PMF5
Syllabus A: Specialist Cost And Management Accounting TechniquesA4. Throughput Accounting

A4ab. Calculating and Interpreting a TPAR

Syllabus A4ab)

a) Discuss and apply the theory of constraints.

b) Calculate and interpret a throughput accounting ratio (TPAR).

What is throughput?

Throughput is the rate of converting raw materials and purchased components into products sold to customers.

In money terms, it is the extra money that is made for an organisation from selling its products.

Throughput = Revenue – Raw material cost

What is throughput accounting?

Throughput accounting (TA) is an approach to accounting which is largely in sympathy with the JIT philosophy.

The following are the main concepts in throughput accounting
  1. In the short run, most costs in the factory (with the exception of materials costs) are fixed

    These fixed costs include direct labour. 

    These fixed costs are called Total Factory Costs (TFC) (operating expenses).

  2. In a JIT environment, the ideal inventory level is zero. 

    Products should not be made unless a customer has ordered them. 

    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 the sale takes place.

  3. Profitability is determined by the rate at which sales are made and, in a JIT environment, this depends on how quickly goods can be produced to satisfy customer orders.

    Since the goal of a profit-orientated organisation is to make money, inventory must be sold for that goal to be achieved.

Traditional Cost Accounting versus Throughput Accounting Ratio

Conventional cost accounting Throughput accounting
1. Inventory is an asset
Inventory is not an asset. it is a result of unsynchronised manufacturing and is a barrier to making profit.
2. Costs can be classified either as direct or indirect Such classifications are no longer useful.
3. Product profitability can be determined by deducting a
product cost from selling price.
Profitability is determined by the rate at which money is earned.
4. Profit can be inceased by reducing cost elements. Profit is a function of material cost, total factory cost and throughput.

Marginal costing and throughput accounting both determine a contribution by calculating the difference between sales revenue and variable costs.

However this contribution figure will be higher under throughput accounting since only material costs are recognised as being variable costs.

Under marginal costing, direct labour costs and certain overhead costs will also be deducted from sales revenues in order to calculate contribution.

Throughput accounting regards such costs as fixed and this is true insofar as they cannot be avoided in the ‘immediate’ sense.

Illustration 1

x y
sales revenue 25 30
material cost 5 8
labour cost (@ $3/hr) 3 6
variable overheads 2 2
fixed overheads 1 4
max demand 10,000 15,000

How do we calculate contribution under Marginal costing?

x x y y
$ $ $ $
sales revenue 25 30
less variable costs
material 5 8
labour 3 6
variable cost 2 10 2 16
---- ---- ---- ----
contribution / unit 15 14

How do we calculate Throughput?

x y
$ $
sales revenue 25 30
less material 5 8
---- ----
return / unit 20 22

Throughput accounting and the theory of constraints

The theory of constraints is applied within an organisation by following ‘the five focusing steps’ – a tool which was developed to help organisations deal with constraints.

  1. Identify the system’s bottlenecks

  2. Decide how to exploit the system’s bottlenecks

    This involves making sure that the bottleneck resource is actively being used as much as possible and is producing as many units as possible.

  3. Subordinate everything else to the decisions made in Step 2

    The production capacity of the bottleneck resource should determine the production schedule for the organisation as a whole. 
     
    Idle time is unavoidable and needs to be accepted if the theory of constraints is to be successfully applied.

  4. Elevate the system’s bottlenecks

    This will normally require capital expenditure.

  5. If a new constraints is broken in Step 4, go back to Step 1

    The likely constraint in the system is likely to be market demand.

The Throughput Accounting Ratio (TPAR)

Where there is a bottleneck resource (limiting factor), performance can be measured in terms of throughput for each unit of bottleneck resource consumed.

Three important ratios

  • Throughput (return) per factory hour
                
    Throughput per unit
    ------------------------------------------------
    Product’s time on the bottleneck resource

  • Cost per factory hour
                          
    Total Factory Cost
    -------------------------------------------------
    Total time available on bottleneck resource

    The cost per factory hour is across the whole factory and therefore only needs to be calculated once (not for each product).

  • Throughput accounting Ratio

    Return per factory hour
    ---------------------------
    Cost per factory hour

TPAR more than 1 would suggest that throughput exceeds operating costs so the product should make a profit.

Priority should be given to the products generating the best ratios.

TPAR less than 1 would suggest that throughput is insufficient to cover operating costs, resulting in a loss.

Criticisms of TPAR
  1. It concentrates on the short-term

  2. It is more difficult to apply throughput accounting concepts to the longer term when all costs are variable

  3. In the long run, ABC might be more appropriate for measuring and controlling performance