management accounting techniques ⏐ 2d: Throughput accounting 55
Required
(a) Calculate the profit per day if daily output achieved is 6,000 units of X, 4,500 units of Y and 1,200
units of Z.
(b) Calculate the TA ratio for each product.
(c) In the absence of demand restrictions for the three products, advise Corrie's management on the
optimal production plan.
Solution
(a) Profit per day = throughput contribution – conversion cost
= [($70 × 6,000) + ($80 × 4,500) + ($200 × 1,200)] – $720,000
= $300,000
(b) TA ratio = throughput contribution per factory hour/conversion cost per factory hour
Conversion cost per factory hour = $720,000/8 = $90,000
Product Throughput contribution per factory hour Cost per factory hour TA ratio
X $70 × 1,200 = $84,000 $90,000 0.93
Y $80 × 1,500 = $120,000 $90,000 1.33
Z $200 × 600 = $120,000 $90,000 1.33
(c) An attempt should be made to remove the restriction on output caused by process alpha's
capacity. This will probably result in another bottleneck emerging elsewhere. The extra capacity
required to remove the restriction could be obtained by working overtime, making process
improvements or product specification changes. Until the volume of throughput can be increased,
output should be concentrated upon products Y and Z (greatest TA ratios), unless there are good
marketing reasons for continuing the current production mix.
Product X is losing money every time it is produced so, unless there are good reasons why it is
being produced, for example it has only just been introduced and is expected to become more
profitable, Corrie should consider ceasing production of X.
56 2d: Throughput accounting ⏐ Part A Specialist cost and management accounting techniques
Knowledge brought forward from earlier studies
Attention! Throughput is defined as sales less material costs whereas contribution is defined as sales less all
variable costs. Throughput assumes that all costs except materials are fixed in the short run.
Fixed overheads are absorbed on the basis of direct labour cost. Tatty and Messy pass through two
processes, blasting and smoothing which incur direct labour time as follows.
Time taken
Process Tatty Messy
Blasting 15 mins 25 mins
Smoothing 25 mins 20 mins
Part A Specialist cost and management accounting techniques ⏐ 2d: Throughput accounting 57
The current market price for Tatty is $75 and for Messy $60 and, at these prices, customers will buy as
many units as are available.
The capacity of the two processes limits the amount of units of products that can be produced. Blasting
can be carried out for 8 hours per day but smoothing can only operate for 6 hours per day.
Required
What production plan should the company follow in order to maximise profits?
(a) Using contribution per minute
(b) Using throughput per minute
Solution
The constraint in this situation is the ability to process the product. The total daily processing time for the
two processes is as follows.
Maximum blasting time = 8 × 60 mins = 480 mins
Maximum smoothing time = 6 × 60 mins = 360 mins
The maximum number of each product that can be produced is therefore:
Tatty Messy
Units Units
Blasting 480 480
= 32 = 19
15 25
Smoothing 360 360
= 14 = 18
25 20
The total number of units that can be processed is greater for blasting so smoothing capacity is the
binding constraint or limiting factor.
(a) Maximising contribution per minute
Contribution of Tatty = $(75 – 12 – 6 – 6) = $51
Contribution of Messy = $(60 – 12 – 10 – 10) = $28
$51
Contribution of Tatty per minute in smoothing process = = $2.04
25
$28
Contribution of Messy per minute in smoothing process = = $1.40
20
The profit maximising solution is therefore to produce the maximum number of units of Tatty,
giving a contribution of 14 × $51 = $714
(b) Maximising throughput per minute
Contribution of Tatty = $(75 – 12) = $63
Contribution of Messy = $(60 – 12) = $48
$63
Throughput per minute of Tatty in smoothing process = = $2.52
25
$48
Throughput per minute of Messy in smoothing process = = $2.40
20
The profit maximising approach is therefore again to produce the maximum number of units of
Tatty, but the result is not as clear cut.
58 2d: Throughput accounting ⏐ Part A Specialist cost and management accounting techniques
Chapter Roundup
• Throughput accounting is a product management system which aims to maximise throughput, and
therefore cash generation from sales, rather than profit. A just in time (JIT) environment is operated, with
buffer inventory kept only when there is a bottleneck resource.
• Performance measures in throughput accounting are based around the concept that only direct materials
are regarded as variable costs.
• In a throughput environment, production priority must be given to the products best able to generate
throughput, that is those products that maximise throughput per unit of bottleneck resource.
Part A Specialist cost and management accounting techniques ⏐ 2d: Throughput accounting 59