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.