A costing methodology that focuses on capacity utilization is called “throughput costing“. It assumes that there is always one bottleneck operation in a production process that governs the speed with which products or services can be completed. This operation becomes the defining issue in determining what products should be manufactured first, since this in turn results in differing levels of profitability.
Through this post I overview throughput costing. This is one among process costing any accountant should know. For cost accountant, it is crucial, it is a must tool! To students, it is the hardest part among cost accounting section you ever found, but please do not get overwhelmed, it is just an overview. You can follow the discussion and earn more costing knowledge. To you fellow bookkeepers, I am sorry girls, we are not journalizing today 🙂
Before going to the throughput costing, it is worth recalling: why cost accounting is most crucial among the others, what the purpose of cost accounting information is.
Why Cost Accounting is Most Crucial
Cost accounting is one of the most crucial aspects of the accounting profession, for it is the primary means by which the accounting department transmits company-related performance information to the management team. A properly organized cost accounting function can give valuable feedback regarding the impact of product pricing, cost trends, the performance of cost and profit centers, and production and personnel capacity, and can even contribute to some degree to the formulation of company strategy.
Despite this wide array of uses, many accountants rarely give due consideration to the multitude of uses to which cost accounting can be put. Instead, they only think of how cost accounting will feed information into the financial statements. This orientation comes from a strong tendency in business schools to train students in generally accepted accounting principles (GAAP) and how they are used to create financial statements.
In this post, I will depart from the strong orientation toward GAAP that is observed in much of most of my discussions, and instead focus on how one can collect data, summarize it, and report it to management with the goal of helping the management team to run the business. For this function, we care much less about the proper reporting of accounting information and more about how information can be presented in a format that yields the greatest possible level of utility to the recipient.
The Purpose of Cost Accounting Information
The purpose of cost accounting differs from that of many other topics discussed in financial accounting and its reporting. It is primarily concerned with helping the management team to understand the company’s operations. This is in opposition to many other accounting topics, which are more concerned with the proper observance of very precise accounting rules and regulations, as laid down by various accounting oversight entities, to ensure that reported results meet certain standards.
The cost accounting function works best without any oversight rules and regulations, because, in accordance with its stated purpose of assisting management, it tends to result in hybrid systems that are custom-designed to meet specific company needs. For example, a company may find that a major requirement is to determine the incremental cost that it incurs for each additional unit of production, so that it can make accurate decisions regarding the price of incremental units sold (possibly at prices very close to the direct cost). If it were to use accounting standards, it would be constrained to use only a costing system that allocated a portion of overhead costs to product costs—even though these are not incremental costs. Accordingly, the cost accounting system used for this specific purpose will operate in contravention of GAAP, because following GAAP would yield results that do not assist management.
Because there are many different management decisions for which the cost accounting profession can provide valuable information, it is quite common to have several costing systems in place, each of which may use different costing guidelines. To extend the previous example, the incremental costing system used for incremental pricing decisions may not be adequate for a different problem, which is creating profit centers that are used to judge the performance of individual managers. For this purpose, a second costing system must be devised that allocates costs from internal service centers to the various profit centers; in this instance, we are adding an allocation function to the incremental costing system that was already in place. Even more systems may be required for other applications, such as transfer pricing between company divisions and the costing of inventory for external financial reporting purposes (which does require attention to GAAP guidelines).
Consequently, cost accounting frequently results in a multitude of costing systems, which may only follow GAAP guidelines by accident. The cost accountant’s primary concern is whether or not the information resulting from each system adequately meets the needs of the recipients.
Any cost accounting system is comprised of three functional areas: the collection of raw data, the processing of this data in accordance with a costing methodology, and the reporting of the resulting information to management in the most understandable format. The area that receives the most coverage is the processing function, for there are a number of different methodologies available, each of which applies to different situations. For example, job costing is used for situations where specifically identifiable goods are produced in batches, while direct costing is most applicable in situations in which management does not want to see any overhead allocation attached to the directly identifiable costs of a product.
We are not going to discuss job costing neither direct costing. We are discussing throughput costing in this post.
Basic Throughput Costing Model
The basic calculation used for throughput accounting is shown below. This format is a simplified version of the layout used by Thomas Corbett on page 44 of Throughput Accounting (Great Barrington, MA: The North River Press, 1998), though all of the numbers contained within the example have been changed.
