ACCA F5 Performance Management - 2010 - Study text

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Chapter 2: Other costing systems

Throughput accounting and constraints

 The Theory of Constraints

 Constraints and bottlenecks in the system

 Dealing with constraints

 The relevance of constraints to throughput accounting

 Performance measurement ratios in throughput accounting

 Throughput accounting and decision-making

5 Throughput accounting and the Theory of Constraints

5.1 Constraints and bottlenecks in the system

Throughput accounting is derived from the Theory of Constraints, which is based

on the view that every system has a constraint. A constraint is anything that limits

the output from the system.

 If a system had no constraint, its output would be either zero or the system

would continue to produce more and more output without limit.

 Therefore for any system whose output is not zero, there must be a constraint

that stops it from producing more output than it does.

Constraints for a manufacturing company might be caused by any of the following:

 external factors, such as a limit to customer demand for the products that the

company makes

 weaknesses in the system itself, such as shortages of key resources and capacity

limitations

 weaknesses in the system’s controls, such as weak management.

In a manufacturing system, constraints can be described as bottlenecks in the

system. A bottleneck is simply a constraint that limits throughput. For example, a

bottleneck might be a shortage of materials, or a shortage of machine time.

5.2 Dealing with constraints

The management of business operations should focus on dealing with the key

constraints. The output of a system is restricted by its key constraint. Management

must identify what this is.

Action by management to improve operational efficiency is a waste of time and

effort if it is applied to any area of operations that is not a constraint. For example,

measures to improve labour efficiency are a waste of time if the key constraint is a

shortage of machine capacity.

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The key constraint limits throughput. As stated earlier, the nature of the key

constraint might be:

 limitations on sales demand

 inefficiency in production, with stoppages and hold-ups caused by wastage,

scrapped items and machine downtime

 unreliability in the supplies of key raw materials, and a shortage of key materials

 a shortage of a key production resource, such as skilled labour.

Goldratt, who developed the Theory of Constraints, argued that:

 Management should identify the key constraint and consider ways of removing

or easing the constraint, so that the system is able to produce more output.

 However, when one constraint is removed, another key constraint will take its

place.

 The new key constraint must be identified, and management should now turn

its attention to ways of removing or easing the new key constraint.

 By removing constraints one after another, the output capacity of the system will

increase.

However, there will always be a key constraint.

5.3 The relevance of constraints to throughput accounting

Goldratt argued that if the aim of a business is to make money and profit, the most

appropriate methods of doing this are to:

 increase throughput

 reduce operating expenses, or

 reduce investment, for example by reducing inventory levels (since there is a

cost to investment).

Goldratt also argued that the most effective of these three ways of increasing profit

is to increase throughput.

Throughput can be increased by identifying the bottlenecks in the system, and

taking action to remove them or ease them.

5.4 Performance measurement ratios in throughput accounting

There are several key performance measurements in throughput accounting.

One of these is net profit, which is total throughput minus Operating expenses.

An objective is to increase net profit.

Performance can also be measured using ratios:

 Return on investment

 Throughput accounting productivity

 Throughput per unit of the bottleneck resource

Chapter 2: Other costing systems

 Operating expenses per unit of the bottleneck resource

 Throughput accounting ratio.

Return on investment

This is measured as:

Net profit

× 100%

Investment

An objective should be to increase the return on investment, either by increasing net

profit or reducing the size of the investment.

Throughput productivity

This is measured as:

Throughput

× 100%

Operating expenses

An objective should be to increase throughput productivity, either by increasing

throughput or reducing operating expenses.

Throughput per unit of constraint

One of the advantages of throughput accounting is that it treats labour costs as a

fixed cost. In many manufacturing companies, where the production process has

been automated, direct labour costs are not a significant part of total production

costs.

However traditional costing systems treat direct labour as a variable cost and

assume that variable overheads vary with labour hours. In addition, fixed

overheads might be absorbed on a labour hour basis. It is often assumed that

performance will be improved by improving labour efficiency.

Throughput accounting challenges this approach to costs and performance

measurement. Labour is a fixed cost and relatively small compared to other costs.

Improving labour efficiency will therefore do little to improve performance and

increase profits.

Net profit will be improved much more effectively by identifying the constraint on

activity and seeking to maximise throughput per unit of the constraint.

Throughput accounting ratio

The throughput accounting ratio is the ratio of [throughput in a period per unit of

bottleneck resource] to [operating expenses per unit of bottleneck resource].

