P2 Advanced Management Accounting - Global Edulink · 2018-10-17 · In marginal costing you may remember the term contribution. This was equal to the selling price of the product

P2 Advanced Management Accounting

Module: 6

Throughput Accounting

1. What is throughput accounting?

Throughput accounting is an alternative management accounting

approach. You may be wondering why we need another method when we

already have absorption costing, marginal costing and activity-based costing?

Well let's think about it using an example of a manufacturer of low price

furniture.

Woodwork Ltd made chairs and tables. The managing director, Ben, wants to

improve the profitability of the business.

His first port of call is the purchasing department to see if the lumber being

purchased is as cheap as possible, but to his disappointment, there is no

saving to be made.

Next, he goes to the factory to see if the productions manager has any ideas. The productions manager says that whilst the workers in sawing

department are always busy, the workers in the sanding and gluing

departments are often idle because they are waiting for the work in

progress units to come down the production line. From this information

Ben realises that he has 2 options to potentially increase profit. His options

are:

Option 1: Lay off some of the sanding and gluing workers – this would save

the cost of labour, reducing production costs and increasing the margin of

profit on each finished unit.

Option 2: Hire additional workers for the sawing department to increase the

volume of work in progress units – this would allow the sanding and gluing

departments to work to optimal capacity and therefore increase the rate of

production.

In this example, option 2 is the approach that a company using throughput

accounting would use, with the focus being on improving profitability through

maximising the use of a scarce resource. In this example, the scarce resource

is the sawing department. The first step in throughput accounting is always

to identify the scarce resource, otherwise known as the “bottleneck”.

2. The Theory of Constraints (TOC)

The theory of constraints is a concept that states you can only produce

products as fast as your slowest department will allow.

The slowest department or part of a process, often referred to as the

‘bottleneck’ is understood to set the pace of the entire operation.

Therefore, the way to improve efficiency is to remove the bottleneck, after

which a new ‘slowest department’ will emerge that will become the new

focus. In the Woodwork Ltd example, after the new sawing staff are hired, the

sawing department would no longer be the “bottleneck”, at this point a new

bottleneck would appear and the manager would aim to remove this as well.

As you can see, this process leads to a culture of continuous improvement

(continuously working to improve the next bottleneck until resolved) which

helps to optimise the production process.

This is the underlying concept of throughput accounting.

Identify

bottleneck

Remove

bottleneck Throughput

increases

3. Throughput accounting theory

Bottlenecks are an essential concept in throughput accounting and managers

will always aim to remove them. However, this is not always immediately possible, therefore throughput accounting (TA) also aims to maximise

profit by focusing on maximising the efficiency of the bottleneck in the

process.

Let's revisit the furniture manufacturer 3 months later. Since Woodwork Ltd

hired new sawing staff, profits have increased by 20%. The managing

director, Ben, is hoping to get this number to 25% in order to hit his targets.

After some more investigation into bottlenecks, Ben discovers that the new

slowest department is the varnishing and painting department.

This is bad news for Ben because varnishing and painting is done entirely by

a very expensive robotic spraying machine. To remove this bottleneck, a

new machine would have to be purchased at the cost of £1.5 million.

Instead of immediately removing this bottleneck, Ben decides to optimise

the output of production so that the robotic spraying machine is put to

the best use possible. He also puts in a purchase request for the new

machine for the next year.

In throughput accounting, the short term action is to optimise the output of the

bottleneck and the long term action is to remove the bottleneck.

Throughput accounting costs

The costs in throughput accounting differ from marginal costing (which

considers labour, materials and variable overheads to be variable costs) in

that it considers material costs to be the only variable cost. All other

costs, including direct labour, are treated as fixed.

Therefore TA identifies costs as either:

In marginal costing you may remember the term contribution. This was

equal to the selling price of the product less all variable costs. Throughput

accounting employs the same equation, with the key distinction that the only

variable cost is material cost. This is known as throughput or throughput

contribution.

