Throughput Accounting: A Critique of This New Method of Accounting - Admission/Application Essay Example

 Decline of Cost Accounting as a Management Accounting tool Managerial decision making is tangled with information generated by the accounting system employed by a company. Cost Accounting has long been the only method of generating data for Management Accounting purposes. 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. It had been serving the purpose reasonably well as long as labor remained the primary variable factor of production. During a given period, profit could only be increased 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 using direct labor hours as basis of apportionment will obviously give wrong results. Any management decision based on these figures might cause more harm than benefit the company. This led to the ushering of a new concept called the Activity Based Costing. The basis of this method was the fact 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 more rational from previous methods, Activity Based costing does not really represent a paradigm shift in generating meaningful data that would assist decision making. 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. They erroneously believe that local efficiency and optimization somehow adds up to overall efficiency and optimization. They consider management of cost rather than management of revenue to be more vital in realizing corporate goals. The total product cost is calculated by totaling direct material cost, direct labor cost and overhead cost, thus making all three constituents relevant during decision making. ABC is based on recognizing cost drivers and improve all links. These approaches do not attach any importance to constraints as being roadblocks to achieving corporate objectives. As a result, the most important factors that actually decide the efficiency and real profitability of an organization are not taken into account. 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. The removal of these constraints 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 Accounting system views an entire organization as an arrangement of chains and flows of interlinked processes. ABC is based on recognizing cost drivers and improving “all” links. Throughput Accounting, on the other hand is based on the fact that: The company “system” is only as strong as its weakest link (Corbett, 1998). The duty of managers is 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. Traditionally, output has been considered the unit for measuring activity levels and 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 practice of considering closing inventory as an asset. This leads to an erroneous approach of making the production, rather than demand as the overriding objective. This approach has led to many situations of huge unsold inventories, subsequent downsizing of labor and closure of factories. This is a clear example of how local optimization does not always enhance the overall efficiency. Instead, at times, it pulls down the entire organization. Basics of Throughput Accounting Most of the top managers of a company are interested in “level of revenue that the organization is able to generate”. This level of revenue is also sometimes refereed to as the attainable levels of throughput. Thus logically, throughput rather than output should be the most important issue for management to focus on. This new method of Management Accounting attempts to do precisely that. According to this method, Value should only be recognized on delivery (Corbett, 1998). Carrying on in the same vein, inventory including constituents like raw-material, WIP, finished goods, is considered to be the investment the company has made. This investment also includes the investment 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. This cost head includes direct and indirect labor cost, depreciation expense, interest payment, supplies and other operating expenses. So the emphasis clearly shifts from output to revenue. The objective of the management is in finding out ways and means of increasing throughput while reducing inventory and operating expenses. Five steps that the managers should take to identify and remove constraints are (Corbett, 1998): Recognize the constraints in the system Choose on a way to make use of the System's Constraint Focus all the additional resources to Constraint Exploitation. Acquire additional constrained resources. If a Constraint Has Been Broken in any of the previous steps, return to Step One 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. This shows that accumulating a large volume of inventory to achieve a predetermined production ratio level would not necessarily increase the throughput. Investments made with an eye on long term returns, the numerator shall also reflect the projected revenue inflows from these investments. But accountants have routinely voiced their doubts as to how effectively and realistically this can be done with regard to investments in Research and Development and Human Resources as these do not add value in the short run. The Inventory Turnover Ratio tries to estimate how quickly a given level of inventory can generate throughput. It also 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. It can be seen that throughput accounting is essentially a short-term approach. This is clear 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 the key to gain competitive advantage in the long run is providing superior product at the most efficient cost as compared to competitors. 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 important concept of constraints. These constraints can in practice 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. A company with constraints in its system shall choose Throughput Accounting. If however, managers feel that local efficiencies will lead to a good choice, then they should go for ABC. References Corbett, Thomas.(1998). Throughput Accounting. Great Barrington, MA: North River Press. Read More