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.

9 comments:

  1. Actually ABC is a methodology to calculate costs. It helps you view costs and identify the reasons for the same. If you want to use ABC for calculating costs then pl use them.

    When you say it distributes the fixed expenses to the products, it is treating fixed expenses as variable. This is typical 'top-down' approach of modeling. There have been lot of changes in ABC modeling and these concepts that are there in books written on ABC, which are published in 90s.

    the basic assumption is not true and in the bottom-up modeling not all the fixed expenses are taken to products (or customers or chennels etc.). The costs based on the utilization of capacity are taken and the rest are shown as 'cost available to use'.

    ABC is not only used for process improvements and hence operational. It can be used for strategic decisions also as to see profitable products, customers and channels to decide the future strategy of acquiring, retaining and chking customers, products etc. Also to find the profitability of alternate channels move the customers to profitable channels.

    More pl see at www.activitybasedmgmt.blogspot.com

    Regds

    Rajen Patil
    +91 98226 19986

    ReplyDelete
  2. Thanks Mr. Rajen for your valuable comments. I agree that ABC provides a good view on costs and who is contributing them. Thanks for pointing out the recent developments in ABC and about 'cost available to use'. It further aligns ABC and Throughput Accounting by not treating a portion of costs as variable but as operating expense.

    ABC can be used to identify low profitable products (or consumers or segments). However, one must exercise caution and not to chuck the products which maximize throughput. Throughput is the real money coming in which covers our fixed and not-so-fixed expenses. There can be a situation where a low profitable product as per ABC may be consuming less time on constraint. Increase in its volume can generate enough throughput to cover the fixed costs and become profitable.

    We can combine the understanding of both ABC & Throughput Accounting to make better portfolio decisions.

    ReplyDelete
  3. Hi Ashutosh

    Let us get back to first principles. What is the purpose of Throughput A/c or ABC?

    We can put it as Decision Support to take valid decisions or making choices in the path towards reaching the goal.

    We must be conscious of the fact that the true constraint in any organisation is "TOP MANAGEMENT's" time and attention.

    http://www.youtube.com/watch?v=iFYoPqcTy3Y

    This resource can be exploited if and only if they are always focusing on the ISSUES that matter the most and always taking the right decisions.

    Is there a mechanism of sifting out the "RIGHT ISSUES"?

    Is there a mechanism of ensuring that the "RIGHT DECISION" is taken all the time?

    TOC as a body of knowledge provides the mechanism of identifying the "ISSUES" through its focusing mechanism. The convergence principle gives us the confidence that there is just ONE core cause that needs to be addressed.

    The thinking that is at the foundation of ABC rests on the belief that there are MULTIPLE ISSUES that need to be addressed. Or in pure TOC terms, there is a belief that sum of local optima would lead to Global Optima.

    The conflict between TA and ABC is at this level.

    As long as the TOP MANAGEMENT is focused on the core cause, (i.e. the direction of solution is right) even if the decision support system provides approximately right information it is good enough.

    Your analysis shows that even without the clarity of WHAT TO CHANGE (What is the CONSTRAINT)we are trying to get accurate answer by attempting to allocate a FIXED SUNK COST.

    Ability to reach the conclusion about the CORE CAUSE rests on clear thinking.

    To my understanding clutter is the biggest enemy of clear thinking.

    ABC is nothing but a clutter and an irritating distraction. And it should be junked from consciousness at the first available opportunity.

    ReplyDelete
  4. Dear Mr. Deepak. Thanks for your detailed comment. I agree with the need of clear thinking.

    The intent here is to relate ABC & TOC but not merge them. Today, there is a clutter in management thinking and people take various positions. There are strong ABC proponents as well. The intent here is to look clearly through the clutter so that one can have a meaningful dialogue with any position and bring them around to the clear thinking.

    In my discussion, the implicit starting point is that TOC has been applied and we have an internal constraint. And we are at portfolio decision and we have calculated Throughput per Unit time on Constraint.

    I wish to present my understanding on SUNK costs. In my analysis I have avoided the trap of falling into SUNK cost. A cost is SUNK only if it cannot be RECOVERED. I did mention the assumption that the Special Machine can be sold at its Net Depreciation value in the books. If it cannot, then definitely its a SUNK cost and has no influence on portfolio decision.

    Also, most of the assets in an organisation are financed by raising either Debt or Equity capital. Though these assets are bought with one time investment but you have regular outgoing cash-flows for principal and interest payments. If an Asset can be sold to retire its corresponding debt, then its not really a SUNK cost.

    Whats your view on the case of a third party contractor doing the special process for SP (rather than owning the special machine). Do you agree with me saying that its a variable cost and not a Fixed cost?

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  5. The test of any method (TA, ABC, etc) is whether it helps to take the right decision, i.e induce actions which helps the company to move towards the goal , of making more money now and importantly in the future as well.