Throughput contribution = Sales revenue - material cost

The focus on making sales and removing bottlenecks

The primary focus with throughput accounting is how fast a business can

generate throughput. A key indicator used to achieve this is the return per time

period, calculated as:

A manager with this as their target will focus on maximising sales, and

hence sales revenue. You'll remember in absorption costing, that producing

an excess of stock can increase profits as the overheads are absorbed into

the stock. In throughput accounting, producing this stock does not

have the same affect on profit margins. In an environment where stock

holding should be kept to a minimum (e.g. to avoid obsolescence) then this

measure is seen as a good one.

With this goal in mind it no longer makes sense to operate the entire factory at

full capacity. Since units can only be produced as fast as the bottleneck will allow, operating the other departments at full capacity only results in a

build-up of stock, which, as we’ve already said is not rewarded. These

items will lay around collecting dust while waiting to be processed by the

bottleneck.

Going back again to Woodwork Ltd. In our first scenario (remember options 1

and 2) the manager with a throughput accounting target will employ more

people (option 2) to remove the bottleneck where they can as that will

increase the throughput contribution more than option 1. The manager is

motivated to continuing growing the business.

In the later scenario, let's say our sawing, gluing and sanding department

are able to produce 50 chairs an hour but the painting and varnishing

department can only finish 40 per hour. The result is 10 chairs building up

every hour waiting to be varnished which are unable to be sold. These

chairs provide no benefit to the business other than to increase storage

costs. Under absorption costing they would build up as stock at no detriment

to the manager as costs are passed over in 'closing stock' to the next period.

In fact, as previously noted, the manager may actually pass some of this

year's overheads to next year and hence actually increase profits – not the

behaviour we want to encourage!

Under throughput accounting the focus turns to maximising the efficiency of

the bottleneck, while operating other departments at a speed the bottleneck

can keep up with.

In our example, a throughput accounting approach would be to reduce output

of the other department's to only 40 chairs an hour and focus attention on

increasing the efficiency of varnishing.

You might find TA unique in that cost control is not the primary focus. The

emphasis is on throughput first, followed by inventory minimisation, and

cost control third.

We can use the return per time period ratio we discussed above to ‘rank’

products in order to determine which one makes best use of the bottleneck

resource. We can adjust the time period to whichever unit of time we like. For

example, if we wanted to calculate our return per minute, the ratio would

simply be:

Let’s use a new example to see this at work.

Example

We produce two different toy cars – Car A and Car B. The information for each

product is as follows:

Car A £ Car B £

Direct material 20 20

Direct labour 7 12

Variable overhead 7 12

Total cost 34 44

Selling price 70 65

Each car is produced in two stages – the modelling stage and the testing

stage. The time required at each stage is as follows:

Minutes required

Process

Modelling

Car A

8

Car B

30

Testing 16 12

However, our capacity is limited. Our modelling machines are available for 16

hours a day and our testing facility is available for 6 hours a day. This gives

us available time of 960 minutes and 360 minutes respectively.

Time available

Modelling 16 hours = 960 minutes

Testing 6 hours = 360 minutes

We want to plan our production in a way that will maximise our profits. Our

first step in doing this is finding out which process is our constraining

resource or ‘bottleneck’. To do this we work out how many of each car we

can process through each stage per day:

Modelling Mins available Mins required Maximum units

Car A 960 8 120

Car B 960 30 32

Testing Mins available Mins required Maximum units

Car A 360 16 22.5

Car B 360 12 30

This calculation shows that for both Car A and Car B we can model more cars

per day than we can test. This means that our bottleneck lies in the testing

stage.

Therefore our issue is figuring out how to best use the limited capacity

of the testing facility – our bottleneck resource.

Traditional approach

Under a traditional approach, we would aim to work out which product

will maximise contribution. You should recall that contribution is selling price

less all variable costs.

