Making the right call with Throughput Accounting
Review
In my last posting I presented an example of a manufacturing company using traditional Cost Accounting (CA) to decide whether a $4,000 purchase of a fixture should be approved or not. Based upon the CA calculations, by purchasing and installing the fixture, the Net Profit improved by $8,500, so it would have been approved. However, if TOC and Throughput Accounting are applied the CI Team’s proposal actually added 2 minutes to workstation 2, and the “apparent capacity” of the line was reduced and would have been rejected, which makes option D: “No, it will actually result in a loss because fewer parts will be made as a result of the proposed change” the correct answer to the question I posed last week.
Here is the breakdown of the results for last week’s question:
Option A: Yes, exactly how it was calculated at $8,500 per year (0%)
Option B: Yes, $4,500 in the first year and then $8,500 each year thereafter (44%)
Option C: I don’t know (16%)
Option D: No, it will actually result in a loss because fewer parts will be made as a result of the proposed change (40%)
In today’s posting we’ll run through the same justification scenario using TOC and Throughput Accounting (TA) to see why our conclusion would have been different.
Current conditions
This company is currently selling 2,000 pieces of a product produced for $500 each. The following is a table summarizing the costs of materials, labor and overhead which were then combined to form the $153.50 standard cost of each part as follows:
Cost Element |
Cost |
Raw Materials |
$ 60.00 |
Direct Labor (55 minutes @ $0.3000) |
11.00 |
Overhead (55 minutes @ $1.8029) |
82.50 |
Standard Unit Cost |
$153.50 |
You will recall that the CI Team had come up with an improvement that involves the purchase of a fixture costing only $4,000 and that the CI Team had concluded that if the fixture was purchased and installed, according to them, would have reduced the overall time to produce a unit of product by 2 minutes as follows:
Workstation |
Original Processing Times |
Proposed Processing Times |
101 |
10 minutes |
6 minutes |
102 |
20 minutes |
22 minutes |
103 |
10 minutes |
10 minutes |
104 |
6 minutes |
6 minutes |
Total Time |
46 minutes |
44 minutes |
The first question to ask
Let’s now look at this proposal using both TOC and Throughput Accounting (TA). First we need to answer an important question that should always be asked in this type of scenario: “What prevents the firm from increasing Throughput?”
It’s important to note that this question is rarely raised in a CA scenario because the over-riding focus is on cost reduction and not revenue enhancement. The answer to our question of what prevents the firm from increasing throughput is simply a function of focus. This leads us to a deeper question: “Where is the system constraint?”
By identifying and focusing improvements on that part of the process that is limiting throughput (the constraint) it becomes relatively easy to see an increase in throughput.
Identifying the true constraint
It’s important to understand the definition of a constraint. A constraint is any factor that limits a company from achieving more “goal units.” In our example, our goal is to produce and sell more product to our customers. Based upon this definition, in our example the constraint appears to be workstation 2, since the length of time it takes to process parts is the largest amount of time at 20 minutes. The fact is this process will not produce any additional parts until the processing time at workstation 2 is reduced. But is workstation 2 the true constraint? We’ll come back to this question shortly.
Rejected by TOC
First, let’s look at how TOC would evaluate this process and the purchase of this fixture. In the first place, we know intuitively that reducing the processing time at workstation 1 by 4 minutes would have absolutely no effect on the production rate of this process simply because workstation 2 dictates the output of the process. Based upon the original processing times, the capacity of this process is one part every 20 minutes. And because part of the CI Team’s plan was to actually increase the processing time at workstation 2 by 2 minutes (the apparent constraint) their idea actually reduces the capacity of this process by 2 minutes per part. So by just using this simple TOC logic, the CI Team’s proposal would have been rejected.
The true capacity
Before we go through any TA calculations (if we in fact need to) to see the financial impact of the CI Team’s proposal, let’s make sure that workstation 2 is the true constraint by first determining the true capacity of this production line.
- Each work station has 40 hours per week of available work time for 50 weeks during the year, or 2,000 hours per year (i.e. 40 hours/week x 50 weeks = 2,000 hours). Converting this time to minutes, we see that this process has 120,000 minutes available per year to produce parts (i.e. 2,000 hours/year x 60 minutes/hour = 120,000 minutes/year).
- If we divide this amount by the constraint time of 20 minutes we can determine the true capacity of this production line.
The true capacity of this process is 120,000 minutes ÷ 20 minutes per part resulting in 6,000 parts per year that could be produced on this production line.
As we can see, the capacity of this production line is far in excess of the total parts currently being sold (i.e. 2,000). The fact that this company’s capacity far exceeds the demand means that in this case the constraint is not workstation 2, it is external to the company. That is, the market is the constraint because this company has the capacity to produce and sell up to 6,000 parts in its current configuration. In this example, there is no need for any financial calculations because they only need to know why they are only selling one third of their capacity.
What would you do?
Next time
In my next posting we’ll answer this question and others that have been asked in this series.
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