Strategic Cost Management - Throughput Costing

 

Strategic Cost Management

Throughput Costing

 

Part A: Discussion of relevant theories and explanation of different formulas

Part B: Three Illustrations along with Solutions

Part A

Introduction

Throughput Costing is a management accounting technique used as a performance measure in the theory of constraints. It is the business intelligence used for maximizing profits. It focuses importance on generating more throughputs. It seeks to increase the velocity or speed of production of products and services keeping in view of constraints. It is based on the concept that a company must determine its overriding goal and then it should create a system that clearly defines the main capacity constraint that allows it to maximize that goal.

 

Throughput Costing is a system of performance measurement and costing which traces costs to throughput time. It is claimed that it complements JIT principles and forces attention to the true determinants of profitability. Throughput Costing is defined as follows:

 

“Throughput Costing is a management accounting system which focuses on ways by which the maximum return per unit of bottleneck activity can be achieved” – CIMA Terminology.

 

Throughput Concepts and Definitions

Throughput:

Throughput is calculated as ‘selling price less direct material cost.’ This is different from the calculation of ‘contribution’, in which both labour costs and variable overheads are also deducted from selling price. In other words, throughput is the excess of sales value over the totally variable cost. That is nothing but contribution margin left after a product’s price is reduced by the amount of its totally variable cost. [Throughput = Sale Value – Totally Variable Cost (here, Totally Variable Cost = Direct Material Cost)]

 

Totally Variable Cost:

This cost is incurred only if a product is produced. In many cases only direct materials are considered as totally variable cost. Direct labour is not totally variable, unless piece rate wages are paid.

 

Capacity Constraints:

It is a resource within a company that limits its total output. For example, it can be a machine that can produce only a specified amount of a key component in a given time period, thereby keeping overall sales from expanding beyond the maximum capacity of that machine. There may be more than one capacity constraint in a company, but rarely more than one for a specified product or product line.

 

Total Cycle Time (TCT):

Total cycle time is the average time required to convert raw materials into finished goods ready to be shipped to customer. It includes the time required for activities such as material handling, production processing, inspecting and packaging.

 

Total Factory Cost (TFC):

With the exception of material costs, in the short run, most factory costs (including direct labour) are fixed. These fixed costs can be grouped together and called total factory costs (TFC).

 

Throughput Efficiency and Throughput Cost:

Throughput efficiency is the relation of throughput achieved to resources used.

Throughput efficiency =	[(Throughput cost) ÷ (Actual TFC)] × 100%
Throughput cost =	Total standard hours on bottleneck resource for actual production during the period × Cost per factory hour

 

Throughput Time Ratio:

It is the ratio of time spent adding customer value to products and services divided by total cycle time. It is also known as the ‘ratio of work content to lead time’.

 

Operating Expenses:

This is sum total of all company expenses including totally variable expenses. It should be noted that throughput costing does not care, if a cost is semi-variable, fixed or allocated – all costs that are not totally variable is lumped together for throughput costing purpose. This group of expenses is considered the price that a company pays to ensure that it maintains its current level of capacity.

 

Investment:

This term is used here also, as it is used in common parlance, i.e. any application of funds, which is intended to provide a return by way of interest, dividend or capital appreciation. But here, however, there is a particular emphasis on company’s investment in working capital.

 

Manufacturing Response Time:

With JIT, products should not be made unless there is a customer waiting for them, because the ideal inventory level is zero. The effect of this will be that there will be idle capacity in some operations except the operation which is bottleneck at the moment. Working on output just to increase WIP or Finished Goods stocks creates no profit and so would not be encouraged.

 

This means that profit is inversely proportional to the level of inventory in the system. It can be expressed as follows:

Profit ∝ (1 ÷ MRT)

Where, MRT = Manufacturing Response Time

 

Profitability:

This concept emphasises that profitability is determined by how quickly goods can be produced to satisfy customer’s order. Production for stock does not create profits. Improving the throughput of bottleneck operations will increase the rate at which customer demand can be met and will improve the profitability. Contribution in its traditional form (sales – variable costs) is not a good guide of profitability because it ignores capacity factors and rate of production.