Car A £ Car B £

Selling price 70 65

Direct material 20 20

Direct labour 7 12

Variable overhead 7 12

Contribution 36 21

Minutes of testing required 16 12

Contribution per minute £2.25 £1.75

Under this approach it appears that Car A provides the higher contribution per

minute, therefore our strategy would be to maximise the production of Car A.

Throughput approach

The idea under this approach is to maximise throughput. You should recall that

throughput is equal to selling price less variable costs, where the only variable

cost is materials.

Therefore our calculation would be:

Car A £ Car B £

Selling price 70 65

Direct material 20 20

Throughput 50 45

Minutes of testing required

16

12

Throughput per minute £3.13 £3.75

Using a throughput approach our strategy would therefore be to focus on

producing the maximum number of units of Car B, as Car B provides the

higher throughput per minute.

4. When to use throughput accounting

Throughput accounting is useful where the focus is short term. This is

because the reality of modern manufacturing is that direct labour and other

overheads are in fact fixed in the short term. We pay our staff and heating

bills anyway even when the factory is not working or if the production process is inefficient. Therefore throughput accounting is best suited to a

management team where overheads and labour will be paid at the end of

the day or week irrespective of how many units are produced.

As discussed earlier, it is also useful where directors want to focus

management attention on eliminating a bottleneck or improving

production flow as the focus is on throughput.

Likewise, it's also useful in environments where the aim is to minimise

stock (e.g. where products become obsolete quickly or are perishable). This is

preferable, for example, to absorption costing systems which actually reward

the build up.

It is therefore important to understand that there is no ‘correct’ answer in the

above example. The most suitable approach will depend on the situation and

the time horizon of management’s goals.

5. Throughput accounting ratio

In the earlier example we explored options for maximising throughput

through our bottleneck resource. This provides value in the short run, but it

ignores the fact that we have other costs to consider, namely labour and

overheads. This is where the throughput accounting ratio comes in.

Throughput accounting ratio = Return per factory hour

Cost per factory hour

The aim of any profit maximising business will be to attain as high a TA ratio

as possible. A TA ratio measures the return of from the product against the

cost of running the factory. So, if a product was returning £5 an hour but the

cost of running the factory was £15 an hour, the product would have a TA

ratio of 0.33 which may make it look like the product is not worthwhile

producing. It is worth noting that the return applies directly to the product

whereas the cost applies to the factory as a whole, so it is not taking other

products into account.

For example, let’s say the selling price for our toy car is £100 per unit with a

material cost per unit of £40. We plan to make 1,000 units in a day.

Production is limited to 5 hours a day in which 200 units are produced per hour

(this is the bottleneck) and our total daily conversion costs are

£30,000.

The first thing we need to do is calculate our return per factory hour. We

calculate this by dividing our product throughput contribution by the product's

time on a the bottleneck resource:

Return per factory hour = Throughout contribution

Product's time on bottleneck resource

We know that our throughput contribution is the sales price minus the direct

material cost. This gives is £60 (£100-£40). We now need to calculate the

product's time on a the bottleneck resource. Production is limited to 200 units

an hour, therefore, the time each unit spends on the bottleneck is 1 divided

by 200, Giving us 0.005.

Now we have the two figures, we can calculate our return per factory hour:

£60

0.005

= £12,000

The next step is to calculate our cost per factory hour. This is done by

dividing our conversion costs by the amount of production hours (in this case

5).

£30,000

5

= £6,000

Finally, we have our return per factory hour and cost per factory hour. We can

now calculate our TA ratio:

£12,000

£6,000

= 2

So, we can see that this product has a high ratio. Anything above 1 in theory

should be worthwhile as it generates more value per hour than it costs.

Generally speaking, priority should be given to products that provide the

highest TA ratios. Remember that cost control is not the primary focus of

TA. It concerns itself mainly with throughput maximisation and inventory

minimisation. It does not concern itself with optimising other costs as the

belief is that other costs are fixed anyway. In reality this assumption is often

accurate.