Throughput Accounting and the bottleneck resource.
16th July 2015
6.30 and I am still at home, just waking up. My dad refused to wake me up even though he had been awake since 5 0 clock. Boy was I angry, I quickly dashed in to have my bath and get something to eat; then I set off to work. On the way to the office, the rain started pouring in. Thank God my mum reminded me to take my umbrella unless the rain would have beaten the living day light out of me.
I got to the office around 15 minutes past 8, drenched from head to toe even though I had an umbrella with me. This was how serious the rain was o. I was given time to cool off and relax then immediately handed some cheque requisition forms to fill.
After, I had nothing left to do, So I continued reading on performance management and this time it was on Throughput accounting. This is what I learnt on the topic, enjoy:
Throughput accounting is based on the theory of constraints and is consistent with the use of just-in-time (JIT) production methods. Throughput accounting is based on the ideology that an organization should seek to maximize throughput by identifying and eliminating bottlenecks.
Theory of constraints
The theory of constraints formulated by Goldraft and Cox in 1986 is an approach to production management and optimizing production performance. The key financial concept is to turn materials into sales as quickly as possible thereby maximizing the net cash generated from sales.
Throughput is the money generated by a system through the sales it makes. When calculating throughput, you have to put the material cost into consideration. The formula for throughput is:
Throughput = Sales – Material cost.
Bottleneck Factor: The constraint
According to the theory of constraints, there would always be a bottleneck resource or factor that sets a limit on the amount of throughput that is possible. Bottleneck resources which prevents output and throughput from getting any higher may include:
- A production resource
- A selling resource
- A need to deliver on time to particular customer
- Lack of material suppliers
A bottleneck resource is a limiting factor, in the theory of constraints and throughput accounting, a bottleneck resource is also known as a binding constraint. Throughput accounting is of the assumption that all other operational costs are fixed, and there is one bottleneck resource with other resources not being bottlenecks.
Idle time should be accepted since it costs no money with all the operational costs being fixed. Production should not exceed the capacity of the bottleneck resource unless there would be a build up of inventories. Operations in the production line prior to the binding constraint should operate at the same speed as the binding constraint ; otherwise excess and unwanted work in progress will be built up.
The only way to increase throughput is to increase the capacity of the bottleneck constraint. When a bottleneck resource is identified, efforts should be put in place to elevate such bottlenecks by devising means of efficient and more effective use of the resource.
For example, if the bottleneck of an organization is machine T, take for example in a water bottled water producing company . The machine deposits water into pre-made bottles and works 5days a week for 10hours per day. Instead of replacing it with a bigger machine that can hold more water, it would be more cost effective to just increase the number of days of operation to maybe 6 or 7 days / and the number of hours to 16 or 18 hours, or schedule refilling and maintenance hours outside of operational hours.
If the capacity of a bottleneck resource is elevated sufficiently it will eventually cease to be a bottleneck resource. Then a new bottleneck resource would emerge and the same approach would be used for such.
Throughput accounting is based on the following assumptions:
- In the short run, all costs in the factory ( with the exception of material costs) are fixed costs. These costs include direct labor cost
- The ideal inventory is zero, being a JIT environment. So products should not be made unless a customer has ordered them. When producing, production is pegged at the rate of the slowest process, which brings about idle capacity in other operations.
- Work in progress should be valued at material cost only until the output is eventually sold, so that no value will be added and no profit earned until sales take place.
- Profitability is determined by how quickly goods are sold. Since the goal of a profit- oriented organization is to make money, inventory must be sold for that goal to be achieved.
Maximizing throughputs in the case of multiple products.
i) Determine the bottleneck resources
ii) Calculate the throughput per unit for each product
iii) Calculate the throughput per limit of limiting factor
iv) Rank products
v) Allocate resources to arrive at optimum production plan
Throughput accounting ratio
The throughput accounting ratio is the ratio of the throughput per unit of bottleneck resource to the factory cost per unit of bottleneck resource.
1) Throughput per unit if each product = Sales – direct material cost
2) Throughput per bottleneck hour = Throughput per unit / Machine hour per unit
3) Factory cost per bottleneck hour = factory cost / total hours obtainable for bottleneck activity
Eric W. Noreen., Dera A. Smith., James T., and Mackey., The theory of constraints and the implications for management accounting.