 

(1)	Return per factory hour (Product-wise) =
	(Sales Price per unit – material Cost per unit) ÷ (Product Time per unit on key resource in hours)
	= Throughput per unit ÷ Product Time per unit on key resource in hours
(2)	Cost per factory hour =
	Total factory costs (TFC) ÷ Total time available on key resource

 

The return and cost per factory hour are combined into the Throughput Costing Ratio (TC Ratio) as follows:

 

TC Ratio =

[Return per factory hour (or minute)] ÷ [Cost per factory hour (or minute)]

 

The TC Ratio should be greater than 1. If it is less than 1 the product will lose money for the company and the company should consider withdrawing it from the market.

 

The TC ratio can be considered in total terms by comparing the total return from the throughput with the TFC, i.e.

 

Primary TC Ratio =

[Total return from throughput (i.e. Sales-Material Costs)] ÷ [TFC (i.e., all costs other than materials)]

 

Throughput Costing and

Contribution Approach

Throughput Costing has certain similarities with the traditional approach of maximizing contribution per unit of scarce resource. However, there are certain differences. In throughput costing return is defined as sales less material costs in contrast to contribution which is sales less all variable costs, i.e., material, labour, overheads. The assumption (i.e., emphasis) in throughput costing is that all costs except material are fixed in relation to throughput in short run. Eminent management accountants like Kaplan and Shank have criticized throughput costing for its short-term emphasis. Besides, throughput costing does not appear to be useful in JIT environment. Throughput helps to direct attention to bottlenecks and forces management to concentrate on the key elements in making profits and approach adopted to gain this objective is reduction in inventory and reducing response time to customer demand.

 

Basic logic of throughput costing and

Comparison with absorption costing

Throughput costing assigns only unit level spending for direct costs as the cost of products or services. Advocates of throughput costing argue that adding any other indirect cost, past or committed cost, to product cost creates improper incentives to drive down the average cost per unit by making more products than that can be used or sold. Since these are committed costs, making more units with the same level of spending arithmetically reduces the average cost per unit and makes the production process appear to be more efficient. Throughput costing avoids this incentive because the cost per unit depends only on the unit level spending (i.e., cost of materials) not how many units are made. Using throughput costing means that cost management analyst must distinguish between

(a)          Spending for resources caused by the decision to produce different levels of products and services, and

(b)          The use of resources that organisation has committed to supply regardless of level of products and services provided.

 

Steps to be followed

To increase the throughput

The theory of constraints is applied within an organisation by following what are called ‘the five focusing steps.’ These are a tool that Goldratt developed to help organisations deal with constraints, otherwise known as bottlenecks, within the system as a whole (rather than any discrete unit within the organisation.) The steps are as follows:

a)             Identify the bottle neck in the system i.e., identification of the limiting factor of the production (or) process such as installing capacity or hours etc.

b)             Decide how to exploit the systems bottleneck that means bottleneck resource should be actively and effectively used as much as possible to produce as many goods as possible.

c)             Subordinate everything else to the decision made in step (b). The production capacity of the bottleneck resource should determined production schedule.

d)             Augment the capacity of the bottleneck resource with the minimum capital input.

e)             Identify the new bottlenecks in the process and repeat the same above steps to address the bottlenecks.

 

Problems with throughput costing

1.         When throughput costing is the driving force behind all production scheduling, a customer that has already placed an order for a product, which will result in a sub-optimal profit level for the manufacturing, may find that its order is never filled.

2.         The company’s ability to create the highest level of profitability is now dependent on the production scheduling staff, who decides, what products are to be     manufactured and in what order.

3.         Another issue is that all costs are totally variable in the long-run since the management then, has the time to adjust them to long-range production volumes.

 

Reporting under throughput costing

When the throughput model is used for financial reporting purposes, the format appears slightly different. The income statement includes only direct materials in the cost of goods sold, which results in a ‘throughput contribution instead of gross margin. All other costs are jumped into an ‘Operating Expenses’ category below the throughput contribution margin, yielding a net income figure at the bottom. All other financial reports stay the same.

 

Though this single change appears relatively minor, it has significant impact. The primary change is that throughput costing does not charge any operating expenses to inventory so that they can be expressed in future period. Instead, all operating expenses are realized during the current period. As a result, any incentive for managers to overproduce is completely eliminated because they cannot use the excess amount to shift expenses out of current period, thereby making their financial results look better than they would otherwise. Though this is a desirable result, such a report can be used only for internal reporting because of the requirement of generally accepted accounting principles that some overheads should be charged to excess production.

