Throughput Accounting

The theory of constraints (TOC) is an approach to production management and optimizing

production performance. It states that producing maximum output or operating at 100% capacity
levels does not ensure that organization’s production is efficient. Modern production efficiency
concept says that production should be linked with the available demand in the market. Thus, simply
producing the output without converting into sales is mirage for the organization.
An organization needs to find its real goal, which is actually the maximization of profits in majority of
organizations. Thus production is designed in such a way that it meets the above stated objective
then it is called efficient production.

Let’s first define few terms before summing up the concept of theory of constraints;

 ‘Throughput’ is the rate at which the system generates money through sales. Thus, it’s the
money received by the business from sales after deducting material cost.
Throughput contribution= Sales – Material cost

 ‘Bottleneck Resource’ the factor that prevents the organization from meeting its goals. Thus
it’s an activity that limits the throughput contribution of the organization.

 ‘Inventory’ is all the money that the system has invested in purchasing things that it intends
to sell. In throughput accounting inventory is valued only at material cost.

 ‘Operational expense’ is all the money that the system spends in order to turn raw material
into sales. Thus it includes direct labor and factory overheads. This operational cost is
assumed to be fixed.
TOC is applied where there is bottleneck resource in the production process. The idea is that the
production must be limited to the capacity of the bottleneck resource but this capacity must be fully
utilized.
There will be idle resources in non-bottleneck areas, but this does not matter. The focus should be
on maximizing throughput, given the limitation of the bottleneck.

JIT System in Throughput Costing

Throughput costing works with JIT system. Ina 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.
However, output through the limiting factor should never be delayed or held up otherwise sales will
be lost. To avoid this being happened a small buffer inventory should be built up immediately prior
to the bottleneck 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, which is
consistent with a just-in-time (JIT) approach.
 Difference between Traditional and Throughput costing

In traditional cost accounting, improving efficiency and creating higher inventory will increase
profits. Higher inventories reduce the cost of sales and increase reported profits.

In the theory of constraints using non-bottleneck resources above the amount required for
maximum throughput is wasteful. It does not increase throughput, it only increases unused
inventory levels.

Identifying the bottleneck resource

Example 1:
Often, in exam questions, you will be told what the bottleneck resource is. If not, it is usually quite
simple to work out. For example, let’s say that an organisation has market demand of 50,000 units
for a product that goes through three processes: cutting, heating and assembly. The total time
required in each process for each product and the total hours available are:

Process Cutting Heating Assembly

Hours per Unit 2 3 4

Total Hours available 100,000 120,000 220,000

Identify the bottleneck resource?

Example 2:
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 maximize 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

Identify the bottleneck stage?

Example 3:
A manufacturing company uses three processes to make its two products, X and Y. The time
available on the three processes is reduced because of the need for preventative maintenance and
rest breaks. The table below details the process times per product and daily time available:

Process Hours available Hours required Hours required

per day to make one unit to make one unit
of product X of product Y

1 22 1·00 0·75
2 22 0·75 1·00
3 18 1·00 0·50

Daily demand for product X and product Y is 10 units and 16 units respectively
Identify the bottleneck process
 LIMITING FACTOR ANALYSIS AND THROUGHPUT ACCOUNTING
Once an organisation has identified its bottleneck resource, as demonstrated above, it then has to
decide how to get the most out of that resource. Given that most businesses are producing more
than one type of product (or supplying more than one type of service), this means that part of the
exploitation step involves working out what the optimum production plan is, based on maximizing
throughput per unit of bottleneck resource.

Steps involved in the calculation of throughput accounting ratio:

1) Identify the bottleneck resource/activity.

2) Calculate the contribution per unit for each product.

Throughput contribution= Sales – Material cost

3) Calculate the contribution per limiting factor/ bottleneck resource

(Contribution per unit/Bottleneck hours needed per unit)
OR
(Contribution per unit*Units per bottleneck hour)

4) Calculate conversion cost per factory hour.

(Labour cost + Factory Overheads)/Number of bottleneck resource hours

Note: Here the cost in numerator should correspond to the hours in denominator from time
point of view.

5) Calculate throughput Accounting ratio

(Throughput contribution per bottleneck resource hour/ conversion cost per factory hour)

6) Rank the products based upon throughput accounting ratio.

Interpretation of TPAR

 TPAR>1 would suggest that throughput exceeds operating costs so the product should make
a profit. Priority should be given to the products generating the best ratios.
 TPAR<1 would suggest that throughput is insufficient to cover operating costs, resulting in a
loss

Example 4:
Beta Co produces 3 products, E, F and G, details of which are shown below:

  E F G

  $ $ $

Selling price per unit 120 110 130

Direct material cost per unit 60 70 85

Maximum demand (units) 30,000 25,000 40,000

   E F G

Time required on the bottleneck

resource (hours per unit) 5 4 3
There are 320,000 bottleneck hours available each month.
Fixed Cost for the month is $640,000
Required:
Calculate the optimum product mix each month and state maximum profit for the month.

