Throughput Accounting

There are many challenging P2 topics that you will need to understand in order to successfully pass your P2  exam. For example, Throughput Accounting is a subject which many students find difficult to grasp at first!

At Astranti we aim to make difficult subjects easy to understand. All of our materials are designed to ensure that our students are given in-depth knowledge of all the key subjects, but in a format that allows you to learn easily and effectively.

As an example we'd like to share with you a new and updated section of our P2 Study Text which explains Throughput Accounting in a straight forward and clear way. 

Throughput Accounting 

Introducing Throughput Accounting

Throughput accounting (TA) is an accounting system that aims to maximise profit by focusing on maximising the efficiency of the bottleneck in the process.

It is similar in concept to marginal costing; however it differs in that it considers material costs to be the only variable cost. All other costs, including direct labour, are treated as fixed.

Therefore TA identifies operating costs as either:

Variable costs – Direct materials

Conversion costs – All other operating costs, such as labour, overheads, rent, utilities etc.

In marginal costing you may remember the term contribution. This was equal to the selling price of the product less all variable costs. Throughput accounting employs the same equation, with the key distinction that the only variable cost is material cost. This is known as throughput or throughput contribution.

Throughput contribution = Sales revenue less material cost

The focus on making sales and removing bottlenecks

The primary focus with throughput accounting is how fast a business can generate throughput. A key indicator used to achieve this is the return per time period, calculated as:

A manager with this as their target will focus on maximising sales, and hence sales revenue. Notice holding stock is not beneficial as it is under absorption costing. In an environment where stock holding should be kept to a minimum (e.g. to avoid obsolescence) then this measure is seen as a good one.

With this goal in mind it no longer makes sense to operate the entire factory at full capacity. Since units can only be produced as fast as the bottleneck will allow, operating the other departments at full capacity only results in a build-up of stock, which, as we’ve already said is not rewarded. These items will lay around collecting dust while waiting to be processed by the bottleneck. Picture an oven that can bake 500 pies an hour working alongside a packaging department that can only package 100. The result is 400 pies building up every hour waiting to be packaged and unable to be sold. These pies provide no benefit to the business other than to increase storage costs and wastage.

The manager will now focus on removing bottlenecks to maximise their performance (and get paid their bonus). The focus turns to maximising the efficiency of the bottleneck, while operating other departments at a speed the bottleneck can keep up with.

In our example, a throughput accounting approach would see us reduce our baking of pies to 100 pies per hour and focus our attention on increasing the efficiency of our packaging. Eventually we would aim to improve the efficiency of our packaging operation to the point that it surpasses our baking operation. Once this happens our new bottleneck becomes the baking operation. We would then focus our attention on how to bake more pies, and so our process continually improves.

You might find TA unique in that cost control is not the primary focus. The emphasis is on throughput first, followed by inventory minimisation, and cost control third.

We can use the return per time period ratio we discussed above to ‘rank’ products in order to determine which one makes best use of the bottleneck resource. We can adjust the time period to whichever unit of time we like. For example, if we wanted to calculate our return per minute, the ratio would simply be:

Let’s use an example to see this at work.

Example

We produce two different toy cars – Car A and Car B. The information for each product is as follows:

	Car A	Car B
Direct material	£20	£20
Direct labour	£7	£12
Variable overhead	£7	£12
Total cost	£34	£44
Selling price	£70	£65

Each car is produced in two stages – the modelling stage and the testing stage. The time required at each stage is as follows:

	Minutes required
Process	Car A	Car B
Modelling	8	30
Testing	16	12

However, our capacity is limited. Our modelling machines are available for 16 hours a day and our testing facility is available for 6 hours a day. This gives us available time of 960 minutes and 360 minutes respectively.

