Problems Associated With Traditional Management Accounting Techniques
The traditional role of accounting is twofold; to assist management to make informed decisions about that which will impact the future performance and to ‘keep score’ in regard to historical performance.
That component which relates to guiding management is where most of the influence occurs as it not only includes the preparation of the analysis but also developing recommendations. This article will focus predominantly on this second responsibility for reasons that should become clear.
The primary areas where finance provides this information and guidance are:
Assessing the performance of the system as a whole – established by the preparation of financial statements (profit and loss, balance sheet, cash flow)
Assessing investment proposals – using calculations such as return on investment (ROI)
Evaluating make or buy alternatives – comparing the price to buy from an external supplier vs in house production
Product costing – assessing the performance of subsidiaries or subsystems within and organization through the use of profit centers evaluating the financial performance of that subsystem
Assessing discrete product or service financial performance – typically performed through the use of product costing to compare the relative contribution of one product over another
When grouped collectively, the common denominator in each case is that often the decision making time-frame is short thereby limiting the amount of time available to gather, validate, analyse and then recommend one approach over another. This tension can often result in finance developing a case for better, faster and more reliable information (a new information system) whereas the real problem lies in the measurements used to evaluate each type of decision. The wrong measurements can have a significant impact on the quality of the decisions being made.
Assessing the performance of the system as a whole
The main distortion that traditional accounting provides when measuring the performance of the system as a whole is in the way in which it values inventory. From a financial point of view, inventory is treated as an asset in the balance sheet and when calculating the profit or loss, movements in inventory impacts the cost of goods sold calculation; increasing inventory values reduces the cost of goods sold calculation (and therefore increases the reported profit) or decreases in inventory values increases the cost of goods sold calculation (and therefore reduces the reported profit).
This contrasts from an operational point of view, `that high inventory holdings can adversely impact quality control and generate rework, increase lead times and due date performance to customers, result in mismatches with changes in customer demand and hide process performance issues. In summary, high inventories are not an asset but are practically a real liability when viewed from an operational perspective.
These two contrasting points of view create a conflict to the extent that high inventory can adversely impact sales (for the reasons described above) whereas high inventory results in an increase in the reported financial performance of the business.
Lets me explain this issue with an example. Company X has the following gross margin calculation:
However, assume management decide to reduce the amount of inventory required to support existing sales. Assume that management were successful in reducing inventory by $4m (10%) , the gross margin calculation would result in the following gross profit
From a traditional accounting and reporting perspective, the reduction in profit caused by the reduction in inventory is therefore seen as a negative outcome from a financial point of view
Evaluating Investment Decisions
The traditional approach to evaluating new investments tends to rely on comparing the net cost of outputs of one option over another. For example, if a mine was evaluating a new shovel at say $4m, the new shovel can move 60 cubic metres per load compared to the existing shovel rate of 40 cubic metres per load. This equates to a time savings of 1/3rd or an additional productivity generating 33% more product. The return on investment is derived from either a) the reduced labor and maintenance required to produce the same amount of tonnes (say, $2m/year), thereby generating a return on investment of 2 years which is within the limits required for investment purposes or b) increased tonnages being able to be sold.
However when the same evaluation is performed from a systems perspective, the type of analysis depends on whether the equipment is a bottleneck or non-bottleneck in the system.
If the equipment is a non-bottleneck
If the equipment is being used in a non-bottleneck situation, any claim of productivity improvement is nothing more than an illusion. The increased rate of performance is generating more product however as this product still needs to be processed through the systems bottleneck and as there has been no increase in the capacity of the system bottleneck, the increased capacity of the shovel effectively results in additional and unnecessary inventory.. Furthermore, the perceived labor and maintenance savings need to result in an actual reduction in labor before they can be counted as savings.
If the equipment is a bottleneck
When the equipment investment decision relates to the systems bottleneck location, the analysis needs to shift from being cost focused to being throughput focused. What is the incremental increase in sales resulting from this investment? In the scenario above, the equipment would result in an additional 33% of throughput resulting in an increase in profitability (e.g assuming existing sales of $100m with a gross margin of 80%, the additional 33% would generate an additional gross margin of ~$25m) providing a payback of 2 months rather than 2 years.
Evaluating make or buy alternatives
This decision compares the cost of making to the cost of buying with the cost of making calculated typically by adding the cost of the raw material with the cost of processing and the cost of overhead. For example, raw material cost per unit for a given widget is $10/unit + direct labor cost of $12/unit plus overhead of say $15 giving a total unit cost of $37/unit. This number is then used to determine whether to continue to make if the external supplier price is above this amount or to buy instead of make if the price is below this price
In reality however, any decision to buy instead of make will have limited or zero impact on the cost of labor or the overhead. Unless personnel are made redundant as a result of the buy decision, no labor cost savings can be claimed. Similarly, the overhead is a fixed cost and is unlikely to change as a result of outsourcing one particular part. Therefore assuming that the vendor price is say $15, the net result for the company is that costs will increase (vendor price – raw material price) by $5
However when the same evaluation is performed from a systems perspective, the analysis used depends on whether the part requires bottleneck processing time.
If the part is manufactured using non-bottleneck resources
Under this scenario the same concerns that were expressed above regarding the false belief that labor and overhead would actually reduce for the business if parts were outsourced applies here.
If the part is manufactured using a bottleneck resource
When part make or buy decisions involves processing at the system bottleneck, the analysis (again) needs to shift from being cost focused to throughput focused. Assuming that the gross margin is 80% (as used above) on sales of $100m and that this particular part is produced at the rate of say 10,000 per year which utilizes the bottleneck at say 2% of its time. By outsourcing this part, there is an increase of 2% in the systems bottlenecks capacity which by definition should result in an increase in sales equal to .02 x $100m = $2m per year at gross margin of 80%. This means that the gross margin should increase to $1.55m (1.6m adjusted for cost of vendor purchases ($15 x 10,000 = $150,000 and the cost of raw materials ($10x 100,000 = $100,000). This is a significant benefit from outsourcing one product that would have been overlooked using traditional accounting methods.
