What Is Throughput Accounting? Theory of Constraints 2024

Posted on October 11, 2024October 11, 2024 by Admin

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Throughput Accounting vs Cost Accounting

As we touched on briefly, throughput accounting differs from traditional cost accounting methods like activity-based costing. It focuses on maximizing throughput — how quickly money is generated via sales — instead of controlling costs relating to operations and production. Below, we’ll cover the key concepts of each method so you can better understand them.

Throughput Accounting Key Concepts

Throughput accounting’s main goal is to remove bottlenecks and constraints to maximize a company’s net profit. You can do this by managing throughput, operating expenses and inventory. We’ll break these three factors down.

Throughput (T): The most critical aspect of TA is throughput. This metric measures the income from generated sales after factoring in the variable costs — like the raw material cost — for producing and selling a unit.
Inventory (I): A key concept of TA is to ensure that a company doesn’t have too much capital tied up in inventory. The idea is similar to the just-in-time inventory management method, where manufacturers have just enough inventory on hand to meet demand. This lowers storage costs, increases available cash and minimizes waste.
Operating expenses (OE): These are expenses that are incurred to convert materials into throughput (products). Unlike other accounting methods, TA handles operating expenses as period costs — such as monthly or quarterly expenses — instead of calculating them into unit production costs.

Cost Accounting Key Concepts

In traditional cost accounting, the cost accountants assign values to everything associated with production. They’ll look at utility usage, labor cost, material prices, machine maintenance and more. The idea behind this managerial accounting system is to make sure that products are being sold at maximum profit levels. Below, we’ll look at some cost accounting factors.

Direct costs: These relate to product production expenses. They include labor costs, direct and raw material costs, distribution costs and more.
Variable costs: Totally variable costs include the cost of materials, which may increase or decrease based on production volume.
Indirect costs: Items like electricity and water usage are considered indirect costs as they can’t be tied directly to a product’s cost.
Operating costs: These are costs associated with a company’s daily operations. They aren’t tied to the product being produced, and they can be variable or fixed.
Fixed costs: Facility payments (mortgage or rent) and monthly equipment payments are two types of fixed costs that are factored into cost accounting.

Advantages and Disadvantages of Throughput Accounting

Before you adopt throughput accounting, you should take the time to consider its advantages and disadvantages. We’ll cover the pros and cons of this method here.

Pros:

Companies can react quickly to changing markets
Customer demands can be handled efficiently
Financial management is simplified
Leaders can identify and remove bottlenecks (constraints)
Decision making relating to product production is easier

Cons:

TA doesn’t account for a company’s truly variable costs or overall financial performance
TA focuses on short-term gains but may affect long-term plans
Bottlenecks can be hard to find, which can delay business decisions
Operating expenses are considered fixed even though they can fluctuate

How to Calculate Throughput Accounting Ratio

Now that you know what throughput accounting is, it’s time to learn how to calculate the throughput accounting ratio (TPAR). The throughput accounting ratio measures the return per factory hour and the cost per factory hour, or the rate of cash generation from sales vs the rate of cost incursion during production.

Totally variable costs (material costs) are simplified as labor, and other expenses are considered fixed over the production period. This means fixed costs can be calculated independently and labeled as overall business costs. The simple formula for TPAR isthroughput accounting = return per factory hour / cost per factory hour.

How to Improve Throughput Accounting Ratio: Tips

To maximize cash flow, reduce waste and increase profits, managers must diligently manage finances. As we discussed in the “advantages and disadvantages” section, if you don’t establish a plan when using throughput accounting, things can go wrong. The tips below will help you stay on top of things.

Monitor Expenses and Make a Plan

Without a plan, it can be hard to grow a business. Managers must assess where the organization currently sits and decide where they want it to be. Look at previous production run costs, plan for risks and issues, and develop a plan to help you achieve your goals. Roadmaps and decision trees are powerful tools that you can use to plan for the future.

