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By Jack M. Ruhl

A constraint is anything that limits a system's performance relative to its goal. The theory of constraints (TOC) is a systems-management philosophy developed by Eliyahu M. Goldratt since the early 1980s in a series of nonfiction books, articles, and novels. TOC's fundamental message is that constraints determine the performance of any system, and any system contains only a few constraints. Constraints may be found within or outside a company. A production bottleneck, which can limit the overall profitability of a manufacturing firm, is an example of an internal constraint. An external constraint could be a lack of customer orders. TOC proponents suggest that the goal of for-profit firms is making money, and constraints must be effectively managed if this goal is to be achieved.

TOC advocates have little use for traditional absorption costing information. In absorption costing, full product cost is calculated as the sum of the cost of direct materials, direct labor, and manufacturing overhead. Absorption costing is required for externally published financial reports, but, as management accounting textbooks point out, absorption costing is often inappropriate for internal management decisions such as product mix, pricing, and make vs. buy.

Recognizing the pitfalls of using absorption costing information inappropriately, TOC advocates suggest that product costs are not useful and should not be calculated. Managers are advised to manage constraints instead of managing product costs since managing product costs may lead managers to make decisions not in the best long-run interests of the firm. For instance, managers focusing on product costs may try to minimize cost per unit by increasing production output beyond the number of units which can be sold. Such actions result in a buildup of excess inventories, which are costly to the company in a variety of ways. TOC provides a set of well-defined measures, called throughput accounting, which are appropriate inputs for such internal management decisions.

Throughput Accounting

Throughput accounting (TA) is an alternative to traditional accounting measurements. TA measurements provide a way of making operational the concepts expressed in TOC. The three measurements are 1) throughput (T); 2) inventory (I); and 3) operating expense (OE).

Throughput (T) is the rate at which a company generates money through sales. TOC emphasizes the fact that money is generated through sales, not production. To generate money, managers produce products which can be sold rather than manufacturing products for inventory. Throughput dollars do not usually equal sales dollars. To determine throughput, all money which has not been generated by the company is calculated. To illustrate, suppose a company sells a product to a customer for $180. If the product contains parts or components that have been purchased from vendors for $60, then throughput is $120 ($180 minus $60)--only $120 has been generated by the company. There are other amounts which must be deducted from sales revenue when calculating throughput: subcontracting costs, commissions paid to salespeople, customs duties, and transportation, if the company does not own the transportation channel.

TOC recognizes that labor is often considered to be a fixed cost, especially in companies which employ skilled laborers who cannot easily be laid off in periods of low demand and subsequently rehired when demand increases. Therefore, in TOC, direct manufacturing labor costs are not deducted from sales in calculating throughput.

Inventory (I) is defined as all the money the system invests purchasing things the system intends to sell. In contrast to traditional accounting, this includes buildings and machinery. This category is called inventory but not assets because management should consider inventories as liabilities. Companies with excess inventory are burdened with a liability, associated with the following costs: interest, storage space, scrap, obsolescence, material handling, and rework. In TOC, there is a strong emphasis on the fact that excess inventory levels frustrate achievement of the goal.

In TOC, the value of inventory does not include the costs of direct manufacturing labor and manufacturing overhead, only the amounts paid for the components purchased from outside vendors.

Operating expense (OE) refers to the money the system spends in turning inventory into throughput. This includes cost of direct labor, salespeople, forepeople, managers, and secretaries. These are all considered to be operating expenses because all these people are charged with turning inventory into throughput.

These measures can be prioritized in terms of importance in achieving the goal--1) throughput; 2) inventory; 3) operating expense. Managers should place most emphasis on increasing throughput, while also monitoring inventory levels and operating expenses. These priorities are in contrast with traditional management practice, in which managers try to lower operating expenses while often paying little or no attention to inventory levels. To increase throughput, managers must focus on constraints.

Managing Constraints--How?

A hypothetical manufacturing firm, Constrained Company, will be used to illustrate the concept of a constraint and show how managers can use Goldratt's five focusing steps as part of a process of continuous improvement. To keep the example simple, assume that Constrained Company operates in a highly stable manufacturing and marketing environment. The plant manufactures only two products, Y and Z, in a setting with zero defects and zero setup time. The sales forecast is precise (equal to the market demand): the firm can sell 100 units of Y and 50 units of Z. The selling price for Y is $150 per unit, and the selling price for Z is $180 per unit.

Consider first the process of manufacturing Product Y. Product Y is made by assembling one part that is purchased for $15, and processing raw materials purchased for $60. Throughput for Product Y is therefore $75 per unit ($150-$15-$60=$75). Assume that the raw materials are processed by Workers A-D. In the Constrained Company example, manufacturing resources are human laborers, but the resources could be machines. As illustrated in the accompanying table, the raw materials for Product Y are processed by each of the four workers, requiring 15 minutes from each worker.