Ways to improve throughput accounting ratio

Speed up the bottleneck process.

By increasing the speed of the bottleneck process the rate of throughput will also increase,
generating a greater rate of income for company if the extra production can be sold. Automation
might be used or a change in the detailed processes. Investment in new machinery can also help
here but the cost of that would need to be taken into account.

Increase the selling prices.

It can be difficult to increase selling prices in what we are told is a competitive market. Volume of
sales could be lost leaving the company with unsold stock or idle equipment. On the other hand,
given the business appears to be selling all it can produce, and then a price increase may be possible.

Reduce the material prices.

Reducing material prices will increase the net throughput rate. Considering the industry maturity,
suppliers of the raw material might be willing to negotiate on price; this could have volume or
quality based conditions attached. The company will have to be careful to protect its quality levels.
Bulk buying increases stock levels and the cost of that would need to be considered.

Reduce the level of fixed costs.

The fixed costs should be listed and targets for cost reduction be selected. ABC techniques can help
to identify the cost drivers and with management these could be used to reduce activity levels and
hence cost. Outsourcing, de-skilling or using alternative suppliers (for stationery for example) are all
possible cost reduction methods.

Main assumptions:

 The only totally variable cost in the short-term is the purchase cost of raw materials that are
bought from external suppliers.
 Direct labour costs are not variable in the short-term. Many employees are salaried and
even if paid at a rate per unit, are usually guaranteed a minimum weekly wage.

Criticisms of TPAR
 It concentrates on the short-term, when a business has a fixed supply of resources (i.e. a
bottleneck) and operating expenses are largely fixed. However, most businesses can't
produce products based on the short term only.
  It is more difficult to apply throughput accounting concepts to the longer term, when all
costs are variable, and vary with the volume of production and sales or another cost driver.
The business should consider this long-term view before rejecting products with a TPAR < 1.
 In the longer-term an ABC approach might be more appropriate for measuring and
controlling performance.

Example 7:
Solar Systems Co (S Co) makes two types of solar panels at its manufacturing plant: large panels for
commercial customers and small panels for domestic customers. All panels are produced using the
same materials, machinery and a skilled labour force. Production takes place for five days per week,
from 7 am until 8 pm (13 hours), 50 weeks of the year. Each panel has to be cut, moulded and then
assembled using a cutting machine (Machine C), a moulding machine (Machine M) and an assembly
machine (Machine A).
As part of a government scheme to increase renewable energy sources, S Co has guaranteed not to
increase the price of small or large panels for the next three years. It has also agreed to supply a
minimum of 1,000 small panels each year to domestic customers for this three-year period.
Due to poor productivity levels, late orders and declining profits over recent years, the finance
director has suggested the introduction of throughput accounting within the organisation, together
with a ‘Just in Time’ system of production.
Material costs and selling prices for each type of panel are shown below.
Large panels Small panels
$ $
Selling price per unit 12,600 3,800
Material costs per unit 4,300 1,160

Total factory costs, which include the cost of labour and all factory overheads, are $12 million each
year at the plant. Out of the 13 hours available for production each day, workers take a one hour
lunch break. For the remaining 12 hours, Machine C is utilised 85% of the time and Machines M and
A are utilised 90% of the time. The unproductive time arises either as a result of routine
maintenance or because of staff absenteeism, as each machine needs to be manned by skilled
workers in order for the machine to run. The skilled workers are currently only trained to work on
one type of machine each. Maintenance work is carried out by external contractors who provide a
round the clock service (that is, they are available 24 hours a day, seven days a week), should it be
required.
The following information is available for Machine M, which has been identified as the bottleneck
resource:
Large panels Small panels
Hours per unit Hours per unit
Machine M 1·4 0·6
There is currently plenty of spare capacity on Machines C and A. Maximum annual demand for large
panels and small panels is 1,800 units and 1,700 units respectively.

Required:
(a) Calculate the throughput accounting ratio for large panels and for small panels and explain
what they indicate to S Co about production of large and small panels.
(b) Assume that your calculations in part (a) have shown that large panels have a higher
throughput accounting ratio than small panels.
Required:
Using throughput accounting, prepare calculations to determine the optimum production mix and
maximum profit of S Co for the next year.
(c) Suggest and discuss THREE ways in which S Co could try to increase its production capacity and
hence increase throughput in the next year without making any additional investment in
machinery.