Throughput Accounting.pdf notes from accounting and finance

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1. Prepared by CPA(T) David Mushi


TOPIC 3
THROUGHPUT ACCOUNTING

Theory of constraints (TOC)
The theory of constraints is an approach to production management. Its key financial
concept is to turn materials into sales as quickly as possible, thereby maximizing the net
cash generated from sales. TOC aims at maximizing sales revenue less material and
variable overhead cost. It focuses on factors such as bottlenecks which act as constraints
to this maximization. TOC was developed by Eliyahu Goldratt, conceptually he was
focusing on idea that every company has identifiable constraints, hence management
should identify the most binding constraints and manage them so that its resources are
used most efficiently.

Bottleneck resource
Bottleneck resource or binding constraint is 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.

THROUGHPUT
Throughput is the rate at which the system generates money through sales. It defined as
sales revenue less direct material cost. Throughput accounting acknowledges only
material cost to be truly variable, all other costs are treated as periodic costs and are
deducted as expense s of the period.
Throughput is a measure of profitability and is defined by the following equation:
Throughput = Sales revenue – Direct material cost

THROUGHPUT ACCOUNTING
Throughput accounting is not a costing system, it is an accounting method. It actually
involves assessment of how effectively a firm utilizes its constraints. Note there is no
calculation, estimation, approximation, apportionment, judgement, evaluation or
prediction of costs of products in throughput accounting.

Throughput accounting is an approach to accounting which is largely in sympathy with
the JIT philosophy. In essence, Throughput Accounting assumes that a manager has a
given set of resources available. these comprise existing buildings, capital equipment and
labor 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 maximization of throughput.

2. Prepared by CPA(T) David Mushi


The aim of throughput accounting is to maximize throughput contribution, whilst
simultaneously reducing operating expenses (conversion cost) and inventory i.e. money
is tied up in inventory (investment cost). The goal is achieved by determining what factors
prevent the throughput from being higher. This constraint is called a bottleneck, for
example there may be a limited number of machine hours or labour hours. In the short-
term the best use should be made of this bottleneck. This may result in some idle time in
non-bottleneck resources, and may result in a small amount of inventory being held so as
not to delay production through the bottleneck. In the long term, the bottleneck should be
eliminated. For example, a new, more efficient machine may be purchased. However,
this will generally result in another bottleneck, which must then be addressed.

TOC is a short-term profit maximizing technique that is very similar in approach to
marginal costing. The only real difference is that the contribution may be more realistic in
that all conversion costs are assumed to be fixed costs

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.

THEORY OF CONSTRAINTS IDENTIFIES THREE TYPES OF COST.
1. Throughput contribution
This is usually Sales revenue less direct material cost i.e. completely variable cost. (Labour
costs tend to be partially fixed and are normally excluded, although if they were fully
variable, they could be included. Direct material cost includes purchased components
and material handling costs.)

2. Conversion costs.
These are all operating costs, excluding completely variable costs, which are incurred in
order to produce the product, that is, fixed labour and overhead, including rent, utilities
and relevant depreciation.

3. Investments cost.
Which include all inventory, raw material, work-in-progress, finished goods, research and
development costs, costs of equipment and buildings, etc.

Throughput Accounting 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

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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 organization is to make money, inventory must be sold
for that goal to be achieved. The bottleneck resource slows the process of
making money.
According to TOC, throughput can be maximized through various sequential of steps
1. Identify the bottleneck of the system
Management focus should be on the bottleneck i.e. concentrate managerial effort
on those items which are in short supply and which, therefore limit the
performance of the entire system.

2. Decide how to exploit the system’s bottlenecks
Ensure that everything the constraints are going to consume will be promptly
supplied by the non-constraints.

3. Subordinate everything else to the above decision
Bottleneck activity determines the production schedule of non-bottleneck
activities. There is no point in over supplying, from non-constraint area more than
what the constraints can handle. Simply this would result in higher WIP
inventories and no increase in sales volume

4. Evaluate the system’s bottlenecks
Step 4 requires taking necessary action to remove the constraint or elevate the
system’s constraints until the constraint no longer limits the system. This may
involve for example replacing the bottleneck machine with a faster one.