Control Variable and Fixed Costs

To improve throughput accounting ratios, company leaders should look at the variable costs of previous production runs and calculate the sales generated from those investments. Additionally, you should manage fixed costs closely. Anything that can lower your fixed costs will help pad your bottom line. Don’t be afraid to shop around for better deals.

Acquire Technology

Consider investing in technology that can speed up production runs, reduce errors and make everyone’s lives easier. Often, new technology is the key to solving current system and process constraints. While the initial outlay might be large, new equipment can save significant amounts of money in the long run.

Use Project Management Software

Managing projects, especially their financial side, is challenging at the best of times. Organizations should use project management software to help them plan and track expenses. Most of the best free project management software solutions offer financial tools and templates that can track income and expenses.

If you want an all-in-one project management solution that can help you track projects, project tasks and financial data while identifying bottlenecks, check out monday.com. You can learn about it in our monday.com review. ClickUp is also a fine option for distributed teams. Our ClickUp review has more information about its features.

Additional Throughput Accounting Ratios

Aside from the throughput accounting ratio, you’ll also find other ratios within the TA method. Here, we’ll briefly cover how to calculate operating expenses, inventory costs and net profit.

Operating Expenses

Operating expenses are costs related to labor, utilities, machine rentals, mortgages and rent, as well as any other items needed to run the company. There’s no ratio for operating expenses; instead, project leaders should simply add up all of the fixed expenses that fall into this category.

Inventory Costs

Inventory costs represent the total amount of money that the company spent on raw materials for the upcoming production run. From a throughput accounting perspective, you must account for all the purchased materials that can be turned into saleable products. Again, there is no ratio for this; just calculate the total cost of materials purchased for the current production run.

Net Profit

There are two ways to calculate net profit. The first is to subtract the operating expenses from the throughput (T – OE). Alternatively, you can use this formula: sales revenue – total variable costs – operating expenses.

How Is Throughput Performance Measured & Example

You can measure throughput by completing calculations and analyzing the results. Still, assessing throughput and profit requires diligence. Managers must determine which products are producing the bigger throughput. Divide the throughput (T) by the duration of the bottleneck — the higher the final value, the better. This is called the turnover per bottleneck minute.

We know this may seem confusing, but it’s much simpler than it sounds. Essentially, you’re measuring the amount of time it takes a product to clear the bottleneck in a production line and analyzing its financial impact.

Here’s a simple example. Let’s say your factory manufactures two products — product X and product Y — but you have just enough staff to run one production line at a time:

Product Xsells for $50. During production, it takes 12 minutes for product X to pass the production line’s bottleneck. The turnover value per bottleneck minute is 50 / 12 = $4.16.
Product Ysells for $50. During production, it takes seven minutes for product Y to pass its production line constraint. The turnover value per bottleneck minute is 50 / 7 = $7.14.

For maximum profit, it’s clear that this factory should prioritize the production of product Y until product X’s production line constraints have been identified and fixed.

What Is the Theory of Constraints?

In 1984, Eli Goldratt created a method called the Theory of Constraints. It helps organizations adopt a culture of continuous improvement by championing the identification and removal of constraints (bottlenecks) from a production system and company processes. Goldratt discusses the method in his book, “The Goal: A Process of Ongoing Improvement.”

While the Theory of Constraints is heavily associated with traditional project management methodologies such as Critical Chain Project Management, you can also use it with Agile methodologies and frameworks. TOC is built around five steps that help project leaders identify and remove bottlenecks. We’ll explain the five steps below.

1. Identify the Constraint

The first step in the Theory of Constraints is to identify the bottleneck that’s slowing production. Tools like kanban boards can reveal where tasks are being delayed. Additionally, you can use the best time-tracking tools to identify which stage of production is backing up.

2. Exploit the Constraint

The next step in TOC is to exploit the constraint. This means deconstructing the process that has become a bottleneck to see how you can improve it. You may discover that team members need additional training, there aren’t enough work tools or the workload is too heavy for the number of employees.

