Throughput

accounting

Topic list Syllabus reference

1 Theory of constraints A5
2 Throughput accounting A5
3 Performance measures in throughput accounting A5(a), (b)
4 Throughput and decision making A5(c)

Introduction
Throughput accounting is the last 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.

55
 Study guide
Intellectual level
A5 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. 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.
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.

56 2e: Throughput accounting ~ Part A Specialist cost and management accounting techniques
 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)

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.

Part A Specialist cost and management accounting techniques ~ 2e: Throughput accounting 57
 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.
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 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
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

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

58 2e: Throughput accounting ~ Part A Specialist cost and management accounting techniques
 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.
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

Part A Specialist cost and management accounting techniques ~ 2e: Throughput accounting 59
 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.
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 u 6,000) + ($80 u 4,500) + ($200 u 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 u 1,200 = $84,000 $90,000 0.93
Y $80 u 1,500 = $120,000 $90,000 1.33
Z $200 u 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.

60 2e: Throughput accounting ~ Part A Specialist cost and management accounting techniques
4.2 How can a business improve a throughput accounting ratio?
Measures Consequences
x Increase sales price per unit x Demand for the product may fall
x Reduce material costs per unit, eg change x Quality may fall and bulk discounts may be
materials and/or suppliers lost
x Reduce operating expenses x 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.

Knowledge brought forward from earlier studies

Limiting factor analysis

x 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.
x 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.
x 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.
x 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.
x 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.

Part A Specialist cost and management accounting techniques ~ 2e: Throughput accounting 61
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
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 u 60 mins = 480 mins
Maximum smoothing time = 6 u 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

62 2e: Throughput accounting ~ Part A Specialist cost and management accounting techniques
 $28
Contribution of Messy per minute in smoothing process = = $1.04
20
The profit maximising solution is therefore to produce the maximum number of units of Tatty,
giving a contribution of 14 u $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.

Chapter Roundup
x 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.
x Performance measures in throughput accounting are based around the concept that only direct materials
are regarded as variable costs.
x 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 ~ 2e: Throughput accounting 63
 Quick Quiz
1 Fill in the blanks in the statements below, using the words in the box. Some words may be used twice.
(a) The theory of constraints is an approach to production management which aims to maximise
(1)........................................ less (2)........................................ . It focuses on factors such as
(3)........................................ which act as (4)........................................
(b) Throughput contribution = (5)........................................ minus (6) ........................................
(c) TA ratio = (7) ........................................ per factory hour y (8) ........................................ per
factory hour

x bottlenecks x throughput contribution

x material costs x constraints
x sales revenue x conversion cost

2 Fill in the right hand side of the table below, which looks at the differences between throughput accounting
and traditional product costing.

Traditional product costing Throughput accounting

Labour costs and 'traditional' variable overheads
are treated as variable costs.
Inventory is valued in the income statement and
balance sheet at total production cost.
Variance analysis is employed to determine whether
standards were achieved.
Efficiency is based on labour and machines working
to full capacity.
Value is added when an item is produced.

3 The following details relate to three services offered by DSF.

V A L
$ per service $ per service $ per service
Selling price of service 120 170 176
Direct labour 20 30 20
Variable overhead 40 56 80
Fixed overhead 20 32 40
80 118 140
Profit 40 52 36

All three services use the same direct labour, but in different quantities.
In a period when the labour used on these services is in short supply, the most and least profitable use of
the labour is:
Most profitable Least profitable
A L V
B L A
C V A
D A L

64 2e: Throughput accounting ~ Part A Specialist cost and management accounting techniques
 chapter 2

11 Environmental management accounting

The importance of environmental management

Organisations are beginning to recognise that environmental awareness

and management are not optional, but are important for long­term survival
and profitability. All organisations:

• are faced with increasing legal and regulatory requirements relating to

environmental management
• need to meet customers’ needs and concerns relating to the
environment
• need to demonstrate effective environmental management to maintain a
good public image
• need to manage the risk and potential impact of environmental
disasters
• can make cost savings by improved use of resources such as water
and fuel
• are recognising the importance of sustainable development, which is
the meeting of current needs without compromising the ability of future
generations to meet their needs.

The contribution of environmental management accounting (EMA)

EMA is concerned with the accounting information needs of managers in

relation to corporate activities that affect the environment as well as
environment­related impacts on the corporation. This includes:

• identifying and estimating the costs of environment­related activities

• identifying and separately monitoring the usage and cost of resources
such as water, electricity and fuel and to enable costs to be reduced
• ensuring environmental considerations form a part of capital investment
decisions
• assessing the likelihood and impact of environmental risks
• including environment­related indicators as part of routine performance
monitoring
• benchmarking activities against environmental best practice.