 

Systematic changes required

For acceptance of the throughput costing

Throughput costing does not have a logical linkage with the more traditional form of cost accounting. This makes it difficult for it to gain acceptance. The main problem is that this method does not use cost as the basis for the most optimal production decisions. This is entirely contrary to the teachings of any other type of costing which holds that the highest margin products should always be produced first. Now question is whether the enterprise should either use throughput or traditional costing exclusively or is there any way to merge the two. Following discussion relates to this issue:

 

a)  Inventory Valuation:

Generally accepted accounting principles clearly state that cost of overhead must be apportioned to inventory. Throughput costing states that none of the overhead cost should be so assigned. In this case, since the rules are so clear, it is apparent that throughput costing loses. The existing system must continue to assign costs irrespective of how throughput principles are used for other decision making (short range) activities.

 

b)  Inventory Investment Analysis:

There are fundamental differences between the two methodologies. Both hold that the objectives always to keep one’s investment at a minimum. In the case of traditional cost accounting, this is because the return on investment is higher when the total amount of investment is forced to the lowest possible level.

 

Throughput costing, however, wants to shrink the amount of investment because it includes work-in-progress inventory in this category. It tries to keep WIP levels down so that waste is reduced in the production system. In short, first system advocates a small investment for financial reasons, while later system favours it because it makes more operational sense. Despite the differences in reasoning, the same conclusion is reached by both methodologies. However, throughput approach is still better, for it forces one to analyse all inventory reduction projects in light of how they together will impact the capacity constraint rather than individually.

 

c)   Capital Investment Analysis:

Traditional cost accounting only analyses each investment proposal on its own rather than considering its impact on the production processes as a whole. It tends to recommend investments that will result in an incremental investment but no overall change in the level of corporate capacity, which is driven by capacity constraint. Throughput costing, however, has a tight focus on investment only in areas that impact capacity constraint – to other investment proposals are rejected. In this instance, it is best to reject the traditional system and conduct analysis based on throughput principles.

 

d)  Product Costing:

Under throughput costing, a product has only a totally variable cost, which may be far lower than the fully absorbed cost that would be assigned to it under more traditional costing system. This totally variable cost is almost always direct materials, which is an easily calculated figure. Full absorption costing, however, requires a large amount of calculation effort, before a detailed cost can be compiled for a product. For companies selling to Government under cost-plus contracts, there are lengthy detailed requirement as to what variable and overhead costs should be assigned to each product manufactured. These rules virtually require the use of absorption costing – throughput costing is not a viable solution. For companies, that do not require detailed costing justifications while selling their products, it may be possible to use the much simpler throughput costing approach.

 

e)   Production Scheduling:

Traditional systems do not include any kind of throughput costing that tells production planners which orders should be produced first. These days with throughput costing, it is possible to customize existing systems or to upgrade packaged software so that this option is available to planner. This would allow them to produce the items that result in the highest throughput per minute of the capacity constraint. Here it is difficult to fully support the throughput approach. Any company that has already received a customer has an obligation to fill it, even if the resulting sale will reduce its overall level of profit from the theoretical maximum that can be calculated with throughput costing.

 

Maximising short-term profit by ignoring orders is tantamount to long-term suicide since customers will leave in droves. Consequently, production planners should be left alone to schedule production in the traditional manner rather than basing their decisions on short-term profit maximisation.

 

f)    Long-term planning:

This is the main application area of throughput costing. The enterprise should estimate the approximate sales levels for each product for a long-time frame enter into a throughput model and determine what mix of prospective sales will result in the highest level of profitability. This method is much superior to use of throughput costing for short-term production decisions, since long-term planning sidesteps problems by avoiding existing customer orders that will result in low profits. Long-term planning does not involve existing customer orders so that decisions to produce various types of products at different price points can be made before the sales force goes out to obtain order.

 

g)  Price Setting:

Throughput costing is favoured by the sales and marketing staff favours throughput costing because the margin on products is simple to obtain-just subtract totally variable costs from the price. This beats the incomprehensible image of allocations accompanying activity based costing. Price setting in throughput environment focuses more on what products can be inserted into the existing production mix at a price that will incrementally increase overall profitability, rather than the painful accumulation and allocation of costs to specific products. Throughput costing is the clear choice here based on case of understandability and the speed with which information can be accumulated.