Consider next, how Product Z is manufactured. As was the case with Product Y, the raw materials are purchased for $60, and processed using workers A-D. Throughput for Product Z is therefore $120 per unit ($180-$60=$120). Product Z requires ten minutes at worker A, thirty minutes at worker B, and five minutes each at workers C and D.

Assume that the plant has only one of each type of worker: A,B,C, and D. Assume also that the workers are not interchangeable; Worker A cannot do the work of B, B cannot do the work of Worker A, and so on. Further, assume that the workers are available 60 minutes each hour, eight hours each day, five days each week. There is no absenteeism and the workers do not take breaks. There are 2,400 minutes of each type of labor available each week (60 minutes x 8 hours x 5 days).

Note that the cost of the labor is part of operating expense. Operating expense includes the salaries and fringe benefits of Workers A, B, C, and D, as well as amounts paid to management, forepersons, the utility company, and so on. Operating expense does not include amounts paid to vendors for raw materials and purchased components. Assume that the total amount of operating expense is $500.

There are two questions to be answered. The first: what is the maximum amount of money the company is capable of earning in a week? The second: what is the appropriate product mix if the goal is to be achieved?

Managers intent on maximizing throughput can employ TOC's five focusing steps which allow them to move the firm toward the achievement of the goal. The five steps are as follows:

1. Identify the system's constraints.

2. Exploit the system's constraints.

3. Subordinate everything else to the decision made.

4. Elevate the system's constraints.

5. Restart the process if a constraint has been broken.

Managers can repeat the five focusing steps again and again as they move their firms along a path of continuous improvement. The five focusing steps are illustrated with regard to the Constrained Company in the following paragraphs.

Identify the System's Constraint(s). As noted earlier, a constraint is anything that limits a system's performance relative to its goal. In a manufacturing setting, a constraint might be a worker or a machine that creates a bottleneck in the manufacturing process. To locate the constraint, a manager might initially scan the plant to see where large amounts of work in process inventory are building up, since work in process builds up in front of a constraint.

Another way to identify the constraint is to compare resource availability with resource requirements. In the Constrained Company there are four resources, Workers A-D. First consider the load placed on Worker A. As noted in the Exhibit, Product Y requires 15 minutes of Worker A's time, while Product Z requires 10 minutes. Since the potential demand for Products Y and Z are 100 units and 50 units, respectively, total Worker A time required to manufacture both Products Y and Z is 2000 minutes ((15 minutes/unit x 100 units) + (10 minutes/unit x 50 units)). Since there are 2400 minutes available each week for each worker, Worker A is not the constraint.

Next, consider the load placed on Worker B. Again referring to the table, the total Worker B time requirement for the production of 100 units of Product Y and 50 units of Product Z is 3000 minutes. Worker B with a weekly deficiency of 600 minutes represents a constraint. Similar calculations for Workers C and D show that neither worker is a constraint. In both cases, then, resource load or time required (1750 minutes) is less than resource availability (2400 minutes).

Exploit the System's Constraint(s). Constrained Company cannot satisfy market demand for both Products Y and Z. To move the firm toward the goal, management must exploit the constraint. Exploit means to squeeze the maximum amount of throughput out of the constraint. The constraint is the labor minutes of Worker B. The first step in exploiting the constraint is to calculate the amount of throughput for one unit of each of the two products. Throughput for Product Y is $75/unit and $120/unit for Product Z . To exploit the constraint, management must know how many minutes of constrained resource are required to get a dollar of throughput. Focusing only on Worker B, product Y throughput per minute is $5 ($75/15 minutes). For product Z, throughput per minute of Worker B time is $4 ($120/30 minutes). Given that the constraint is Worker B time, Constrained Company should manufacture 100 units of Product Y and only 30 units of Product Z. This product mix will consume all of the available minutes of Worker B's time. Total throughput will be ($75/unit x 100) units + ($120 x 30) units = $11,100. Net profit is $1,100 ($11,100-$10,000).

TOC proponents suggest that managers often make product mix decisions with little or no regard to the amount of throughput per unit of constraint. Rather than focus on constraints, managers might encourage the production and sale of the product with the highest selling price (Product Z) or the product with the lowest materials cost (Product Z). Using this approach, the firm could sell 60 units of Product Y and 50 units of Product Z to achieve a throughput of $10,500 and a profit of only $500. Assuming that the cost of raw materials are the only variable costs, managers might encourage the production and sale of the product with the highest contribution margin per unit, Product Z ($180­$60=$120). Using the contribution margin approach, the decisions would again be to sell 60 units of Product Y and 60 units of Product Z.

