Use the Theory of Constraints and Activity-Based Costing to Determine the Optimal Product Mix Decisions - Essay Example

29th April, Use the Theory of Constraints and Activity-Based Costing to Determine the Optimal Product Mix Decisions Introduction Among all of the manufacturing industries, most of the efforts are drawn in order to develop such a product mix which should be optimal in nature. Different theories and perspectives have been presented in this area of research. This article particularly highlights the development of optimal product mix by utilizing three major approaches such that the utility, strengths, weaknesses and their implications have been mainly analyzed. Broadly, expanded ABC approach, TOC based approach and the multi-factor approaches have been discussed which have deeper implications in designing an optimal product mix for a manufacturing entity. Expanded ABC based Model The shortcomings of traditional costing to incorporate production process are mainly encompassed by Theory of Constraints (TOC) and Activity Based Costing (ABC). Production decisions become quite convenient when they are facilitated by the paradigms of TOC and ABC gelling together (Kee). Apparently it seemed as if the both of these paradigms have the nature of competing with each other in assisting production decisions. However, later on when their strengths and limitations were analyzed, a complementary view of both the paradigms came into effect. If the product cost obtained under ABC, is incorporated with the availability of the physical resources, a comprehensive model of production process can be developed which can facilitate the production decisions by implementing the principles and guidelines of the Theory of Constraints. Mixed-integer programming is the framework which is used to integrate the product cost estimated under ABC with the availability of physical resources along with the production capacities. The major benefit provided by the mixed-integer programming is the effectiveness of decisions relating to marketing and production. With the help of the expanded model of ABC, a firm can evaluate simultaneous results of product cost, availability of physical resources and the marketing opportunities in order to identify an optimal product mix. The other major benefit of expanded ABC program includes the identification of bottleneck resources and their economic impacts upon the firm’s production process. Identification of excess resources is also a hallmark for the expanded ABC approach due to which those excess resources can be deployed elsewhere to enhance the overall productivity of the firm. Lastly, the program for continuous improvement can also be identified and applied which can enhance the potential productivity and profitability of the firm because of the implementation of expanded ABC approach. Besides the advantages of the expanded ABC approach, there are different sorts of limitations attached with the implementation of this approach. Expanded ABC approach takes into consideration the quantitative effects of the revenues, product cost, availability of resources and the production capabilities. However, in order to design an optimal product mix, qualitative factors also play their significant part over which the expanded ABC approach remains silent. As a result, expanded ABC approach barely manages to provide only partial information regarding the marketing and the production decisions. Another limitation of expanded ABC is the usefulness of the reliance of this approach towards estimates and assumptions regarding the business activities of the firm over a certain time period. There is a strong dependency of the usefulness of the decisions taken under expanded ABC approach on the accuracy of the estimates and assumptions used by the firm. Lastly, the cost of implementing expanded ABC model can turn out to be on a higher side because of the substantial amount of time and effort required in its implementation, analysis of the results inferred from the mixed-integer programming and other related activities. However, it is important to note that the cost of implementing expanded ABC model can be quite lower than the potential benefits that a firm can reap in terms of developing an optimal product mix which can lead to effective marketing and production decisions. TOC based Model One of the most famous techniques to reach at the optimal product mix solutions includes a Theory of Constraint (TOC) based approach in combination with Throughput Accounting. The research of Souren et al (2005) encompasses a fairly comprehensive as well as illustrative assessment of the applicability of the TOC based approach in arriving at the optimal product mix solution. The framework applied to find out optimality of the product mix with the help of TOC based approach remained effective in demonstrating its results. The results inferred from the framework showed the non-optimality of the product mix decisions if TOC based approach is to be applied with. In other words, TOC based approach remained quite ineffective towards leading an optimal product mix solution. The constructed framework shows multiple conditions such that all of which needed to be satisfied in order for TOC based approach to provide optimal product mix solution which eventually ended up in failing at least one or more conditions. The TOC based approach however cannot provide more accurate and correct results as compared to Linear Programming (LP) based approaches but still some school of thoughts prefer TOC based approach over LP based approach. The reason for their preferences include the difficulty of framing the correct constraints and objective functions in LP models, comprehensive but easier way to use TOC based approaches especially to those managers who are unfamiliar with LP models etc. Another approach that can also be compared with TOC based approach is the contribution margin based approach. Both these approaches compete with each other in the allocation of direct and indirect costs with minor errors. However when both of these approaches are correctly modified, they provided similar results which shows their identical nature. In this way, it can be postulated that TOC based approach has remained quite ineffective in contributing some original methodology and results in designing an optimal product mix solution as the contribution margin based approach also provides the exactly same results. However, some theorists still believe that TOC based approach should not be completely sidelined due to its imitating results, but it should be taken into use because of the its comprehensive nature and higher acceptance among the industry practitioners. Overall, the TOC based approach is unable to provide the most optimal product solutions, but still it is quite effective in at least providing acceptable product mix solutions. Multifactor Model Another approach towards developing optimal product mix is the inclusion of several other factors that were not previously taken into consideration by the researchers (Tsai). Besides the integration of traditional approaches of TOC based approach and expanded ABC approach, another approach is presented in which four factors were considered in developing optimal product mix solution. These four factors include the capacity constraints or limitations, addition of a new product to the existing product mix, management’s degree of control over the availability of resources and the availability of purchase discounts. Purchase discount is mainly catered through the economic concept of price elasticity of demand. The above four factors have been taken into consideration by the researcher such that each of the above mentioned factor is framed into a generalized model which describes the impact of modification of all these factors upon the optimal product mix. Since the number of factors used by the researcher, are quite many, therefore, it is quite difficult to exactly estimate as to which factor with what magnitude can lead to develop an optimal product mix solution. Conclusion In the light of the literature reviewed above in analyzing the different approaches to develop optimal product mix for a firm, three major approaches were taken into consideration namely as expanded ABC based approach, TOC based approach and lastly, multifactor approach. Expanded ABC approach not only includes ABC technique bust also integrates the Theory of Constraints technique along with it and on the basis of this, it enables to provide a relatively approximate optimal product mix having ignored the various disadvantages of the application of this expanded ABC based approach. On the other hand, if TOC based approach is taken into consideration in its individual capacity, this theory does not provide better results as compared to Linear Programming based approach. However, this technique provides the identical results shown by the Contribution Margin Theory. This shows that the TOC based approach has remained quite ineffective in leading towards optimal product mix solutions. At the same time, if the efforts of multifactor theory are taken into account in contributing towards the optimal product mix solution, the nature of the theory has become quite complicated such that it is quite hard in setting out an exact set of parameters to develop the optimal product mix. Thus, in a summarized way, the best technique among all is the expanded ABC based model which has shown the most accurate results in designing an optimal product mix solutions for a manufacturing firm. Works Cited Kee, Robert. "Integrating Activity-Based Costing With the Theory of Constraints To Enhance Production-Related Decision-Making ." American Accounting Association Accounting Horizons 9.4(1995): 48-61. Print. Souren, Rainer, Ahn, Heinz and Schmitz, Christian. "Optimal product mix decisions based on the Theory of Constraints? Exposing rarely emphasized premises of Throughput Accounting." International Journal of Production Research43.2 (2005): 361-374. Print. Tsai, Wen-Hsien, Kuo, Lopin, Lin, Thomas W., Kuo, Yi-Chen and Shen, Yu-Shan. "Price elasticity of demand and capacity expansion features in an enhanced ABC product-mix decision model ." International Journal of Production Research 48.21 (2010): 6387-6416. Read More