    In your example of SP, GN where you are describing the cloud if I understand right constraint is internal. So as per TOC , the action that will take the company towards the goal is not to summarily eliminate SP and sell the machine , but exploit (subordinate) and then if requierd elevate, (as long as the incremental T from SP is higher than incremental OE) so that company can sell both GN and SP.


    Selling machine and reducing OE (mostly one time at best) is not in line with the goal of the company , unless in a very exceptional scenario of obsolescense (no pull from the market) and where SP machine is so specialized that it cannot be used for anything else.


    The necessary condition in the cloud of producing products which reduce OE is a bit of mystery to me. (OE by defn is fixed)


    The concept of treating fixed costs as variable and apportioning to various products to arrive at the product cost is fraught with danger.

    You make the point about "TOC initiatives are more strategic and ABC is more process improvement oriented", what is strategy / tactic / process is matter of another discussion, but TOC actually outlines the process of POOGI, identify / decide how to exploit / subordinate/ elevate / go back ; techniques like Lean, SS, etc provide the tools and techniques to improve a process (constraint) once it is clear from TOC that improving this process will actually help in making more money.
    I am yet to be convinced that ABC brings any decent return on the time spent , in fact many times ABC analysis takes one way from the goal

    Thanks
    Aniruddha

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  6. Thanks Aniruddha for giving your detailed feedback and bringing out specific points.

    Yes, SP & GN are a very simplistic assumptions where I assumed that market never becomes a constraint for either of them. SO I agree with you on various alternate actions that can be taken.

    The cloud is structured to communicate with an ABC proponent as well. Hence it talks about reducing operating expense to increase profit.

    Coming to your statement on 'OE by defn is fixed'. In Throughput Accounting OE is everything apart from the variable cost of materials (and sales commissions to some extent). However, the cost structure of companies are changing such that the OE is not entirely fixed. For instance:
    - A product goes out to third party for a special process (Titanium welding, special NDT checks etc..).
    - Movement towards 'pay per use' model. You will be well aware of cloud computing and its impact on IT cost structure. A company, which sell its products online, it pays the hosting website based on transactions.
    - Movement towards outsourcing direct procurement. This again will make overhead cost of procurement variable in nature.

    Hence to cover situations like this I used the term quasi-variable.

    I agree that TOC has POOGI framework and can be applied for process improvement. However, personally I will use TOC to drive significant jumps in a company's profit. Challenging the existing process improvement methods will not be a priority. And as you said we can work with them under TOC framework.

    Consider ABC a 'Nice To Have' dials in a cockpit of a senior manager. He gets an all round view of costs and where they are coming from. Steering only on based of them can be fatal sometimes. However, these dials doesn't stand in way of applying Throughput Accounting and steering properly.

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  7. Hi Ashutosh

    Like mentioned earlier. The issue is of focus.

    Is Balance Sheet window-dressing an issue that the management should focus on?

    It appears as an option when the REAL ISSUE is out of sight due to lack of clear thinking.

    Do you remember the story of Arjun taking an aim?

    Would he have given any attention to anything other than the eye of the revolving fish?

    Nice-to-have dials are like that distraction.

    We need to forgive the ABC proponents if they have not been introduced to the necessity of focus.

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  8. Ashutosh, your definition of sunk cost is a bit of a stretch, with this defn virtually no cost is sunk , a worker can be fired, machine sold, for that matter an entire factory sold ;
    I don't think a company run on the above principles will be able to achieve the goal of making more money now and fulfill necessary conditions of keeping employees and other stakeholders satisfied

    More importantly as Deepak says its about focus and priority. Companies focued on increasing Throughput (T) would spend their limited time on creating Decisive Competitive Edge in the market rather than hair-splitting exercise of trying to find some quasi-variability in costs, apportioning them and in the end at best may be saving 2-3% here and there.
    Remember the rule 80-18-2, 80% of time on increasing T, 18% on managing Inventory and 2% on costs control.
    This should not be misunderstood that TOC advocates no cost control or encourages wastage, in fact with TOC , costs will be far better controlled.

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  9. Sunk cost has a plain textbook definition and I do not intend to stretch it. All I am saying is that we need to analyse any situation on its own merit. If something has worked till date, we cannot take it as given. With TOC spirit, every situation merits its own analysis even if we need to challenge our conventional thinking.

    TOC is not prescriptive and definitely not formula based. As you have said, its about 'clear thinking'. I only tried to look beyond the usual formulas here. It really doesn't matter if in many cases the quasi-variable costs are in-significant to be included in Throughput calculation. We always owe a situation (or a client or a competing concept) a proper analysis and a fair attention.

    'Its about focus and priority.' I totally agree!
    Companies have limited time'. I agree and that's why they hire consultants to do thorough analysis and suggest action and priorities. :)

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