Thursday, January 5, 2012

Reconciling ABC (Activity Based Costing) & Throughput Accounting


Recently, I got into an interesting conversation on ABC (Activity Based Costing) and Throughput Accounting. I was of the view that both have fairly common ground and do not conflict. However, I couldn't garner a convincing argument at that time. Hence this blog post where I attempt to reconcile both ABC & Throughput Accounting. 


Lets begin with Throughput Accounting. Throughput is Sales - Variable Cost. The variable cost here includes the 'True' variable costs like raw materials and to some extent the sales commissions. All other costs are considered fixed and as Operating Expense. Hence, the bottom-line, i.e. Net Profit is calculated as Throughput - Operating Expense. Its obvious that to increase Profit, one must aim to Increase Throughput while keeping the Operating Expense constant.
Considering the scenario where the constraint is internal, Throughput Accounting says that one must evaluate Throughput generated per Unit time on constraint (T/c) for each product of the product portfolio. Then to maximize the overall Throughput, the product with the highest T/c should receive the priority on the constraint followed by the one with next highest T/c.

Now lets come to Activity Based Costing (ABC). ABC claims that traditional accounting do not reflect the true cost of a product. ABC says that the true cost of a product is a function of the activities that go into making of that product. Traditional accounting allocates overheads without taking into account the activities involved in making that product. To clarify this with an example, a product 'SP' requires a special process and hence is routed to a Special Machine. An another product 'GN' doesn't require the special process. The traditional accounting will allocate the overhead cost of Special Machine to all the products based on a cost driver. This would under-estimate the cost of SP and over-estimate the cost of GN. ABC addresses this situation by changing the cost drivers to reflect the activities that go into a product. It would tell us that the fixed cost of that Special Machine is in fact solely dependent on producing SP. 
Lets take another example of procurement activity. Not all product will have same amount of procurement activity going in. Under ABC, the allocation of procurement overhead should be in accordance with the extent of procurement activity for each product. The products with higher procurement activity will have higher allocation. The cost driver can be 'Variety of Sourced Parts in a Product' or 'Weight of Sourced Parts in a Product' depending on the nature of products.


Till now, we have clarified Throughput Accounting and ABC in their own language. Lets proceed further and combine the language.

What ABC does in principle is to treat the fixed costs as variable. By allocating a fixed cost to a product's activity, its treatment changes to 'cost per unit' of that product and hence variable with volume.  In Throughput Accounting, the same fixed costs are Operating Expense. So within the context of Throughput Accounting, the ABC treats even the Operating Expense as variable. TOC (Theory of Constraints) proponents may term this against the tenets of Throughput Accounting, but lets continue to examine further with TOC spirit. 

Lets examine the assumption that true variable costs are only raw materials and sales commission.
Consider the earlier example of products SP & GN. Assume that SP has a higher T/c (Throughput per Unit time on Constraint) compared to GN. Hence SP needs to be produced and GN to be shelved. This would increase Throughput and hence Net profit (assuming that Operating Expense remains same). Refer below:



But if we were to eliminate SP, then the corresponding Special Machine will no longer be required. It can be sold off and all associated costs are erased. The Operating Expense will reduce, maybe to the extent to compensate the loss in Throughput to yield a higher Net Profit than before. Refer below:
 


Is this against the basic tenet of TOC which says that the objective of a company is 'To make money now and in future'.  No!! In the end its about Profit, not Throughput. But then, how do we resolve the following conflict.



The conflict can be resolved with an injection: 'ABC helps to locate other quasi-variable costs which are hidden inside Operating Expense. '




Lets challenge this new understanding by applying it to our products SP and GN:

  • If, SP has higher T/c compared to GN. Hence the initial product portfolio decision would be to produce SP and eliminate GN.
    • Now, ABC tells us that the high cost of a Special Machine is associated only with SP. So, we include the cost associated with Special Machine as the variable cost for SP and recalculate T/c. If T/c is still higher for SP, then we produce SP as before. But if T/c is lower for SP, then the decision should be to eliminate SP and produce GN instead. The assumptions are that market doesn’t become a constraint if either SP or GN is produced and the Special Machine can be sold at its Net Depreciation value.

    • What if market becomes the constraint for GN and we cannot eliminate SP completely. Then no benefit will come as Special Machine and its associated cost will still exist. Then we take out the cost associated with special machine from variable cost and go back to our decision of producing SP. Hence, the cost associated with Special Machine is variable with make or eliminate decision for the SP product, not with each SP unit.

  • What if we sell the Special Machine and contract a third party to perform the special process? Then the cost of special process becomes variable with each unit of SP. ABC will help bring that out. Then, we recalculate Throughput and T/c by including the variable cost of third party process. If T/c of SP is now lower, then we choose GN and produce it to market demand. Rest of the constraint time is allotted to SP.

From the above discussion, one can at least conclude that both ABC & Throughput Accounting need not be at loggerheads and ABC can be leveraged within Throughput Accounting for effective decision making.


In a broader sense, ABC based management is generally used in organizations to identify the high cost activities and hence prioritize them for improvement and reduce wastage. In Throughput Accounting context, it would impact and reduce the Operating Expense. TOC initiatives are more strategy oriented and aimed towards bringing significant impact. ABC based management is more process improvement oriented. And both are not in conflict. I have tried to clarify the same in my previous post on how strategic performance models co-exist with process improvement models. Of course, caution should be exercised to align them and ensure that improvement activities do not create new bottlenecks or hurt global optima.

