Throughput accounting part 1
- 1. Lecture Topic: Introduction Throughput is the money generated from sales minus the cost of the materials used in making items sold. i.e. Throughput = Sales - Material cost In throughput accounting all other direct costs except direct material are recognised as costs. For instance, direct labour is added with indirect materials and other overheads to form conversion costs. Throughput accounting recognise direct material only as variable cost. Direct labour and direct expenses are recognised as fixed costs. Bottleneck resource A bottleneck resource is a limiting factor or a constraint that prevent output and throughput getting higher. So a bottleneck resource can be a production factor such as machine time or time or it can be lack of product quality etc.. So when they is a bottleneck resource, the objective of an organisation should be to maximise throughput. Bottleneck resource is also called binding constraint. Theory of constraints (TOC) It is an approach to production management which aims to maximise sales revenue less material cost. It concentrates on bottlenecks which are constraints or limiting factors that prevent During the lecture, take notes here. Insert a sub-page for each lecture topic. Important Points: Introduction Bottleneck resource and theory of constraints Similarities of throughput accounting marginal costing Difference between conventional cost accounting and throughput accounting Concepts underpinning throughput accounting Factors that affect the value of throughput accounting Limitations of throughput accounting Throughput accounting ratio (TPAR) Ways to improve a throughput accounting ratio Steps in throughput accounting Today's Topics: Homework: Throughtput accounting Sunday, 10 October 2021 1:09 pm Throughput Page 1
- 2. cost. It concentrates on bottlenecks which are constraints or limiting factors that prevent maximisation of throughput. TOC says that they is no need to hold inventory as inventory costs money in terms of storage space etc.. The theory of constraints states that the aim of management should be to maximise total throughput and the only way to increase throughput is by increasing the capacity of the constraint. Management should focus on increasing the capacity of the bottleneck resource. For example, time on Machine Type X may be a bottleneck resource. The only way to increase throughput is to increase the output capacity of Machine Type X. ○ Moving from working 5 days a week to working 6 or 7 days a week ○ Moving from working a 12-hour production day to an 18-hour or 24-hour production day ○ Carrying out routine maintenance work on the machine outside normal working hours, so that maintenance does not disrupt production. Ways in which this might be done, without buying a new Type X machine, could include: If the capacity of a bottleneck resource is elevated (increased) sufficiently it will eventually to be a bottleneck resource. Another resource in the system will become the new bottleneck resource. The same approach is now going to be used for the new bottleneck resource. Similarity of throughput accounting to marginal costing terminology The following are the similarities of throughput accounting to marginal costing terminologies: Marginal costing Throughput accounting Variable Cost = Direct Material Cost Fixed Cost = Total Factory Cost (Including labour cost) Contribution (Sales – Variable Cost) = Throughput (Sales – Direct Material Cost) Difference between conventional cost accounting andthroughput accounting The following are the differences between conventional cost accounting and throughput accounting: Conventional cost accounting Throughput accounting Inventory is an asset Inventory is not an asset. It is a barrier to making profit. Costs can be classified as direct or indirect. Such classification is no longer useful hence they is no such classification Direct labour is a variable cost All labour costs are fixed costs and are part total factory cost (TFC) Profitability is determined by deducting a product cost from selling price. Profitability is determined by the rate at which money or throughput is earned. Concepts underpinning throughput accounting Throughput accounting is based on following concepts: Throughput Page 2
- 3. Cost behavior a. In the short-term all manufacturing cost with the exception of material cost are fixed These fixed costs include direct labour. It is useful to group all these costs together and call them Total Factory Costs (TFC). Inventory b. Throughput is only created when a finished output has been sold. So by keeping items as stock, this prevent throughput from being made. Therefore, managers should always think of increasing throughput while at the same time tries to reduce inventory operational expenses. Managers should look for best ways to reduce stock as soon as possible. Just in Time (JIT) technique may be used which require products to be made when customers has ordered them to have inventory level at zero. Throughput accounting is based on following concepts: The selling price of the item sold. When the price increases this can increase throughput. a. b. The purchase of cost of direct materials. The higher the cost of acquiring materials the lower the throughput. Efficiency in the usage of direct materials. If