Units of a bottleneck resource are measured in hours (labour hours or machine

hours). This means that the throughput accounting ratio can be stated as:

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Throughput accounting ratio =

Throughput per hour of bottleneck resource

Operating expenses per hour of bottleneck resource

Example

A business manufactures product Z, which has a selling price of $20. The materials

costs are $8 per unit of Product Z. Total operating expenses each month are

$120,000.

Machine capacity is the key constraint on production. There are only 600 machine

hours available each month, and it takes three minutes of machine time to

manufacture each unit of Product Z.

Required

(a) Calculate the throughput accounting ratio.

(b) How might this ratio be increased?

Answer

(a) Throughput per unit = $(20 – 8) = $12

Throughput per machine hour = $12

× (60 minutes/3 minutes) = $240

Operating expenses per machine hour =

$120,000

600 hours

= $200

Throughput accounting ratio =

$240

$200

=1.20

(b) To increase the throughput accounting ratio, it might be possible to:

−

Raise the selling price for Product Z for each unit sold, to increase the

throughput per unit.

−

Improve the efficiency of machine time used, and so manufacture Product

Z in less than three minutes.

−

Find ways of reducing total operating expenses, in order to reduce the

operating expenses per machine hour.

5.5 Throughput accounting and decision-making

When a company can make more than one product, throughput per unit of

constraint factor can be used to rank products in order of priority for production.

Example

A company manufactures a single product, X, for which the sales price is $350 per

unit and the material cost per unit is $75.

Product X is made in two consecutive production operations, which are carried out

in Department P1 and Department P2. The capacity per month in each department

is 6,400 hours.

Chapter 2: Other costing systems

Conversion costs per week in each department are as follows:

Department

Conversion costs per month $73,600 $32,000

Hours per month capacity 6,400 6,400

Conversion cost per hour $11.50 $5

The company is operating at full capacity, and it makes and sells 400 units of

Product X each month.

It has now been offered an opportunity to make and sell 150 units of a Product Y

each month to a large customer, who will pay $310 per unit. The direct material cost

per unit of Product Y would be $150. Product Y would be made in departments P1

and P2, and the production time required per unit would be as follows:

Product X Product Y

hours per unit hours per unit

Department P1 8 12

Department P2 16 6

On the basis of ‘traditional costing’, the decision would be to reject the customer

order for 1,500 units of Product Y per month, because Product Y would appear to

make a loss.

Product

$ $

Direct materials 75

150

Conversion costs

P1 at $11.50 per hour 92

138

P2 at $5 per hour 80

Total cost per unit 247

318

Sales price 350

310

Profit/(loss) per unit 103

(8)

However, this would be an incorrect decision if the goal is to maximise profit. There

is currently spare capacity in Department P1, but time in Department P2 is a key

constraint. Profit is maximised by maximising throughput per hour worked in

Department P2.

Product

$ $

Sales price 350

310

Direct materials cost 75

150

Throughput per unit 275

160

Hours per unit in Department P2 16

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Throughput per P2 hour $17.19

$26.67

The optimal production plan is to make 150 units of Product Y per month, and use

the rest of the time to make units of Product X.

Current production plan: Make and sell 400 units of X

$ $

Total throughput: 400 × $275

110,000

Operating expenses

Department P1 73,600

Department P2 32,000

Total operating expenses 105,600

Net profit 4,400

The optimum production plan is to make 150 units of Product Y, which would

require (× 6 hours per unit) 900 hours per month. This would leave 5,500 hours of

time in Department P2 to make Product X: this would be sufficient time for

(5,500/16 hours per unit) 343 units per month.

(

Note: Making 150 units of Y and 343 units of X would require a total of 4,544 hours

in Department P1 per month. Time in Department P2 is therefore still the key

constraint.)

Optimal production plan: 150 units of Y and 343

units of X

Product Y: 150 × $160

24,000

Product X: 343 × $275

94,325

Total throughput 118,325

Operating expenses 105,600

Net profit 12,725

Net profit per month would increase by $8,325.

Paper F5

Performancemanagement

CHAPTER

Limiting factors and

linear programming

Contents

1 Costs for decision-making

2 Limiting factor decisions: single limiting factor

3 Limiting factor decisions: linear programming

4 Linear programming: graphical solution

5 Linear programming: shadow prices and slack

Paper F5: Performance management

Costs for decision-making

 Management information for making decisions

 Using marginal costing for decision-making

1 Costs for decision-making

1.1 Management information for making decisions

One of the functions of management is to make decisions about how to run the

business. Decisions involve making a choice about what should be done, between

different possible options. To help them make good-quality decisions, managers

need reliable and relevant information.