EM and effect on financial performance

Some EMA initiatives

KAPLAN PUBLISHING 67
Traditional and advanced costing methods

12 Identifying and accounting for environmental costs

Management are often unaware of the extent of environmental costs and

cannot identify opportunities for cost savings. Environmental costs can be
split into two categories:

Internal costs

These are costs that directly impact on the income statement of a company.
There are many different types, for example:

• improved systems and checks in order to avoid penalties/fines

• waste disposal costs
• product take back costs (i.e. in the EU, for example, companies must
provide facilities for customers to return items such as batteries, printer
cartridges etc. for recycling. The seller of such items must bear the cost
of these "take backs")
• regulatory costs such as taxes (e.g. companies with poor environmental
management policies often have to bear a higher tax burden)
• upfront costs such as obtaining permits (e.g. for achieving certain levels
of emissions)
• back­end costs such as decommissioning costs on project completion

External costs

These are costs that are imposed on society at large, but not borne by the
company that generates the cost in the first instance. For example,

• carbon emissions
• usage of energy and water
• forest degradation
• health care costs
• social welfare costs

However, governments are becoming increasingly aware of these external

costs and are using taxes and regulations to convert them to internal costs.
For example, companies might have to have a tree replacement
programme if they cause forest degradation, or they receive lower tax
allowances on vehicles that cause a high degree of harm to the environment.
On top of this, some companies are voluntarily converting external costs to
internal costs.

68 KAPLAN PUBLISHING
 chapter 2

13 Other classifications

Other classifications include those from :

(1) Hansen and Mendoza :

(i) Environmental prevention costs: the costs of activities undertaken
to prevent the production of waste.
(ii) Environmental detection costs: costs incurred to ensure that the
organisation complies with regulations and voluntary standards.
(iii) Environmental internal failure costs: costs incurred from performing
activities that have produced contaminants and waste that have not
been discharged into the environment.
(iv) Environmental external failure costs: costs incurred on activities
performed after discharging waste into the environment.
(2) The US Environmental Protection Agency makes a distinction
between four types of costs:
(i) Conventional costs : raw materials and energy costs having
environmental relevance
(ii) Potentially hidden costs : costs captured by accounting systems but
then losing their identity in 'general overheads'
(iii) Contingent costs : costs to be incurred at a future date, e.g. clean­
up costs
(iv) Image and relationship costs : costs that, by their nature, are
intangible, for example the costs of preparing environmental
reports.
(3) The United Nations Division for Sustainable Development
describes environmental costs as comprising of costs incurred to
protect the environment (for example, measures taken to prevent
pollution) and costs of wasted material, capital and labour, ie
inefficiencies in the production process.

Further examples of environmental costs

KAPLAN PUBLISHING 69
Traditional and advanced costing methods

14 EMA techniques

The most appropriate management accounting techniques for the

identification and allocation of environmental costs are those identified by
the United Nations Division for Sustainable Development. These include
(Source : Student Accountant, Issue 15):

1. Input / outflow analysis

This technique records material inflows and balances this with

outflowson the basis that what comes in, must go out.

For example, if 100kg of materials have been bought and only 80kg of
materials have been produced, then the 20kg difference must be
accounted for in some way. It may be, for example, that 10% of it has
been sold as scrap and 90% of it is waste. By accounting for outputs in
this way, both in terms of physical quantities, and, at the end of the
process, in monetary terms too, businesses are forced to focus on
environmental costs.

2. Flow cost accounting

This technique uses not only material flows, but also the organisational
structure. It makes material flows transparent by looking at the physical
quantities involved, their costs and their value. It divides the material
flows into three categories : material, system and delivery and disposal.
The values and costs of each of these three flows are then calculated.
The aim of flow cost accounting is to reduce the quantity of materials
which, as well as having a positive effect on the environment, should
have a positive effect on a business' total costs in the long run.

3. Activity­based costing

ABC allocates internal costs to cost centres and cost drivers on the
basis of the activities that give rise to the costs. In an environmental
accounting context, it distinguishes between environment­related costs,
which can be attributed to joint cost centres, and environment­driven
costs, which tend to be hidden on general overheads.

4. Lifecycle costing

Within the context of environmental accounting, lifecycle costing is a

technique which requires the full environmental consequences, and,
therefore, costs, arising from the production of a product to be taken
account across its whole lifecycle, literally ‘from cradle to grave’.

70 KAPLAN PUBLISHING
 chapter 2

15 EMA : Advantages and disadvantages

Advantages of environmental Disadvantages
costing

• better/fairer product costs • time consuming

• improved pricing ­ so that • expensive to implement

products that have the biggest
environmental impact reflect this
by having higher selling prices

• better environmental cost • determining accurate costs and

control appropriate costs drivers is
difficult

• facilitates the quantification of • external costs not experienced

cost savings from by the company (e.g. carbon
"environmentally­friendly" footprint) may still be
measures ignored/unmeasured

• should integrate environmental • some internal environmental

costing into the strategic costs are intangible (e.g. impact
management process on employee health) and these
are still ignored

• reduces the potential for cross­ • a company that incorporates

subsidisation of environmentally external costs voluntarily may be
damaging products at a competitive disadvantage
to rivals who do not do this

KAPLAN PUBLISHING 71
Traditional and advanced costing methods

16 Chapter summary

72 KAPLAN PUBLISHING