3. Subordinate Everything Else

After deconstructing a constraint, managers must ensure that non-constraints — other processes that occur before the constraint — aren’t causing the bottleneck. If they are, you’ll need to adjust the other processes using a system called the Drum-Buffer-Rope (DBR) method. The DBR method sets a rhythm that helps ensure all processes work harmoniously.

4. Elevate the Constraint

By step four, the production management team should fully understand the bottleneck that they’re facing. Now, the idea is to figure out how to fix the problem. Leaders must determine if they need more employees, better training methods, more tools, more production machines, more space or something else. Decision tree analysis is key during this stage of TOC.

5. Prevent Inertia and Repeat

The Theory of Constraints believes in continuous improvement, or Kaizen. Once one constraint has been fixed, you should find another. When you find a new constraint, repeat the above steps until it is fixed. To learn more about continuously improving and moving forward, read our Kaizen guide.

How Does Throughput Accounting Approach Constraints (Bottlenecks)?

When managers discover a constraint using methods found in the Theory of Constraints and throughput accounting, they work to exploit the bottleneck and generate solutions. Generally speaking, most constraints are caused by scarce resources, poor working conditions, a lack of training, broken or outdated equipment, or an insufficient workforce.

The above problems are usually easy to anticipate and fix when issues do arise, especially if you have a solid risk management plan. Below are some things you can do to help you overcome these common workplace issues.

Track Production and Projects With Software

We’ve already touched on project management software, but it’s worth mentioning again. Since projects have so many moving parts, it can be hard to stay on top of them. Project management software helps you track every aspect of your project, including time, budgets, tasks, key performance indicators, HR, customer relationship management (CRM) and much more.

There are project management platforms out there for traditional methodologies and Agile frameworks. If you’re a fan of traditional work styles, check out our roundup of the best Gantt chart software. If you prefer Agile frameworks, our review of the best Agile tools is for you.

Zoho Projects is one of the best platforms for Agile frameworks, as well as Critical Chain Project Management and Critical Path Project Management, which both follow TOC methods. It’s easy to use and affordable, and it integrates with many Zoho and third-party platforms. You can learn more about the software in our Zoho Projects review.

Develop a Training Plan

Many workplace issues result from inadequate training. It’s vital for all employees to receive comprehensive training so that they know their roles and who to contact within the organizational structure when they have concerns.

Aside from initial training, you should establish a plan for ongoing training. This way, you can ensure that your workforce is ready for anything. Read our project human resource management guide to learn more.

Protect Your Supply Chain

Supply chain issues can quickly derail any project, especially production-based ones. You can overcome many issues related to supply chain and market demand by protecting your supply chain and knowing your region’s key suppliers. Make sure you have a few backup suppliers to fall back on. Being able to identify where to source materials can limit or eliminate bottlenecks.

Enhance Production Lines

Technology changes rapidly. You should do everything you can to maintain production line equipment and find tools that enhance your team’s efficiency and save you money. Newer machines are also far more reliable than those of yesteryear. Having reliable production lines can drastically reduce downtime and constraints.

Final Thoughts

While relatively new, throughput accounting is becoming one of the most popular accounting methods thanks to its ease of use. Along with the Theory of Constraints, throughput accounting can help teams identify constraints, generate solutions, improve efficiency and profits, and reduce waste. If you’re looking to simplify business management, TA could be for you.

Do you use the Theory of Constraints and throughput accounting in your workplace? Do you prefer traditional cost accounting methods? What project management software do you use to help track risks, issues and finances? Let us know in the comments. Thanks for reading.

FAQ: Throughput Costing

Throughput accounting focuses on maximizing throughput and generating sales, while cost accounting focuses on controlling costs related to production and operations.
The three core measures of throughput accounting are throughput (T), inventory (I) and operating expenses (OE).
The throughput accounting ratio (TPAR) formula is throughput accounting = return per factory hour / cost per factory hour.
Throughput operating expenses are costs incurred to convert materials into products, which lead to sales.