Subordinate Everything Else to the Decision Made. Having made the decision to sell 100 units of Product Y and 30 units of Product Z, everything else must be subordinated to this decision. Specifically, local (e.g., departmental) performance measurements, such as efficiency measurements, must be subordinated to the decision made in the previous step. To illustrate, consider the utilization of Worker C, given the decision to manufacture 100 units of Product Y and 30 units of Product Z. This product mix requires only 1650 minutes of Worker C time (100 units x 15 minutes/unit + 30 units x 5 minutes/unit). As indicated above, each worker has a capacity of 2400 minutes. Since workers are not interchangeable, Worker C will have 750 nonproductive minutes.

If Worker C's foreperson is evaluated on the basis of labor efficiencies, the foreperson will receive an unfavorable evaluation, since the more nonproductive minutes there are for Worker C, the less favorable the efficiency measures. The foreperson will be tempted to obtain additional materials for Worker C to work on so that the efficiency measures improve. Such an action results only in additional inventory, not additional throughput, since the constraint is not Worker C. The TOC message is clear: the results of the efficiency performance measures must be disregarded if they conflict with the decision which exploits the constraint.

This logic can also be applied to per unit costs. Forepersons throughout the plant might try to lower per unit costs by increasing production beyond that which the constrained resource could process. Lower per unit cost would result if the fixed costs were spread over more rather than less units. However, this would result in the buildup of excess inventory.

Elevate the System's Constraints. This refers to efforts to make the constraint into a nonconstraint. This could be accomplished in several ways. Since the constraint is Worker B time, it might be possible to hire another worker with B-type skills. A second approach would be to train workers A, C, or D to do the same type of work as Worker B. One could also attempt to train Worker B to go faster. At some point, the constraint will be broken.

Restart the Process if a Constraint Has Been Broken. Management, intent on a process of continuous improvement, cannot stop after breaking the Worker B constraint. Once this constraint is broken, another constraint will appear. In this example, suppose that management elevated the constraint by purchasing another machine or hiring another Worker B at a salary of $800 per week. Worker B is no longer the constraint; the firm can now produce 100 units of Product Y and 50 units of Product Z. Throughput for Product Y is now $7,500 (100 units x $75/unit) and throughput for Product Z is $6,000 (50 units x $120/unit). Total throughput is now $13,500; it has increased by $2,400 ($13,500­$11,100). Net income has increased by $1,600.

Criticisms of TOC and TA

Most of the criticism of TOC and TA is aimed at TOC's short term focus. Robert Kaplan, in the Journal of Management Accounting Research (Fall 1990), criticized TA for ignoring fixed costs and emphasizing short term optimization by assuming that variables such as product price, customer orders, technology, and production design are fixed and therefore maximizing throughput is appropriate. He suggests that TOC is little more than a powerful short-run optimization procedure.

A related shortcoming of TOC is that it is not very helpful to strategic decision makers. A strategic decision typically requires the investment of significant capital over a long time period. Certainly, fixed costs are relevant in strategic decisions, and managers must focus on more than just throughput. Therefore, critics say, TOC is not very useful for most long-run decisions on products such as pricing.

Advantages of TOC and TA

TOC is a comprehensive management theory. Although the foregoing paragraphs outlined only the principal aspects of TOC, the theory provides a program for managing inventory, improving quality, and improving profitability. TOC suggests that managers should identify the weakest links in the chain of events in which raw materials are converted into throughput which is then delivered to a customer. Once the weakest links are identified, managers should set the pace for the entire system based on the speed at which the weakest link operates.

A second advantage of TOC lies in the simplicity and low cost of TA reports, which report only T, I, and OE. The low cost aspect of the TA reports is due to the fact that no one has to devise and keep track of complicated cost allocations. Further, firms can eliminate most if not all variance reports. This is in stark contrast to accounting reports that are prepared using traditional costing concepts. The case studies reported by Eric Noreen, Debra Smith, and James T. Mackey in The Theory of Constraints and Its Implications for Management Accounting indicate that many firms prepared costly and elaborate weekly or monthly traditional accounting reports which were often incomprehensible to most people in the organization. Those firms adopting TOC and TA found that TOC and TA concepts were easily understood. Since the TOC concepts and TA reports were so simple and easy to understand, everyone in the organization knew what had to be done to achieve the firm goal. *

Jack M. Ruhl, PhD, is an associate professor and chair of the department of accountancy at the Haworth College of Business, Western Michigan University.

Michael Goldstein, CPA
The CPA Journal



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