direct materials are used efficiently, the of materials per unit will be reduced. c. Machine capacities d. e. Human resources f. Materials in scarcity Factors that affect the value of throughput accounting In order to maximise throughput, managers should try their best to find bottlenecks and remove them. When its impossible to remove the bottlenecks, the managers should ensure that those bottlenecks are fully utilised. Limitations of throughput accounting Selling price may be uncompetitive. a. Suppliers of materials may not be reliable. For instance stoppage in supply may affect production and thereby affecting throughput. b. c. Product quality may be low. d. Need to deliver the goods sold in time. Sometimes goods delivery may be delayed and goods may become stock and thereby affecting throughput. e. Very little attention is paid to overhead costs. If overheads are high profits will be The following are the limitations of throughput accounting: Throughput accounting ratio (TPAR) The throughput accounting ratio (TA ratio or TPAR) is the ratio of the throughput per unit of bottleneck resource to the factory cost per unit of bottleneck resource. The definition means we first calculate the throughput and divide it with usage of the bottleneck resource to get throughput per unit of bottleneck resource. Then we calculate total factory costs and divide it the limiting factor to get factory cost per unit of bottleneck resource. Finally we divide the throughput per unit of bottleneck resource with factory cost per unit of bottleneck resource. The throughput accounting ratio (TA ratio) is a useful ratio and below is the formula for calculating it: TPAR = Throughput per unit of bottleneck resource Throughput Page 3
- 4. TPAR = Throughput per unit of bottleneck resource Factory cost per unit of bottleneck resource (Note: Instead of ‘per unit of bottleneck resource’, you may come across the term ‘per factory hour’. This means the same thing in this context.) The factory cost per unit of bottleneck resource (factory hour) is calculated using the following formula: Factory cost per unit of bottleneck resource = Total factory costs . Total units of bottleneck resource Total throughput should exceed total factory costs; otherwise the organisation will make a loss. This means that the TA ratio should exceed 1.0. A TA ratio that is below 1.0 is likely not profitable. Products can be ranked in order of priority. Higher TA ratios should be given priority over lower TA ratios. Note: Note that ranking products in order of priority according to their TA ratio will always give the same ranking as putting them in order of throughput per unit of bottleneck resource. Ways of improve a throughput accounting ratio for a business By increasing selling price - when a product has the lowest selling price and they is little or no inventory for the product it mean that they is potential of selling all the units even if the price is increased. Hence the price should be increased which will increase TPAR. But if the business faces tough price competition a price increase could simply result in lower sales hence they is no need to increase the price. a. b. Increase the speed of the machine process or efficiency of the machine - if a machine is identified as a bottleneck if the capacity or speed of processing is increased this will increase throughput. This can be achieved by increasing productivity if the workforce through more training etc. c. By reducing factory costs - they is a need to investigate the factory costs to determine if there is any way to make cost savings. Some items can be outsourced or find alternative cheap supplies to reduce the costs. d. By reducing material costs - check if they are opportunities to buy the materials from alternative suppliers that are cheaper. But they is a need to be much careful as cheaper materials may sometimes be of low quality which may have impact on the quality of the final product. Sometimes bulk buying may result in discounts but the cost of holding those materials as inventory may outweigh the benefit gained from the discount. e. Elevating the bottleneck - sometimes by increasing the capacity of the bottleneck resource can increase throughput. This can be done by buying a new machine for instance to increase the hours. In an exam question on throughput accounting, you may be asked to explain ways in which the TA ratio for a product might be increased. The following are the ways TPAR can be improved: Steps in throughput accounting 1. To identify the bottleneck resource. 2. Concentrate on each bottleneck to ensure that they are all being fully and efficiently The following are the steps in throughput accounting: Throughput Page 4
- 5. 2. Concentrate on each bottleneck to ensure that they are all being fully and efficiently utilised. So they is a need to decide on how to exploit the constraint in order to maximise throughput. 3. Scale down or rank the throughput of non-bottleneck activities to match what can be with by the bottleneck. 4. Remove the bottleneck if possible 5. Since throughput accounting is a continues improvement process, return to step 1 and evaluate the system now that bottlenecks have been removed. Summary After the lecture, use this space to summarize the main points of this Lecture Topic. Throughput Page 5