To conclude, in TOC spirit, both Throughput Accounting and ABC are not in conflict and there is harmony between them. 

Having put forth my viewpoint, I now invite readers to debate it to further improve our understanding.

Sunday, January 1, 2012

Frameworks' Deluge: Demystifying Business Frameworks for Performance Management and Business Excellence

A very happy new year to the readers. It has been my constant endeavor to provide different prespectives on issues which concern business and society.

Approach to business and management has become more structured in modern times. Numerous tools in form of models and frameworks are available to business mangers to perform effectively in the complex business world. However, from my experience, managers  often feel overwhelmed and lost in deluge of these models and frameworks. This happens when managers lose touch with the original thinking and intent behind frameworks and models.

In my following post, the first in 2012, I have tried to clarify, with graphical illustrations, a selection of business models and frameworks which often confound business managers.


Introduction
Today one often hears the names of business frameworks like Balanced Scorecard, Lean Policy Deployment, EFQM Model, Malcolm Baldrige Model, Business Performance Improvement Resource (BPIR) model, Singapore Quality Award (SQA) framework and others. Many organizations also create their own hybrids which only adds to the list. Also these frameworks have led to a cottage industry of consultants who help with their implementation.

Before jumping on the bandwagon and adopting a framework, an organization needs to know the purpose behind each framework and select judiciously. Otherwise the framework may end up just being the flavor of the week. To evaluate and differentiate frameworks, one needs to understand first their Core Intent, Inspiration and Geography focus. Of these, Core Intent is the most apt criteria to categorize the frameworks. Following are the two categories of ‘Business Excellence Frameworks’ and ‘Strategy Performance Management’ Frameworks explained. 

Business Excellence Frameworks
As evident form the table above, all models have their roots in Total Quality Management movement. TQM essentially says that quality is all-pervasive; it is responsibility of everyone and applies to all activities in an organization. The TQM concept was further structured and enhanced with a performance measurement system into the 'Business Excellence' models known today. Quality bodies in different regions took independent initiatives to come up with their own implementable frameworks and hence the reason we have several models similar to each other.

Selection Criteria: Choice of a business excellence model hence would primarily be governed by the geographical region in which company is operating. A US company could go for Malcolm Baldrige and an European company could go for EFQM. A company can also in turn look at its customer base to decide which model to go for to enhance its image. Other factor that could influence the choice would be availability of consultancy support for implementation.

Strategy Performance Management Frameworks
As evident from table above, Balanced Scorecard and Lean Policy Deployment Matrix essentially serve the same purpose, i.e. implementing business strategy. It involves percolating strategy to operational activities and managing performance. It’s worth mentioning that companies have been implementing strategy before these models arrived. These models are derivatives of in-house systems of various organizations.

Selection Criteria: Both the models have global appeal. The choice is fairly simple here. Companies need to select the one which gels well with their internal systems. For instance, companies with strong 'Lean' focus would prefer to go for Lean Policy Deployment Matrix.

Points of Divergence
Now we come to the contentious issue. What is the difference between the two categories? Are they mutually exclusive or overlap. One can easily argue that both
• Spell out operational level performance measures and targets
• Both measure performance and provide feedback
• Both talk about improvement
So do we really need both? Yes, because both serve different objectives. Let’s examine them further to clarify.

Strategy Performance Management frameworks
In these frameworks, Business Strategy is the input which drives the selection of performance measure at various levels. It is focused towards achieving strategic goals by aligning local actions in the organization.

Refer the figure below. The business strategy is defined in terms of strategic objectives and strategic initiatives are launched to meet them. Targets are cascaded to every level which ensures overall achievement of strategy objectives. 



Business Excellence frameworks
Under this category, Internal assessment and Benchmarking drives the selection of performance measures and targets. The focus is on continuous improvement of organizational processes with an aim to be the best-in-class in the industry.

Refer the figure below. The internal assessment and benchmarking throws up the performance gaps. The process improvement programs are launched to close the gaps. These are on-going programs which cover both governing and operational processes. For instance, strategy formulation and implementation processes (which is a governing process) itself needs improvement on on-going basis. An improvement program can also be about improving the balanced scorecard process itself.


The differences are quite evident by now. They are summarized below. As evident, both have different intent and differ in their approach.

Points of Intersection
However, there are points of intersection between the two frameworks.
  1. Both categories’ frameworks drill down to local actions and targets. This essentially means that quarterly performance targets of employees will have measures coming from both.

  2. The initiatives under the two categories can potentially overlap. This is evident from the figure below. A strategic initiative to reduce product development time (essentially to increase speed to market) will closely match with process improvement efforts for product development. Similarly, strategic initiative of multiskilling will have bearing on employees’ incentives and rewards process.


  
Conclusion
It’s clear by now that both the framework types are required for competitive success. One cannot replace the other. For instance, processes like Strategy formulation and implementation need improvement even though no strategic initiative will directly address them.

Combining them would be a mistake as it will dilute the original intent behind the frameworks. However, given the areas of intersection and limited organizational resources, it is imperative to avoid conflict and align both frameworks within an organization. A common steering committee which is responsible for both frameworks (Strategy Performance Management and Business Excellence) can ensure the alignment in both planning and end results.