Which is better: Activity Based Costing (ABC), Theory of Constraints (TOC) or an integration of the two? That is the essence of this article. The authors support the integrated approach.

The ABC approach to costing products assigns all cost, fixed and variable, to specific products. This is accomplished by using activity drivers (labor hours), which essentially take the cost of an activity (salary for engineers), and allocates them to a cost object (product). Critics of ABC argue that the cost of implementing ABC outweigh the benefits. These cost include: recasting the general ledger into the activities of the organization, the need for dual reporting systems (GAAP and ABC system), and the cost associated with recording all material, labor, and overhead expenses and then tracing and allocating these costs to individual products. Many large companies, Proctor and Gamble and Harley Davidson, for example, have found that tracing direct labor costs to cost objects is not cost effective. The benefit of tracing direct labor does not exceed the cost. As a result, many companies will actually drive both their labor and overhead costs to their cost objects with activity drivers.

An undesired result of ABC is that high-volume products and customers appear more profitable while the low-volume products and customers appear less profitable. In the example given in the article, this occurs in the liquor industry when one switches from the allocation of overhead by material consumption and no longer traces the direct labor cost. To illustrate this, if a company is allocating material procurement cost based on purchases and only few relatively large purchases are made, large volume products would be allocated less cost.

With the TOC approach, direct material is treated as a variable cost and all other manufacturing cost are assumed fix. The allocation of fixed cost is assumed to be meaningless and misleading, hence it is not performed. The throughput margin per unit (similar to contribution margin) is used to guide product pricing and capital investment decisions. The TOC approach requires much less data and is easier to implement.

One variable cost is used (direct material) because proponents of TOC believe that in today’s complex companies very few variable costs exist. When costs are fixed, allocation to products is extremely misleading because the allocation suggests that changing product volume will also result in a change in the fix costs. TOC advocates handle this problem by taking a more holistic view to product costing. Proponents argue that prices should be determined by the market, not from marking up an arbitrarily determined product cost. However, the price charged:

1. Should at least cover all out of pocket variable expenses plus the
    opportunity cost for using constraint resources.

2. Should, to ensure survival in the long run, cover all fixed and variable
    cost.

Critics of TOC argue it is nothing more than a contribution margin approach and it doesn’t supply management with useful information.

The authors of this paper support an integration of ABC and TOC to properly cost products. In addition to materials, the integrated approach would include all significant variable costs to arrive at a net throughput contribution. Research has shown that there are fewer and fewer variable cost. Costs that are traditionally thought to be variable are not in the real world. For example:

1. Labor cost – step fixed costs.

2. Advertising – discretionary fixed costs.

3. Building depreciation – purely fixed.

Some organizations may have significant variable cost; e.g., energy, freight, or other product level activities, but the authors contend that most organizations cannot accurately identify true variable cost and favorable costs/benefits don’t exist.

After the contribution margin is identified, the remaining cost would be separated into direct and indirect costs. Direct cost would then be traced to the individual products, and indirect cost would be pooled and traced using cost drivers to the individual product (ABC approach).

· TOC:

o Traditional TOC allocates only direct material to products. The remaining costs, which are assumed to be fixed, are allocated using the throughput margin per unit (similar to contribution margin).

o Under the TOC approach, an organization would never drop a product line that covered its raw material and constrained opportunity costs.

· ABC:

o Traditional ABC allocates all costs, fixed and variable, to products.

o Under the ABC approach, because low volume products are over cost, a company may drop the incorrect product line.

· Integrated:

o Integrated approach allocates all significant variable cost to the product, and segregates the remaining cost into direct and indirect. The former is traced directly to the individual product and the latter is traced using cost drivers.

o Under the integrated approach, the contribution to indirect activities amount would indicate the reduction in indirect activities that would have to take place in order to justify dropping the product line.

"The integrated approach provides a more accurate estimate of truly variable cost than the standard TOC approach and addresses the distinction between direct and indirect fixed cost. ABC is then used for all significant indirect fixed cost. This approach requires much less effort than standard ABC and provides more information than the standard TOC.

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