Throughput Accounting – A critique of this new method of accounting

Decline of Cost Accounting as a Management Accounting tool

Managerial decision making is inextricably intertwined with information generated by the accounting system employed by a company. Cost Accounting has long been – it is almost a hundred years since Cost Accounting was first utilized by finance professionals to provide data that might be gainfully used in managerial decision making – the only method of generating data for Management Accounting purposes and it had been serving the purpose reasonably well as long as labor remained the primary variable factor of production and the only known way to increase profit during a given period was by extending the gap between revenue earned and cost (mostly labor cost) incurred. The situation however started changing rather quickly and labor is now no longer a variable factor of production, instead it has become a part of fixed factory overhead in almost all manufacturing organizations. Thus the excessive emphasis on reducing labor cost and the practice of apportioning overhead expenses (as has been done through decades) using direct labor hours as basis of apportionment will obviously give wrong results and any management decision based on these figures might cause more harm than benefit the company. It is not that Cost Accountants were not aware of these problems and an urge to put things in order ushered in the new concept called Activity Based Costing that accepted that labor is not the only driver of overhead expenses, especially in case of multi-product companies. This new method of accounting identified drivers that generated overhead expenses and apportioned these expenses in accordance with relative importance of those drivers.

Activity Based Costing – Old Wine in a New Bottle?

Though Activity Based Costing attempts to apportion overhead expenditure in a more rational way, it does not really represent a paradigm shift in generating really meaningful data that would assist management in taking decisions. The similarities in approach between Activity Based Costing and conventional Cost Accounting are all too apparent for anybody to overlook those.
Both the approaches consider ‘efficiency’ as the primary goal to achieve overall corporate objectives and erroneously believe that local efficiency and optimization somehow adds up to overall efficiency and optimization. Both the approaches consider management of cost rather than management of revenue to be more vital in realizing corporate goals and calculate product cost by totaling direct material cost, direct labor cost and overhead cost thus making all three constituents relevant during managerial decision making. These approaches to Management Accounting do not attach any importance to constraints as being roadblocks to achieving corporate objectives thereby completely missing the all important factor that actually decides the efficiency and real profitability of an organization.

Theory of Constraint

It has been observed that in every organization there is at least one constraint that restricts the organization from reaching its corporate goals and removal of this constraint automatically ensures an overall improvement in the performance of the entire organization. These constraints can be in the form of managerial constraints, capacity constraints, market constraints or even logistical constraints. Throughput accounting system lays a lot of emphasis on managers’ abilities to manage and exploit non-constraint resources in order to optimize and, if possible, release constraint resources to ensure higher organizational performance.

Local optimization does not necessarily lead to overall optimization

This accounting system views an entire organization as an arrangement of chains and flows of interlinked processes and exhorts managers to locate the weakest link in this chain and strengthen it as it might hamper the performance of the entire organization. It also assumes that local optimizations need not necessarily lead to overall corporate optimization. This concept though is rather difficult for divisional controllers and departmental managers to realize as they have a characteristically stunted view that begins and ends with their departments or divisions.
An example might clarify the issue a bit more. Output has traditionally been considered the unit for measuring activity levels and hence efficiency of an organization. Thus maximizing output, irrespective of whether it has a ready market or not, has been one of the holy grails of corporate organizations. This has been further bolstered by the fact that closing inventory is always considered as an asset and thus it increases the gross profit of an organization. This erroneous approach, where production, rather than the demand for it, becomes the overriding objective has led to many unfortunate situations of huge unsold inventories and subsequent downsizing of labor force and closure of factories. This is a clear example of how local optimization does not always enhance the overall efficiency; rather, at times, it pulls down the entire organization.

Basics of Throughput Accounting

Ask any member of the top management of a company and you will find that the only criterion these people are interested in is how much revenue the organization is able to generate or the attainable levels of throughput as some would prefer to call it. Thus one has to admit that throughput rather than output should logically be the most important issue for management to focus on. This new method of Management Accounting attempts to do precisely that. Carrying on in the same vein, inventory is considered to be the investment the company has made and this includes other than conventional constituents of inventory such as raw material, work-in-progress and finished goods, investments done in capital items such as buildings, plant and machinery. However, all expenses incurred in converting raw materials to finished goods are separately accounted for under the head operating expenses and this includes direct and indirect labor cost, depreciation expense, interest payment, supplies and other operating expenses. So the emphasis clearly shifts from output to revenue and management becomes involved in finding out ways and means of increasing throughput (i.e. revenue inflow) while reducing inventory (money blocked in the organization and cannot be put to any use till it is freed) and operating expenses (i.e. cash outflow). The metrics of managerial efficiency also changes and become more meaningful with following measurements:

a) Net Profit (NP) = Throughput – Operating Expense
b) Return on Investment (ROI) = Net Profit / Inventory, and
c) Inventory Turnover (IT) = Throughput / Inventory

The concept of Net Profit actually utilizes the idea of marginal income while retaining the traditional emphasis on cost control and skillfully aligning it with the concept of revenue generation.
The measure of Return on Investment uses inventory as a denominator and quite clearly emphasizes that accumulating a large volume of inventory to achieve a predetermined production ratio level would not necessarily increase the throughput. However, there are a lot of investments that are made with an eye on long term returns and while considering these items in the denominator, projected revenue inflows that are expected to occur due to these investments should also be considered in the numerator to make the ratio more meaningful. But accountants have routinely voiced their doubts as to how effectively and realistically this can be done especially with regard to investments in Research and Development and Human Resources as these do not ostensibly add value in the short run.
The Inventory Turnover Ratio tries to estimate how quickly a given level of inventory can generate throughput and once again highlights the futility of accumulating large volumes of inventory unless such volumes can generate commensurate levels of throughput.

Does it signal the ultimate demise of Traditional and Activity Based Costing?

There has been a long standing and often vigorous debate in this regard and it must be admitted that throughput accounting is essentially a short-term approach as is obvious from its rationalization that since direct labor and overhead cost cannot be changed during short-term, managing these costs would be impossible and not relevant.
Proponents of Activity Based Costing however believe that in the long run competitive advantage can be attained only if an organization provides superior product at most efficient cost as compared to competitors and thus managing the cost in the long run is equally important in gaining competitiveness.
In spite of its apparent short term emphasis, throughput system of accounting however introduces the all important concept of constraints that can in practice indeed curtail the ability of an organization to achieve corporate goals. Any accounting system that does not take into account these constraints cannot properly portray the functioning of an organization. This might lead to management taking wrong and potentially debilitating decisions that may affect long term sustainability of an organization.
Considering these factors it seems that the best option for an organization would be to embrace Activity Based Costing as a long term perspective while retaining Throughput Accounting as a short term measure.

Bibliography

Corbett, Thomas. Throughput Accounting. North River Press, 1998.