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5. If in the preceding steps, a constraint has been broken, go back to step 1
Once the bottleneck (constraint) is broken, it will generally be replaced by another
or new bottleneck elsewhere. In this case it becomes necessary to go back to step 1,
but do not allow inertia (unwillingness to take action) to cause a system constraint.

MEASURE OF THROUGHPUT/THROUGHPUT ACCOUNTING RATIO
When there is a bottleneck resource, performance can be measured in terms of throughput
for each unit of bottleneck resource consumed. There are three interrelated ratios:
1. Return per factory hour
Return per factory hour = Sales – Material costs
Factory hours
✓ Sales minus Material cost is termed as Throughput
✓ Factory hours are basing in terms of use of bottleneck hours available

2. Cost per factory hour
Cost per factory hour = Total factory costs
Factory hours
✓ Total factory cost includes all costs with exception of Material costs
✓ Factory hours means total time available on bottleneck resource as in first ratio

3. Throughput Accounting ratio
✓ The most important ratio in this topic and it is just compilation of the above two
ratios.
✓ Throughput Accounting ratio is the rate at which a firm generates more money by
spending an hour of a bottleneck resource
Throughput Accounting ratio = Return per factory hour
Cost per factory hour
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.

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.

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✓ 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

IMPROVING THE TPAR
Options to increase the TPAR include the following:
✓ Increase the sales price for each unit sold, to increase the throughput per unit
✓ Reduce material costs per unit (e.g. by changing materials or switching suppliers),
to increase the throughput per unit
✓ reduce total operating expenses, to reduce the cost per factory hour
✓ improve the productivity of the bottleneck, e.g. the assembly workforce or the
bottleneck machine, thus reducing the time required to make each unit of product.
Throughput per factory hour would increase and therefore the TPAR would
increase.

Example
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
TZS per unit
Material cost
TZS per unit
Throughput contribution
TZS per unit
X 150 80 70
Y 120 40 80
Z 300 100 200

Conversion costs are $720,000 per day.

Required
i. 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.
ii. Calculate the TA ratio for each product.
iii. 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
= [(TZS 70 x 6,000) + (TZS 80 x 4,500) + (TZS 200 x 1,200)] – TZS 720,000
= TZS 300,000

6. Prepared by CPA(T) David Mushi


(b) TA ratio = Throughput contribution per factory hour / conversion cost per factory
hour
Conversion cost per factory hour = TZS 720,000 / 8 = TZS 90,000

Product Throughput contribution per
factory hour
Cost per factory
hour
TA ratio
X TZS 70 x 1,200 = TZS 84,000 TZS 90,000 0.93
Y TZS 80 x 1,500 = TZS 120,000 TZS 90,000 1.33
Z TZS 200 x 600 = TZS 120,000 TZS 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, A Ltd should consider ceasing production
of X.

APPLICATION OF THROUGHPUT ACCOUNTING IN DECISION MAKING
Multiproduct decision making
Throughput accounting may be applied to a multiproduct decision-making problem in
the same way as limiting factor analysis. The usual objective in questions is to maximize
profit. Given that fixed costs are unaffected by the production decision in the short run,
the approach should be to maximize the throughput earned.
STEPS
Step 1: Identify the bottleneck constraint.
Step 2: Calculate the throughput per unit for each product.
Step 3: Calculate the throughput per unit of the bottleneck resource for each product.
Step 4: Rank the products in order of the throughout per unit of the bottleneck resource.
Step 5: Allocate resources using this ranking and answer the question.

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THROUGHPUT ACCOUNTING WITH OTHER COSTING TECHNIQUES
TA is seen by some as too short term, as all costs 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 good
complement of ABC, however, since ABC focuses on labour and overhead costs.
TA attempts to maximize throughput whereas traditional systems attempt to maximize
profit. By attempting to maximize throughput an organization could be producing in
excess of the profit maximising output. Production scheduling problems inevitably mean
that the throughput maximizing output is never attained, however, and so a throughput
maximising approach could well lead to the profit maximising output being achieved.

REVIEW QUESTIONS
QUESTION 1.
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 organization, 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 utilized
85% of the time and Machines M and A are utilized 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.

