Throughput

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Throughput

accounting

Topic list Syllabus reference


1 Theory of constraints A4
2 Throughput accounting A4
3 Performance measures in throughput accounting A4 (a), (b)
4 Throughput and decision making A4 (c)

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.

1.1 Example: An illustration of the theory of constraints


Machine X can process 1,000 kg of raw material per hour, machine Y 800 kg. Of an input of 900 kg, 100
kg of processed material must wait on the bottleneck machine (machine Y) at the end of an hour of
processing.

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.

Question Throughput accounting

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.

2.1 Bottleneck resources


The aim of modern manufacturing approaches is to match production resources with the demand for
them. This implies that there are no constraints, termed bottleneck resources in TA, within an
organisation. The throughput philosophy entails the identification and elimination of these bottleneck
resources by overtime, product changes and process alterations to reduce set-up and waiting times.
Where throughput cannot be eliminated by say prioritising work, and to avoid the build-up of work in
progress, production must be limited to the capacity of the bottleneck resource but this capacity must
be fully utilised. If a rearrangement of existing resources or buying-in resources does not alleviate the
bottleneck, investment in new equipment may be necessary.

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

2.2 Example: Throughput accounting in a service industry


A not-for-profit organisation performs a medical screening service in three sequential stages.
1. Take an X-ray
2. Interpret the result
3. Recall patients who require further investigation / inform others that all is fine.
The ‘goal unit’ of this organisation will be to progress a patient through all three stages. The number of
patients who complete all three stages is the organisation’s throughput, and the organisation should seek
to maximise its throughput. The duration of each stage and the weekly resource available is as follows.
Process Time per patient (hours) Total hours available
per week

Take an X-ray (stage 1) 0.50 80


Interpret the result (stage 2) 0.20 40
Recall patients (stage 3) 0.40 60
You can see from the above table that the maximum number of patients (goal units) who can be dealt with
in each process is as follows.
X-rays 80/0.5 = 160
Interpret results 40/0.20 = 200
Recall patients 60/0.40 = 150
It is clear that the recall procedure (stage 3) is the bottleneck resource (constraint). Throughput, and
therefore the organisation’s performance cannot be improved until stage 3 can deal with more patients.
There are a number of actions that the organisation could take to improve throughput.
(a) Investigate whether less time could be spent on the bottleneck activity.
(b) Ensure there is no idle time in the bottleneck resource as this will be detrimental to overall
performance.
(c) Increase the bottleneck resource available.
There is little point in improving stage 1 and stage 2 if the process grinds to a halt at stage 3. Patients are
only helped when the whole process is completed and they are recalled if necessary. Increasing the
bottleneck resource, or the efficiency with which it is used may be relatively cheap and easy to do as stage
3 is a relatively simple piece of administration in comparison to the first two stages that use expensive
machinery and highly skilled personnel.

2.3 Is it good or bad?


TA is seen by some as too short term, as all costs other than direct material are regarded as fixed.
Moreover, it concentrates on direct material costs and does nothing for the control of other costs such

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.

3 Performance measures in throughput accounting 6/09


FAST FORWARD
Performance measures in throughput accounting are based around the concept that only direct materials
are regarded as variable costs.

(a) Return per factory hour


Sales − direct material costs
Usage of bottleneck resource in hours (factory hours)

This enables businesses to take short-term decisions when a resource is in scarce supply.
(b) Throughput accounting ratio

Return per factory hour


Total conversion cost per factory hour

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.

Question Performance measurement in throughput accounting

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

4 Throughput and decision making


FAST FORWARD
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.

The TA ratio can be used to assess the relative earning capabilities of different products and hence can
help with decision making.

4.1 Example: throughput accounting


Corrie produces three products, X, Y and Z. The capacity of Corrie's plant is restricted by process alpha.
Process alpha is expected to be operational for eight hours per day and can produce 1,200 units of X per
hour, 1,500 units of Y per hour, and 600 units of Z per hour.
Selling prices and material costs for each product are as follows.
Product Selling price Material cost Throughput contribution
$ per unit $ per unit $ per unit
X 150 80 70
Y 120 40 80
Z 300 100 200
Conversion costs are $720,000 per day.

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.

4.2 How can a business improve a throughput accounting ratio?


Measures Consequences
• Increase sales price per unit • Demand for the product may fall
• Reduce material costs per unit, eg change • Quality may fall and bulk discounts may be
materials and/or suppliers lost
• Reduce operating expenses • Quality may fall and/or errors increase

4.3 Limitations of the throughput accounting ratio


As we have seen, the TA ratio can be used to decide which products should be produced. However, the
huge majority of organisations cannot produce and market products based on short-term profit
considerations alone. Strategic-level issues such as market developments, product developments and the
stage reached in the product life cycle must also be taken into account.

4.4 Throughput and limiting factor analysis


The throughput approach is very similar to the approach of maximising contribution per unit of scarce
resource, which you will have covered in your earlier studies.

56 2d: Throughput accounting ⏐ Part A Specialist cost and management accounting techniques
Knowledge brought forward from earlier studies

Limiting factor analysis


• An organisation might be faced with just one limiting factor (other than maximum sales demand)
but there might also be several scarce resources, with two or more of them putting an effective
limit on the level of activity that can be achieved.
• Examples of limiting factors include sales demand and production constraints.
– Labour. The limit may be either in terms of total quantity or of particular skills.
– Materials. There may be insufficient available materials to produce enough units to satisfy
sales demand.
– Manufacturing capacity. There may not be sufficient machine capacity for the production
required to meet sales demand.
• It is assumed in limiting factor analysis that management would make a product mix decision or
service mix decision based on the option that would maximise profit and that profit is maximised
when contribution is maximised (given no change in fixed cost expenditure incurred). In other
words, marginal costing ideas are applied.
– Contribution will be maximised by earning the biggest possible contribution per unit of
limiting factor. For example if grade A labour is the limiting factor, contribution will be
maximised by earning the biggest contribution per hour of grade A labour worked.
– The limiting factor decision therefore involves the determination of the contribution earned
per unit of limiting factor by each different product.
– If the sales demand is limited, the profit-maximising decision will be to produce the top-
ranked product(s) up to the sales demand limit.
• In limiting factor decisions, we generally assume that fixed costs are the same whatever product or
service mix is selected, so that the only relevant costs are variable costs.
• When there is just one limiting factor, the technique for establishing the contribution-maximising
product mix or service mix is to rank the products or services in order of contribution-earning
ability per unit of limiting factor.

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.

4.4.1 Example: throughput v limiting factor analysis


A company produces two products, Tatty and Messy, which have the following production costs.
Tatty Messy
$ $
Direct material cost 12 12
Direct labour cost 6 10
Variable overhead 6 10
Fixed overhead 6 10
Total product cost 30 42

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

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