Throughput accounting

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Throughput accounting (TA) is a principle-based and simplified management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting. It is an approach that identifies factors that limit an organization from reaching its goal, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt [1] as an alternative to traditional cost accounting. As such, Throughput Accounting [2] is neither cost accounting nor costing because it is cash focused and does not allocate all costs (variable and fixed expenses, including overheads) to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output (see definition of T below for TVC) e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. [3] Throughput Accounting is a management accounting technique used as the performance measure in the Theory of Constraints (TOC). [4] It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the speed or rate at which throughput (see definition of T below) is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations.

Management accounting field of business administration, part of the internal accounting system of a company

In management accounting or managerial accounting, managers use the provisions of accounting information in order to better inform themselves before they decide matters within their organizations, which aids their management and performance of control functions.

Eliyahu M. Goldratt Israeli physicist and management guru

Eliyahu Moshe Goldratt was an Israeli business management guru. He was the originator of the Optimized Production Technique, the Theory of Constraints (TOC), the Thinking Processes, Drum-Buffer-Rope, Critical Chain Project Management (CCPM) and other TOC derived tools.

Cost accounting financial term

Cost accounting is the process of recording, classifying, analyzing, summarizing, and allocating costs associated with a process, and then developing various courses of action to control the costs. Its goal is to advise the management on how to optimize business practices and processes based on cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

Contents

Management accounting is an organization's internal set of techniques and methods used to maximize shareholder wealth. Throughput Accounting is thus part of the management accountants' toolkit, ensuring efficiency where it matters as well as the overall effectiveness of the organization. It is an internal reporting tool. Outside or external parties to a business depend on accounting reports prepared by financial (public) accountants who apply Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB) and enforced by the U.S. Securities and Exchange Commission (SEC) and other local and international regulatory agencies and bodies such as International Financial Reporting Standards (IFRS).

Financial Accounting Standards Board

The Financial Accounting Standards Board (FASB) is a private, non-profit organization standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles (GAAP) within the United States in the public's interest. The Securities and Exchange Commission (SEC) designated the FASB as the organization responsible for setting accounting standards for public companies in the US. The FASB replaced the American Institute of Certified Public Accountants' (AICPA) Accounting Principles Board (APB) on July 1, 1973.

U.S. Securities and Exchange Commission government agency

The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government. The SEC holds primary responsibility for enforcing the federal securities laws, proposing securities rules, and regulating the securities industry, the nation's stock and options exchanges, and other activities and organizations, including the electronic securities markets in the United States.

International Financial Reporting Standards technical standard

International Financial Reporting Standards, usually called IFRS, are standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB) to provide a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. They are a consequence of growing international shareholding and trade and are particularly important for companies that have dealings in several countries. They are progressively replacing the many different national accounting standards. They are the rules to be followed by accountants to maintain books of accounts which are comparable, understandable, reliable and relevant as per the users internal or external. IFRS, with the exception of IAS 29 Financial Reporting in Hyperinflationary Economies and IFRIC 7 Applying the Restatement Approach under IAS 29, are authorized in terms of the historical cost paradigm. IAS 29 and IFRIC 7 are authorized in terms of the units of constant purchasing power paradigm. IAS 2 is related to inventories in this standard we talk about the stock its production process etc IFRS began as an attempt to harmonize accounting across the European Union but the value of harmonization quickly made the concept attractive around the world. However, it has been debated whether or not de facto harmonization has occurred. Standards that were issued by IASC are still within use today and go by the name International Accounting Standards (IAS), while standards issued by IASB are called IFRS. IAS were issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On 1 April 2001, the new International Accounting Standards Board (IASB) took over from the IASC the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and Standing Interpretations Committee standards (SICs). The IASB has continued to develop standards calling the new standards "International Financial Reporting Standards".

Throughput Accounting improves profit performance with better management decisions by using measurements that more closely reflect the effect of decisions on three critical monetary variables (throughput, investment (AKA inventory), and operating expense — defined below).

Throughput is the movement of inputs and outputs through a production process. Without access to and assurance of a supply of inputs, a successful business enterprise would not be possible.