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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. (5 marks)

(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. (6 marks)

QUESTION 2.
Glam Co is a hairdressing salon which provides both ‘cuts’ and ‘treatments’ to clients. All
cuts and treatments at the salon are carried out by one of the salon’s three senior stylists.
The salon also has two salon assistants and two junior stylists.
Every customer attending the salon is first seen by a salon assistant, who washes their
hair; next, by a senior stylist, who cuts or treats the hair depending on which service the
customer wants; then finally, a junior stylist who dries their hair. The average length of
time spent with each member of staff is as follows:

Cut Treatment
Hours Hours
Assistant 0·1 0·3
Senior stylist 1 1·5
Junior stylist 0·5 0·5

The salon is open for eight hours each day for six days per week. It is only closed for two
weeks each year. Staff salaries are $40,000 each year for senior stylists, $28,000 each year
for junior stylists and $12,000 each year for the assistants. The cost of cleaning products
applied when washing the hair is $0·60 per client. The cost of all additional products
applied during a ‘treatment’ is $7·40 per client. Other salon costs (excluding labour and
raw materials) amount to $106,400 each year. Glam Co charges $60 for each cut and $110

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for each treatment. The senior stylists’ time has been correctly identified as the bottleneck
activity.

Required:
(a) Briefly explain why the senior stylists’ time has been described as the ‘bottleneck
activity’, supporting your answer with calculations. (4 marks)
(b) Calculate the throughput accounting ratio (TPAR) for ‘cuts’ and the TPAR for
‘treatments’ assuming the bottleneck activity is fully utilised. (6 marks)

QUESTION 3. ACCA ADAPTED
MN manufactures automated industrial trolleys, known as TRLs. Each TRL sells for
$2,000 and the material cost per unit is $600. Labour and variable overhead are $5,500 and
$8,000 per week respectively. Fixed production costs are $450,000 per annum and
marketing and administrative costs are $265,000 per annum.
The trolleys are made on three different machines. Machine X makes the four frame panels
required for each TRL. Its maximum output is 180 frame panels per week. Machine X is
old and unreliable and it breaks down from time to time. It is estimated that, on average,
between 15 and 20 hours of production are lost per month. Machine Y can manufacture
parts for 52 TRLs per week and machine Z, which is old but reasonably reliable, can
process and assemble 30 TRLs per week.
The company has recently introduced a just-in-time (JIT) system and it is company policy
to hold little workin-progress and no finished goods inventory from week to week. The
company operates a 40-hour week, 48 weeks a year (12 months 4 weeks).
Required
Calculate the throughput accounting ratio for the key resource for an average hour next
year.

QUESTION 4.
Yam Co is involved in the processing of sheet metal into products A, B and C using three
processes, pressing, stretching and rolling. Like many businesses Yam faces tough price
competition in what is a mature world market.
The factory has 50 production lines each of which contain the three processes: Raw
material for the sheet metal is first pressed then stretched and finally rolled. The
processing capacity varies for each process and the factory manager has provided the
following data:
Processing time per metre in hours

Product A Product B Product C
Pressing 0·50 0·50 0·40
Stretching 0·25 0·40 0·25
Rolling 0·40 0·25 0·25

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The factory operates for 18 hours each day for five days per week. It is closed for only two
weeks of the year for holidays when maintenance is carried out. On average one hour of
labour is needed for each of the 225,000 hours of factory time. Labour is paid $10 per hour.
The raw materials cost per metre is $3·00 for product A, $2·50 for product B and $1·80 for
product C. Other factory costs (excluding labour and raw materials) are $18,000,000 per
year. Selling prices per metre are $70 for product A, $60 for product B and $27 for product
C. Yam carries very little inventory.

Required:
(a) Identify the bottleneck process and briefly explain why this process is described as
a 'bottleneck'.
(b) Calculate the throughput accounting ratio (TPAR) for each product assuming that
the bottleneck process is fully utilized.
(c) Assuming that the TPAR of product C is less than 1:
i. Explain how Yam could improve the TPAR of product C
ii. Briefly discuss whether this supports the suggestion to cease the production
of product C and briefly outline three other factors that Yam should
consider before a cessation decision is taken