Both financial and non-financial information is needed to make decisions. This

chapter (and the chapters that follow) concentrate mainly on financial information

for decision-making, but it is useful to remember that factors of a non-financial

nature will often influence the choices that managers make.

Since it is often assumed that the aim of a business should be to maximise profits,

financial information to assist managers with decision-making will consist mainly of

information about revenues and costs.

Information for decision-making is different from information about historical costs.

This is because decisions are concerned with the future, not what has happened in

the past:

 Information about costs and revenues, to assist with decision-making, should be

about future costs and future revenues.

 Decisions should be concerned with cash and cash flow. Only those costs and

revenues that represent cash flow are relevant to decision-making. Non-cash

items of cost or revenue, such as depreciation or absorbed fixed overheads, are

not relevant for decision-making. The conventions of financial accounting and

financial reporting, such as the accruals concept, are irrelevant for business

decisions.

 It is assumed for the purpose of providing cost information for decision-making

that the aim or objective is to maximise profit.

 Historical costs are irrelevant for decision-making, because they are not future

costs. Costs that have been incurred in the past are ‘sunk costs’: they have

already happened, and any decision taken now cannot affect what has already

happened in the past.

 However, historical costs can provide a guide to what future costs will be.

Historical costs might therefore be used as information for decision-making, but

only because they provide an estimate of what costs will be in the future.

These principles of relevant costs and revenues should be applied to all decision-

making by management.

Chapter 3: Limiting factors and linear programming

Principles of relevant costing will be explained in more detail in a later chapter, but

a useful definition of relevant costs and revenues is as follows:

Relevant costs and revenues are future cash flows that would arise as a direct

consequence of a decision being taken.

1.2 Using marginal costing for decision-making

It is often assumed that marginal costs are relevant costs for the purpose of decision-

making.

 The marginal cost of a product is the extra cost that would be incurred by

making and selling one extra unit of the product.

 Similarly, the marginal cost of an extra hour of direct labour work is the

additional cost that would be incurred if a direct labour employee worked one

extra hour. When direct labour is a variable cost, paid by the hour, the marginal

cost is the variable cost of the direct labour wages plus any variable overhead

cost related to direct labour hours.

Examples of the use of marginal costing for decision-making are:

 Planning decisions: marginal costing can be used to estimate future profits. This

can be very useful when a company prepares its annual budget.

 Limiting factor decisions. Marginal costing is also used when there is a shortage

of a key resource, such as materials or skilled labour, to identify the output plan

that will maximise profits.

 Make or buy decisions. When there is a choice between making an item in-

house or buying it externally from a sub-contractor, marginal costing can be

used to decide on the profit-maximising programme for buying externally.

This chapter focuses on decision-making when there are limiting factors that restrict

operational capabilities. Decision-making techniques for limiting factor situations

are based on the assumption that as a normal rule:

 marginal costs or variable costs are the only relevant costs to consider, and

 fixed costs will be the same whatever decision is taken; therefore fixed costs are

not relevant to the decision.

Paper F5: Performance management

Limiting factor decisions: single limiting factor

 Definition of a limiting factor

 Maximising profit when there is a single limiting factor

 Identifying limiting factors

2 Limiting factor decisions: single limiting factor

2.1 Definition of a limiting factor

It is often assumed in budgeting that a company can produce as many units of its

products (or services) as is necessary to meet the available sales demand. Sales

demand is therefore normally the factor that sets a limit on the volume of

production and sales in each period.

Sometimes, however, there could be a shortage of a key production resource, such

as an item of direct materials, or skilled labour, or machine capacity. In these

circumstances, the factor setting a limit to the volume of sales and profit in a

particular period is the availability of the scarce resource, because sales are

restricted by the amount that the company can produce.

If the company makes just one product and a production resource is in limited

supply, profit is maximised by making as many units of the product as possible

with the limited resources available.

However when a company makes and sells more than one different product with

the same scarce resource, a budgeting problem is to decide how many of each

different product to make and sell in order to maximise profits.

2.2 Maximising profit when there is a single limiting factor

When there is just one limiting factor (other than sales demand), total profit will be

maximised in a period by maximising the total contribution earned with the

available scarce resources.

 The objective should be to maximise total contribution.

 This will be achieved by making the optimum use of the scarce resource and

maximising the contribution earned from each unit of the scarce resource that is

used.

 Products should therefore be ranked in order of priority for manufacture and

sale according to the contribution earned by each product (or service) for each

unit of the scarce resource that the product uses.

 The products or services should be produced and sold in this order of priority,

up to the maximum expected sales demand for each product.

ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing

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