In general, to invest is to distribute money in the expectation of some benefit in the future. For example, investment in durable goods, in real estate by the service industry, in factories for manufacturing, in product development, and in research and development. However, this article focuses specifically on investment in financial assets.

Inventory goods held for resale

Inventory or stock is the goods and materials that a business holds for the ultimate goal of resale.

History

When cost accounting was developed in the 1890s, labor was the largest fraction of product cost and could be considered a variable cost. Workers often did not know how many hours they would work in a week when they reported on Monday morning because time-keeping systems were rudimentary. Cost accountants, therefore, concentrated on how efficiently managers used labor since it was their most important variable resource. Now however, workers who come to work on Monday morning almost always work 40 hours or more; their cost is fixed rather than variable. However, today, many managers are still evaluated on their labor efficiencies, and many "downsizing," "rightsizing," and other labor reduction campaigns are based on them.

Goldratt argues that, under current conditions, labor efficiencies lead to decisions that harm rather than help organizations. Throughput Accounting, therefore, removes standard cost accounting's reliance on efficiencies in general, and labor efficiency in particular, from management practice. Many cost and financial accountants agree with Goldratt's critique, but they have not agreed on a replacement of their own and there is enormous inertia in the installed base of people trained to work with existing practices.

Standard cost accounting is a traditional cost accounting method introduced in the 1920s, as an alternative for the traditional cost accounting method based on historical costs.

Constraints accounting, which is a development in the Throughput Accounting field, emphasizes the role of the constraint, (referred to as the Archemedian constraint) in decision making. [5]

In mathematics, a constraint is a condition of an optimization problem that the solution must satisfy. There are several types of constraints—primarily equality constraints, inequality constraints, and integer constraints. The set of candidate solutions that satisfy all constraints is called the feasible set.

The concepts of Throughput Accounting

Goldratt's alternative begins with the idea that each organization has a goal and that better decisions increase its value. The goal for a profit maximizing firm is stated as, increasing net profit now and in the future. Profit maximization seen from a Throughput Accounting viewpoint, is about maximizing a system's profit mix without Cost Accounting's traditional allocation of total costs. Throughput Accounting actions include obtaining the maximum net profit in the minimum time period, given limited resource capacities and capabilities. These resources include machines, capital (own or borrowed), people, processes, technology, time, materials, markets, etc. Throughput Accounting applies to not-for-profit organizations too, where they develop their goal that makes sense in their individual cases, and these goals are commonly measured in goal units.

In economics, profit maximization is the short run or long run process by which a firm may determine the price, input, and output levels that lead to the greatest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.

Throughput Accounting also pays particular attention to the concept of 'bottleneck' (referred to as constraint in the Theory of Constraints) in the manufacturing or servicing processes.

Throughput Accounting uses three measures of income and expense:

The chart illustrates a typical throughput structure of income (sales) and expenses (TVC and OE).
T=Sales less TVC and NP=T less OE. ThroughputStructure.jpg
The chart illustrates a typical throughput structure of income (sales) and expenses (TVC and OE).
T=Sales less TVC and NP=T less OE.

Organizations that wish to increase their attainment of The Goal should therefore require managers to test proposed decisions against three questions. Will the proposed change:

  1. Increase throughput? How?
  2. Reduce investment (inventory) (money that cannot be used)? How?
  3. Reduce operating expense? How?

The answers to these questions determine the effect of proposed changes on system wide measurements:

  1. Net profit (NP) = throughput – operating expense = T – OE
  2. Return on investment (ROI) = net profit / investment = NP/I
  3. TA Productivity = throughput / operating expense = T/OE
  4. Investment turns (IT) = throughput / investment = T/I

These relationships between financial ratios as illustrated by Goldratt are very similar to a set of relationships defined by DuPont and General Motors financial executive Donaldson Brown about 1920. Brown did not advocate changes in management accounting methods, but instead used the ratios to evaluate traditional financial accounting data.

Explanation

[7]
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For example: The railway coach company was offered a contract to make 15 open-topped streetcars each month, using a design that included ornate brass foundry work, but very little of the metalwork needed to produce a covered rail coach. The buyer offered to pay $280 per streetcar. The company had a firm order for 40 rail coaches each month for $350 per unit.