QUESTION 5.
Ride Ltd is engaged in the manufacturing and marketing of bicycles. Two bicycles are
produced. These are the ‘Roadster’ which is designed for use on roads and the ‘Everest’
which is a bicycle designed for use in mountainous areas. The following information
relates to the year ending 31 December 2005:
(1) Unit selling price and cost data is as follows:
Roadster $ Everest $
Selling price 200 280
Material cost 80 100
Variable production conversion costs 20 60

(2) Fixed production overheads attributable to the manufacture of the bicycles will
amount to $4,050,000.
(3) Expected demand is as follows:
Roadster 150,000 units
Everest 70,000 units
(4) Each bicycle is completed in the finishing department. The number of each type of
bicycle that can be completed in one hour in the finishing department is as follows:
Roadster 6.25
Everest 5.00
There are a total of 30,000 hours available within the finishing department.

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(5) Ride Ltd operates a just in time (JIT) manufacturing system with regard to the
manufacture of bicycles and aims to hold very little work-in-progress and no
finished goods stocks whatsoever.
Required:
(a) Using marginal costing principles, calculate the mix (units) of each type of bicycle
which will maximize net profit and state the value of that profit.
(b) Calculate the throughput accounting ratio for each type of bicycle and briefly
discuss when it is worth producing a product where throughput accounting
principles are in operation. Your answer should assume that the variable overhead
cost amounting to $4,800,000 incurred as a result of the chosen product mix in part
(a) is fixed in the short-term.
(c) Using throughput accounting principles, advise management of the quantities of
each type of bicycle that should be manufactured which will maximize net profit
and prepare a projection of the net profit that would be earned by Ride Ltd in the
year ending 31 December 2005. (5 marks)
(d) Explain two aspects in which the concept of ‘contribution’ in throughput
accounting differs from its use in marginal costing. (4 marks)

QUESTION 6.
Saint Mary University is private University offering three type of CPA (T) review classes
known as Level A, Level B and Level C. Saint Mary University currently rent lecture
rooms from a neighboring government university. Saint Mary University has lecture
rooms on its premises, but it has never been put into use since it would cost TZS
100,000,000 to equip. The Managing director of Saint Mary University is keen to maximize
profits and has heard of something called ‘throughput accounting’, which help him to do
this. The following information is available:

i. All students do five subjects irrespective of which levels they are having:
• Couse 1: Financial Reporting
• Course 2: Public Finance and Taxation
• Course 3: Auditing and Assurance
• Course 4: Performance Management
• Course 5: Financial Management
ii. The fee of review classes A, B and C is TZS 540,000; TZS 700,000 and TZS 800,000
respectively per student.

iii. The only materials costs relating to the review classes are for Financial Reporting,
Public Finance and Taxation and Performance Management. These are as follows:

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Level A Level B Level C
TZS per
student
TZS per
student
TZS per
student
Financial Reporting 1,400 1,600 2,000
Public Finance and Taxation 7,000 8,000 9,000
Financial Management 5,000 5,000 5,000

iv. There are five members of staff employed by Saint Mary University. Each works
standard 40-hour week for 50 weeks of the year, a total of 2,000 hours each per
annum. Their salaries are as follows:

Lecturer Salary per annum TZS
Financial Reporting 4,000,000
Public Finance and Taxation 3,600,000
Auditing and Assurance 7,000,000
Performance Management 9,000,000
Financial Management 5,000,000

The only other Saint Mary University cost (comparable to ‘factor cost’ in a
traditional manufacturing environment) are general overheads, which include the
lecture room cost, amount to TZS 20,000,000 per annum.

v. Maximum annual demand for level A, Level B and level C 700, 800 and 1,200
students respectively. Time spent by each of the five different staff members on
each CPA(T) review class level is as follows:

Level A Level B Level C
TZS per
student
TZS per
student
TZS per
student
Financial Reporting 0.25 0.25 0.25
Public Finance and Taxation 0.27 0.25 0.30
Auditing and Assurance 0.24 0.28 0.30
Performance Management 0.75 1.00 1.25
Financial Management 0.60 0.70 0.74

Part hours are shown as decimals e.g.0.25 hours = 15 minutes (0.25 x 60). Lecturer
of performance management’s hours have been correctly identified as bottleneck
resource.

Required
i. Calculate the throughput accounting ratio for Level C. use hours as provided
in the table
ii. Calculate optimum product mix and the maximum profit per annum