The exhibit shows a series of electronic devices that a company can choose from for its near-term production requirements. The second column describes the amount of throughput that each of the products generates per minute in the bottleneck operation; “throughput” is the amount of margin left after all direct material costs have been subtracted from revenue.
For example: the 19” color television produces $81.10 of throughput, but requires 10 minutes of processing time in the bottleneck operation, resulting in throughput per minute of $8.11. The various electronic devices are sorted in the exhibit from top to bottom in order of largest throughput per minute. This ordering tells the user how much of the most profitable products can be produced before the total amount of available time in the bottleneck (which is 62,200 minutes, as noted at the top of the exhibit) is used up.
The calculation for bottleneck utilization is shown in the “Unit Demand/Actual Production” column. In that column, the 19” color television has a current demand for 1,000 units, which requires 10,000 minutes of bottleneck time (as shown in the following column).
This allocation of bottleneck time progresses downward through the various products until we come to the 50” High Definition TV at the bottom of the list, for which there is only enough bottleneck time left to manufacture 1,700 units.
By multiplying the dollars of throughput per minute times the number of minutes of production time, we arrive at the cumulative throughput dollars resulting from the manufacture (and presumed sale) of each product, which yields a total throughput of $405,360.
We then add up all other expenses, totaling $375,000, and subtract them from the total throughput, which gives us a profit of $30,360. These calculations comprise the basic throughput accounting analysis model.
Throughput Costing Analysis Based On Additional Allocated Cost
Now let’s re-examine the model based on a re-juggling of the priority of orders. If the cost accounting manager were to examine each of the products based on the addition of allocated overhead and direct labor costs to the direct materials that were used as the foundation for the throughput dollar calculation, she may arrive at the conclusion that, when fully burdened, the 50” High Definition TV is actually the most profitable, while the 19” Color Television is the least profitable. Accordingly, she recommends that the order of production be changed to reflect these “realities”, which gives us the new throughput report shown below:
The result is a significant loss, rather than the increase in profits that had been expected.
Why the change?
The trouble is that allocated overhead costs have no bearing on throughput, because allocated costs will not change in accordance with incremental production decisions, such as which product will be manufactured first. Instead, the overhead cost pool will exist, irrespective of any modest changes in activity levels.
Consequently, it makes no sense to apply allocated costs to the production scheduling decision, when the only issue that matters is how much throughput per minute a product can generate.
Throughput Costing Analysis Based on Additional Investment
Capital budgeting is an area in which throughput costing analysis can be applied with excellent results. The trouble with most corporate capital budgeting systems is that they do not take into consideration the fact that the only valid investment is one that will have a positive impact on the amount of throughput that can be pushed through a bottleneck operation. Any other investment will result in greater production capacity in other areas of the company that still cannot produce any additional quantities, since the bottleneck operation controls the total amount of completed production. For example: the throughput model in the next exhibit shows the result of an investment of $28,500 in new equipment that is added later in the production process than the bottleneck operation. The result is an increase in the total investment, to $528,500, and absolutely no impact on profitability, which yields a reduced return on investment of 5.7%.
A more profitable solution would have been to invest in anything that would increase the productivity of the bottleneck operation, which could be either a direct investment in that operation, or an investment in an upstream operation that would reduce the amount of processing required for a product by the bottleneck operation.
Throughput Costing Analysis with One Less Product
As another example, the cost accounting staff has conducted a lengthy activity-based costing analysis, which has determined that a much larger amount of overhead cost must be allocated to the high definition television, which results in a loss on that product. Accordingly, the product is removed from the list of viable products, which reduces the number of products in the mix of production activity, as shown below:
The result is a reduction in profits. The reason is that the cost accounting staff has made the incorrect assumption that, by eliminating a product, all of the associated overhead cost will be eliminated, too. Though a small amount of overhead might be eliminated when the production of a single product is stopped, the bulk of it will still be incurred.
Throughput accounting does a very good job of tightly focusing attention on the priority of production in situations where there is a choice of products that can be manufactured. It can also have an impact on a number of other decisions, such as whether to grant volume discounts, outsource manufacturing, stop the creation of a product, or invest in new capital items. Given this wide range of activities, it should find a place in the mix of costing methodologies at many companies. We now shift to a discussion of activity-based costing (ABC), whose emphasis is the complete reverse of throughput accounting—it focuses on the proper allocation of overhead.