The cost accountant determined that the cost of operating the foundry vs. the metalwork shop each month was as follows:
Overhead Cost by DepartmentTotal Cost ($)Hours Available per monthCost per hour ($)
Foundry7,300.0016045.63
Metal shop3,300.0016020.63
Total10,600.0032033.13
The company was at full capacity making 40 rail coaches each month. And since the foundry was expensive to operate, and purchasing brass as a raw material for the streetcars was expensive, the accountant determined that the company would lose money on any streetcars it built. He showed an analysis of the estimated product costs based on standard cost accounting and recommended that the company decline to build any streetcars.
Standard Cost Accounting Analysis StreetcarsRail coach
Monthly Demand1540
Price$280$350
Foundry Time (hrs)3.02.0
Metalwork Time (hrs)1.54.0
Total Time4.56.0
Foundry Cost$136.88$91.25
Metalwork Cost$30.94$82.50
Raw Material Cost$120.00$60.00
Total Cost$287.81$233.75
Profit per Unit$ (7.81)$116.25
However, the company's operations manager knew that recent investment in automated foundry equipment had created idle time for workers in that department. The constraint on production of the railcoaches was the metalwork shop. She made an analysis of profit and loss if the company took the contract using throughput accounting to determine the profitability of products by calculating "throughput" (revenue less variable cost) in the metal shop.
Throughput Cost Accounting Analysis Decline ContractTake Contract
Coaches Produced4034
Streetcars Produced015
Foundry Hours80113
Metal shop Hours160159
Coach Revenue$14,000$11,900
Streetcar Revenue$0$4,200
Coach Raw Material Cost$(2,400)$(2,040)
Streetcar Raw Material Cost$0$(1,800)
Throughput Value$11,600$12,260
Overhead Expense$(10,600)$(10,600)
Profit$1,000$1,660
After the presentations from the company accountant and the operations manager, the president understood that the metal shop capacity was limiting the company's profitability. The company could make only 40 rail coaches per month. But by taking the contract for the streetcars, the company could make nearly all the railway coaches ordered, and also meet all the demand for streetcars. The result would increase throughput in the metal shop from $6.25 to $10.38 per hour of available time, and increase profitability by 66 percent.

Relevance

One of the most important aspects of Throughput Accounting is the relevance of the information it produces. Throughput Accounting reports what currently happens in business functions such as operations, distribution and marketing. It does not rely solely on GAAP's financial accounting reports (that still need to be verified by external auditors) and is thus relevant to current decisions made by management that affect the business now and in the future. Throughput Accounting is used in Critical Chain Project Management (CCPM), [9] Drum Buffer Rope (DBR)—in businesses that are internally constrained, in Simplified Drum Buffer Rope (S-DBR) [10] —in businesses that are externally constrained (particularly where the lack of customer orders denotes a market constraint), as well as in strategy, planning and tactics, etc.

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Finance academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

The theory of constraints (TOC) is a management paradigm that views any manageable system as being limited in achieving more of its goals by a very small number of constraints. There is always at least one constraint, and TOC uses a focusing process to identify the constraint and restructure the rest of the organization around it. TOC adopts the common idiom "a chain is no stronger than its weakest link". This means that processes, organizations, etc., are vulnerable because the weakest person or part can always damage or break them or at least adversely affect the outcome.

The thinking processes in Eliyahu M. Goldratt's theory of constraints are the five methods to enable the focused improvement of any cognitive system.

Cost of goods sold carrying value of goods sold during a particular period

Cost of goods sold (COGS) refers to the carrying value of goods sold during a particular period.

<i>The Goal</i> (novel) book

The Goal is a management-oriented novel by Eliyahu M. Goldratt, a business consultant known for his Theory of Constraints, and Jeff Cox, a best selling author and co-author of multiple management-oriented novels. The Goal was originally published in 1984 and has since been revised and republished. This book can be used for case studies in operations management, with a focus geared towards the Theory of Constraints, bottlenecks and how to alleviate them, and applications of these concepts in real life. It is used in management colleges to teach students about the importance of strategic capacity planning and constraint management. Time Magazine listed the book as one of "The 25 Most Influential Business Management Books.

