Throughput accounting

Chapter Learning Objectives

Calculate and interpret a throughput accounting ratio (TPAR).[2] Suggest how a TPAR could be improved.[2] Apply throughput accounting to a multi-product decision-making problem.[

Throughput accounting, which can also be referred to as the Theory of Constraints (TOC), focuses on organisational constraints or bottlenecks which restrict production. The objective is to maximise output (or throughput) by converting raw materials to finished items as quickly as possible. These finished items are then despatched to customers as soon as possible (as in a JIT system). 1.1 Bottlenecks

The most important aspect of the theory of Throughput Accounting (TA) is that the speed of output of the factory is restricted to the speed of the bottleneck which is, in effect, the limiting factor or constraining resource. The objectives, therefore, are: Identify the bottleneck(s) Remove them, or reduce the extent to which they constrain activity.

1.2

Terminology

Throughput accounting uses three key terms: Throughput contribution Sales revenue completely variable costs. (Completely variable costs usually comprise direct materials only because labour costs usually include a fixed element). Conversion costs = all operating costs excluding completely variable costs incurred to produce the product. Investment = all types of stock, equipment costs, buildings costs etc. The purpose of throughput accounting is to maximise throughput contribution whilst minimising conversion costs and investment. 1.3 Throughput per hour

One of the key measures of throughput is the ratio:

Throughput contribution Time

which provides us with a value of throughput contribution per hour. By emphasising time as a key factor, managers attention is drawn to areas of the business which reduce the speed of operations, ie bottlenecks. This can be used in decision making by ranking products according to the time they spend using bottleneck resources. To do this, the formula is modified thus: Product return per minute =

Throughput contribution Minutes on bottleneck resource

A company produces two products X and Y which have unit selling price and cost values as follows: Product Selling price Direct materials Direct labour Variable overhead Fixed overhead X 130 ___ 20 10 10 10 ___ 50 ___ Profit 80 Y 104 ___ 20 18 18 18 ___ 74 ___ 30

Fixed overhead costs are absorbed on the basis of direct labour costs. The direct labour cost is incurred at the rate of 20 per hour in respect of the time spent in the two processes. Process X A B 8 min 22 min ______ 30 min ______ The maximum process times available per week are as follows: Process A Process B 2000 minutes 800 minutes Product Y 30 min 14 min ______ 44 min ______

Calculate the production plan to maximise profits. 1.5 Solution

The first step is to recognise that this is a limiting factor problem with two possible constraints: process A time and/or process B time. Firstly consider the maximum numbers of product X and Y that can be produced: Product X Process A Product Y

2000 = 250 8

2000 = 67 30

Process B

800 = 36 22

800 = 57 14

As the maximum number of units of both products is limited by the time available in process B, we can see that process A is not an effective constraint. The traditional approach to this type of problem is to use the contribution per process B minute to rank the products. This gives: Product X =

(130 20 10 10 ) 22 90 22
= 4.09 per minute

Product Y

(104 20 18 18) 14 48 14
= 3.43 per minute

On this basis product X would be preferred. If the same problem is considered using throughput contribution as the basis of ranking: Product X

(130 20 ) 22 (104 20 ) 14

5.00 per minute

Product Y

6.00 per minute

On this basis product Y is preferred. Clearly since the ranking basis changes the decision, they cannot both provide an optimum solution. Which is correct? The answer depends on the variability of the labour and variable overhead cost. In the short term it is now more likely that the labour cost is fixed, so under these circumstances the throughput accounting approach probably provides the better solution. 1.6 Controlling costs

Whilst the measurement of throughput per hour is important, we must recognise the need to consider any costs associated with increasing the throughput.

To do this we use the throughput accounting ratio:

Value added per time period Conversion cost per time period
where value added equals sales less material costs equals throughout contribution. Traditional efficiency measures are no longer valid as they encourage production for stock. Instead efficiency is measured by:

Standard minutes of throughput achieved Minutes available

1.7 Summary of throughput accounting

In principle there is little difference between throughput accounting and marginal costing, both relying on the contribution concept. However, they differ in their classification of labour and other costs.