 

Throughput Ratios

There are three main ratios that are calculated in throughput costing:

1.         Return per factory hour,

2.         Cost per factory hour and

3.         Throughput costing ratio (TC Ratio).

 

(1)	Return per factory hour =
	Throughput per unit ÷ Product time per unit on bottleneck resource
(2)	Cost per factory hour =
	Total factory costs ÷ Total time available on bottleneck resource
(3)	Throughput costing ratio (TC Ratio) =
	Return per factory hour ÷ Cost per factory hour

 

Strategic Cost Management

Throughput Costing Formulas

 

Total Factory Cost (TFC):

With the exception of material costs, in the short run, most factory costs (including direct labour) are fixed. These fixed costs can be grouped together and called total factory costs (TFC).

 

Total Cycle Time (TCT):

Total cycle time is the average time required to convert raw materials into finished goods ready to be shipped to customer. It includes the time required for activities such as material handling, production processing, inspecting and packaging.

 

List of Throughput Costing Formulas

1	Throughput =
	Sale Value – Totally Variable Cost [Here, Totally Variable Cost = Direct Material Cost]
2	Throughput cost =
	Total standard hours on bottleneck resource for actual production during the period × Cost per factory hour
3	Throughput efficiency =
	[(Throughput cost) ÷ (Actual TFC)] × 100%
4	Return (i.e. Throughput) per factory hour (Product-wise) =
	[Selling Price per unit – material Cost per unit] ÷ [Product Time per unit on key (i.e. bottleneck) resource in hours]
	= Throughput per unit ÷ Product Time per unit on key (i.e. bottleneck) resource in hours
5	Cost per factory hour =
	Total factory costs (TFC) ÷ Total time available in hours on key (i.e. bottleneck) resource
6	Throughput Costing Ratio (TC Ratio) =
	[Return per factory hour (or minute)] ÷ [Cost per factory hour (or minute)]
7	Primary TC Ratio =
	[Total return from throughput (i.e. Sales-Material Costs)] ÷ [TFC (i.e., all costs other than materials)]
8	Throughput Time Ratio =
	It is the ratio of time spent adding customer value to products and services divided by total cycle time. It is also known as the ‘ratio of work content to lead time’.

 

Important note:

The TC Ratio should be greater than 1. If it is less than 1 the product will lose money for the company and the company should consider withdrawing it from the market.

Part B

Illustration: 1

Modern Co produces 3 products, A, B and C, details of which are shown below:

Particulars	A	B	C
Selling price per unit (Rs)	120	110	130
Direct material cost per unit (Rs)	60	70	85
Variable overheads (Rs)	30	20	15
Maximum demand (units)	30,000	25,000	40,000
Time required on the bottleneck resource per unit (hours)	5	4	3

 

There are 3, 20,000 bottleneck hours available each month.

Required:

Calculate the optimum product mix based on the throughput concept.

Solution: 1

Illustration: 2

A factory has a key resource (bottleneck) of Facility A which is available for 31,300 minutes per week. Budgeted factory costs and data on two products, X and Y, are shown below:

Product	Selling price p.u.	Material cost p.u.	Time in Facility A
X	Rs 35	Rs 20.00	5 minutes
Y	Rs 35	Rs 17.50	10 minutes

 

  Budgeted factory costs per week:

	Rs
Direct labour	25,000
Indirect labour	12,500
Power	1,750
Depreciation	22,500
Space costs	8,000
Engineering	3,500
Administration	5,000

 

Actual production during the last week is 4,750 units of product X and 650 units of product Y. Actual factory cost was Rs 78,250.

 

Calculate:

1)        Total factory costs (TFC)

2)        Cost per Factory Minute

3)        Return per Factory Minute for both products

4)        Throughput Costing Ratios for both the products

5)        Throughput cost per week

6)        Throughput Efficiency

 

Solution: 2

Illustration: 3

H Ltd. manufactures three products. The material cost, selling price and bottleneck resource details per unit are as follows:

Particulars	Product: X	Product: Y	Product: Z
Selling price (Rs)	66	75	90
Material cost (Rs)	24	30	40
Bottleneck resource time	15 minutes	15 minutes	20 minutes

 

Budgeted factory costs for the period are Rs 2, 21,600. The bottleneck resources time available is 75,120 minutes per period.

 

Required:

1.         Company adopted throughput accounting and products are ranked according to ‘product return per minute’. Select the highest rank product.

2.         Calculate throughput costing ratio and comment on it.

Solution: 3