Assessing the performance of subsidiaries or subsystems within and organization
From a traditional accounting perspective, when subsidiaries or subsystems are measured based on their own contribution to profit, then the issue invariably requires the calculation of a transfer price for products that are outputs of one division of the business and inputs into another. The transfer price is typically calculated based on cost (raw material, direct labor and overhead) plus percentage margin based on the cost. The implications of this calculation method is that if costs go up or down so to does the margin and therefore the profitability of the sub system.
This method can therefore cause divisions to become either indifferent about their approach to managing costs or actively skew their cost allocations to favor higher margin calculations
From a TOC perspective the concept of applying transfer prices amongst sub systems does not encourage process improvement and therefore ads no value to the system or its owner
Traditional accounting uses product pricing to establish whether the company is able to sell its products for more than it costs to produce them. The assumption being that if you are selling products for more than it costs to produce them, then you must be making money.
This false assumption can be tested by determining the maximum profit that an organisation can make using the traditional methods of calculating product prices and then comparing that to the TOC method.
The traditional method considers the contribution margin (selling price – direct variable costs) as the guiding factor when determining what product to give preference to when there is limited internal capacity (a bottleneck).
The scenario has been simplified
There is one business that produces two products with the following attributes
The resources required to produce these two products and the demand placed upon those resources is provided below
Multiplying the market weekly demand by the resource minutes provides an indication of the total amount of time required to manufacture each product and in total. This is shown in the table highlighting the fact that Resource B has more demand
placed upon it than it has available to it (2400 minutes in a week). This means that resource B is the system bottleneck and that it has insufficient capacity to meet the market demand for both products ie. a choice needs to be made to determine which product will take priority and therefore have maximum usage of resource B and which will be only able to utilize the residual availability
The following table shows the calculated utilization requirements for each product by resource highlighting the fact that Resource B has 3000 minutes of demand placed upon it that cannot be achieved in the 2400 weekly working hours
Minutes of resource time required to meet monthly demand
As the business is now required to make a choice as to which product (X or Y) will be given preference in terms of resource B utilization, a method of determining this needs to be made. In traditional accounting terms this is determined through the calculation of contribution margin as described above . When the product pricing decisions are based on contribution margin, the resulting profit/loss is shown in the following table as a loss of $300.
1 – Demand for each product per week
2 – Supply per week recognizes that as resource B is a system bottleneck it is not possible to meet all the demand of both products. As the contribution margin (CM)for product Y is $60/unit (see note 5) and the CM for product X is $5, then preference is given to producing up to the maximum of product Y (100 units) before allocating the residual availability of resource B to product X. As Product Y requires 1500 minutes to product 100 units, the remaining minutes of the week (2400 – 1500 = 900 minutes) is then divided by the number of minutes of resource B required to produce one unit of Product X . This equals 900/15=60 units which is what is shown here for Product X
3- Revenue per unit and in total assuming 100 units of sales of product Y and 60 units of sales of product X
4- Variable cost of raw materials used to manufacturer each product and in total
5- Throughput/Contribution margin is the selling price – variable costs which has been calculated on the basis of the 100 units of Product Y and 60 units of Product X sold
6 – Fixed overhead that applies to the business overall
7 – Net profit showing that in this scenario, the business makes a $300 loss
Theory of Constraints method
The TOC method looks to maximize profitability by maximizing the throughput per constraint unit of time (T/Cu) rather than using contribution margin.
The following calculations follow the same format as that described above.
Resource B continues to be the system bottleneck and therefore has insufficient capacity to meet the market demand for both products ie. a choice needs to be made to determine which product will take priority and therefore have maximum usage of resource B and which will be only able to utilize the residual availability.
TOC adopts a T/Cu basis for determining the product prioritization method at the system bottleneck which is calculated in the following table
This table shows the the T/Cu rate is higher for product X than for product Y and therefore this method proposes that Resource B will give preference to product X first before allocating any remaining capacity to the manufacturer of product Y.
The following table shows the impact of this decision on business profitability indicating a turnaround on profit of $300.
1 – Same demand profile for each product per week
2 –In this scenario preference is given to producing up to the maximum of product X (100 units) before allocating the residual availability of resource B to product Y based on the T/Cu calculation describe above. As Product X requires 1500 minutes to product 100 units, the remaining minutes of the week (2400 – 1500 = 900 minutes) is then divided by the number of minutes of resource B required to produce one unit of Product X . This equals 900/30=30 units which is what is shown here for Product Y
3- Revenue per unit and in total assuming 100 units of sales of product X and 30 units of sales of product Y
4- Variable cost of raw materials used to manufacturer each product and in total
5- Throughput/Contribution margin is the selling price – variable costs which has been calculated on the basis of the 100 units of product X sold and 30 units of product sold
6 – Fixed overhead that applies to the business overall
7 – Net profit showing that in this scenario, the business makes a $300 profit in stark contrast to the lost reported using the traditional product cost method
In each of the areas of responsibility described above, logical arguments are provided to suggest that the traditional accounting approach to assisting management to make informed decisions is flawed.
What is more concerning however is that after 30 years of this analysis being provided to the accounting profession and business managers alike , there has been no substantial change in the approach. The question is therefore why?
This issue is covered in a separate article
For a genral overview of the Theory of Constraints, go to www.tocstudyguide.com for more information