# 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.

## 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).

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).

## 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.

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]

## 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.

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:

• Throughput (T) is the rate at which the system produces "goal units." When the goal units are money [6] (in for-profit businesses), throughput is net sales (S) less totally variable cost (TVC), generally the cost of the raw materials (T = S – TVC). Note that T only exists when there is a sale of the product or service. Producing materials that sit in a warehouse does not form part of throughput but rather investment. ("Throughput" is sometimes referred to as "throughput contribution" and has similarities to the concept of "contribution" in marginal costing which is sales revenues less "variable" costs – "variable" being defined according to the marginal costing philosophy.)
• Investment (I) is the money tied up in the system. This is money associated with inventory, machinery, buildings, and other assets and liabilities. In earlier Theory of Constraints (TOC) documentation, the "I" was interchanged between "inventory" and "investment." The preferred term is now only "investment." Note that TOC recommends inventory be valued strictly on totally variable cost associated with creating the inventory, not with additional cost allocations from overhead.
• Operating expense (OE) is the money the system spends in generating "goal units." For physical products, OE is all expenses except the cost of the raw materials. OE includes maintenance, utilities, rent, taxes and payroll.

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

${\displaystyle {\text{Throughput}}={\text{Sales revenue – Total Variable Costs}}}$ [7]
${\displaystyle {\text{Throughput accounting Ratio}}={\text{Return per factory hour}}/{\text{Cost per factory hour}}}$ [8]

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 Department Total Cost ($) Hours Available per month Cost per hour ($) Foundry 7,300.00 160 45.63 Metal shop 3,300.00 160 20.63 Total 10,600.00 320 33.13
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 Streetcars Rail coach Monthly Demand 15 40 Price $280$350 Foundry Time (hrs) 3.0 2.0 Metalwork Time (hrs) 1.5 4.0 Total Time 4.5 6.0 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 Contract Take Contract Coaches Produced 40 34 Streetcars Produced 0 15 Foundry Hours 80 113 Metal shop Hours 160 159 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.

## Related Research Articles

Cost accounting is defined as "a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods and performing services in the aggregate and in detail. It includes methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them with standard costs." (IMA) Often considered a subset of managerial accounting, its end 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.

In management accounting or managerial accounting, managers use accounting information in decision-making and to assist in the management and performance of their control functions.

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 highest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.

Inventory or stock refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation.

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.

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". That means that organizations and processes 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.

Focused improvement in the theory of constraints is an ensemble of activities aimed at elevating the performance of any system, especially a business system, with respect to its goal by eliminating its constraints one by one and by not working on non-constraints.

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

The Goal is a management-oriented novel by Eliyahu M. Goldratt, a business consultant known for his theory of constraints, and Jeff Cox, an 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.

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. Therefore this model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

In accounting and economics, fixed costs, also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or rents being paid per month. These costs also tend to be capital costs. This is in contrast to variable costs, which are volume-related and unknown at the beginning of the accounting year. Fixed costs have an effect on the nature of certain variable costs.

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.

In the field of accounting, when reporting the financial statements of a company, accounting constraints are boundaries, limitations, or guidelines.

Throughput is rate at which a product is moved through a production process and is consumed by the end-user, usually measured in the form of sales or use statistics. The goal of most organizations is to minimize the investment in inputs as well as operating expenses while increasing throughput of its production systems. Successful organizations which seek to gain market share strive to match throughput to the rate of market demand of its products.

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.

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.

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.

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