This is a list of topics related to the Theory of constraints.

Activity-based costing method of measuring economic consumption

Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

Operating expense operating expenses

An operating expense, operating expenditure, operational expense, operational expenditure or opex is an ongoing cost for running a product, business, or system. Its counterpart, a capital expenditure (capex), is the cost of developing or providing non-consumable parts for the product or system. For example, the purchase of a photocopier involves capex, and the annual paper, toner, power and maintenance costs represents opex. For larger systems like businesses, opex may also include the cost of workers and facility expenses such as rent and utilities.

<i>Critical Chain</i> (novel) book by Eliyahu Goldratt

Critical Chain is a novel by Dr. Eliyahu Goldratt using the Critical Chain theory of Project Management as the major theme. It is really a teaching method for the theory.

Overhead (business) overhead

In business, overhead or overhead expense refers to an ongoing expense of operating a business. Overheads are the expenditure which cannot be conveniently traced to or identified with any particular cost unit, unlike operating expenses such as raw material and labor. Therefore, overheads cannot be immediately associated with the products or services being offered, thus do not directly generate profits. However, overheads are still vital to business operations as they provide critical support for the business to carry out profit making activities. For example, overhead costs such as the rent for a factory allows workers to manufacture products which can then be sold for a profit. Such expenses are incurred for output generally and not for particular work order; e.g., wages paid to watch and ward staff, heating and lighting expenses of factory, etc. Overheads are also very important cost element along with direct materials and direct labor.

Financial management focuses on ratios, equity and debt. It is useful for portfolio management,distribution of dividend,capital raising,hedging and looking after fluctuations in foreign currency and product cycles.Financial managers are the people who will do research and based on the research, decide what sort of capital to obtain in order to fund the company's assets as well as maximizing the value of the firm for all the stakeholders. It also refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. It is the specialized function directly associated with the top management. The significance of this function is not seen in the 'Line' but also in the capacity of the 'Staff' in overall of a company. It has been defined differently by different experts in the field.

Management accounting principles Management accounting case

Management accounting principles (MAP) were developed to serve the core needs of internal management to improve decision support objectives, internal business processes, resource application, customer value, and capacity utilization needed to achieve corporate goals in an optimal manner. Another term often used for management accounting principles for these purposes is managerial costing principles. The two management accounting principles are:

  1. Principle of Causality and,
  2. Principle of Analogy.
J. Lee Nicholson American economist

Jerome Lee Nicholson was an American accountant, industrial consultant, author and educator at the New York University and Columbia University, known as pioneer in cost accounting. He is considered in the United States to be the "father of cost accounting."

Theory of constraints (TOC) is an engineering management technique used to evaluate a manageable procedure, identifying the largest constraint (bottleneck) and strategizing to reduce task time and maximise profit. It assists in determining what to change, when to change it, and how to cause the change. The theory was established by Dr. Eliyahu Goldratt through his 1984 bestselling novel The Goal. Since this time, TOC has continued to develop and evolve and is a primary management tool in the engineering industry. When Applying TOC, powerful tools are used to determine the constraint and reduce its effect on the procedure, including:

References

  1. Eliyahu M. Goldratt and Jeff Cox - The Goal - ISBN   0-620-33597-1.
  2. Thomas Corbett - Throughput Accounting - ISBN   0-88427-158-7.
  3. Etienne Du Plooy - Throughput Accounting Techniques - ISBN   978-0-9946979-0-5.
  4. Eric Noreen - Theory of Constraints and its Implications for Management Accounting - ISBN   978-0-88427-116-1.
  5. John A. Caspari and Pamela Caspari - Management Dynamics - ISBN   0-471-67231-9.
  6. Eliyahu M. Goldratt - The Haystack Syndrome (pp 19) - ISBN   0-88427-089-0.
  7. Performance management, Paper f5. Kaplan publishing UK. Pg 17
  8. Performance management, Paper f5. Kaplan publishing UK. Pg 17
  9. Eliyahu M. Goldratt - Critical Chain - ISBN   0-620-21256-X.
  10. Eli Schragenheim and H William Dettmer - Manufacturing at Warp Speed - ISBN   1-57444-293-7