	Time available
Modelling	16 hours = 960 minutes
Testing	6 hours = 360 minutes

We want to plan our production in a way that will maximise our profits. Our first step in doing this is finding out which process is our constraining resource or ‘bottleneck’. To do this we work out how many of each car we can process through each stage per day:

Modelling	Mins available	Mins required	Maximum units
Car A	960	8	120
Car B	960	30	32
Testing	Mins available	Mins required	Maximum units
Car A	360	16	22.5
Car B	360	12	30

This calculation shows that for both Car A and Car B we can model more cars per day than we can test. This means that our bottleneck lies in the testing stage.

Therefore our issue is figuring out how to best use the limited capacity of the testing facility – our bottleneck resource.

Traditional approach

Under a traditional approach, we would aim to work out which product will maximise contribution. You should recall that contribution is selling price less all variable costs.

	Car A	Car B
Selling price	£70	£65
Direct material	£20	£20
Direct labour	£7	£12
Variable overhead	£7	£12
Contribution	£36	£21
Minutes of testing required	16	12
Contribution per minute	£2.25	£1.75

Under this approach it appears that Car A provides the higher contribution per minute, therefore our strategy would be to maximise the production of Car A.

Throughput approach

The idea under this approach is to maximise throughput. You should recall that throughput is equal to selling price less variable costs, where the only variable cost is materials. Therefore our calculation would be:

	Car A	Car B
Selling price	£70	£65
Direct material	£20	£20
Throughput	£50	£45
Minutes of testing required	16	12
Throughput per minute	£3.13	£3.75

Using a throughput approach our strategy would therefore be to focus on producing the maximum number of units of Car B, as Car B provides the higher throughput per minute.

When to use throughput accounting

Throughput accounting is useful where the focus is short term. This is because the reality of modern manufacturing is that direct labour and other overheads are in fact fixed in the short term. We pay our staff and heating bills anyway even when the factory is not working or if the production process is inefficient. Therefore throughput accounting is best suited to a management team where overheads and labour will be paid at the end of the day or week irrespective of how many units are produced.

As discussed earlier, it is also useful where directors want to focus management attention on eliminating a bottleneck or improving production flow as the focus is on throughput.

It is also useful in environments where the aim is to minimise stock (E.g. where products become obsolete quickly or are perishable). This is preferable, for example, to absorption costing systems which actually reward the build up.

It is therefore important to understand that there is no ‘correct’ answer in the above example. The most suitable approach will depend on the situation and the time horizon of management’s goals.

Throughput accounting ratio

In the earlier example we explored options for maximising throughput through our bottleneck resource. This provides value in the short run, but it ignores the fact that we have other costs to consider, namely labour and overheads. This is where the throughput accounting ratio comes in.

The aim of any profit maximising business will be to attain as high a TA ratio as possible. A TA ratio less than 1 indicates that the throughput is not enough to cover labour and overhead costs. Therefore a product must have a TA ratio greater than 1 in order to be viable.

For example, let’s say sales for our toy car were £10,000 with material costs of £4,000. Throughput is therefore £6,000. If labour and overheads are £3,000 the product is making a profit and the ratio is more than 1 (i.e. 6,000/3,000 = 2). If labour and overheads are £12,000 the product is loss making and the ratio is less than 1(actually 6,000/12,000 = 0.5).

Generally speaking, priority should be given to products that provide the highest TA ratios therefore.

Remember that cost control is not the primary focus of TA. It concerns itself mainly with throughput maximisation and inventory minimisation. It does not concern itself with optimising other costs as the belief is that other costs are fixed anyway.

In reality this assumption is often accurate. While labour is traditionally thought of as variable you will find that in many environments it is fixed in the short term. Firing or making workers redundant cannot simply be done overnight – there are processes and often costs associated with it that can take weeks or months to resolve. By the time you deal with the fuss of it all it might end up being cheaper to just keep your redundant workers on the payroll!

Therefore the TA ratio is simply a measure to determine whether ‘fixed’ costs are being met. Throughput accounting does not aim to concern itself with controlling or reducing these costs.

Astranti Financial Training.