Theory of Constraints versus Traditional Management Accounting

The Theory of Constraints, or TOC, was developed by Eli Goldratt in the early 1980s.

Constraints are anything that limits a system from achieving its goal. They can be external, such as market demand or vendor quality. They can be internal, such as capacity of a plant or single machine limitations, behavior of manager or workers, logistics, or management policy.

A system can have many constraints, but only one is critical or dominant at a given time. Things that seem to be constraints are often proven not to be once the critical constraint is broken. The most common constraint is lack of capacity.

STEPS TO BREAK CONSTRAINTS (FOCUSING STEPS)

CAN BE APPLIED TO ANY CONSTRAINT

1. Identify the system’s constraints – determine what is limiting performance.

2. Decide how to exploit the dominant constraint, and develop a plan for overcoming the limitation.

3. Subordinate everything else to the plan in Step 2. Effective management of current constraint should be the top priority. Performance should be measured by reference to meeting the plan, not by reference to meeting local objectives. Improvements in non-constraining activities should not be done.

4. Elevate the system’s constraint. Improve the system to break the constraint.

5. Once the constraint is broken, return to Step 1 and find the new constraint.

Throughput is selling price less cost of materials, also called contribution margin or throughput contribution.

Operating Expenses - All other costs, including ALL employee time. (Materials are the ONLY costs included in throughput.)

SUCCESSES USING THEORY OF CONSTRAINTS
COMPANY	CONSTRAINT	RESULTS
General Motor's Saginaw Division	Too much work in progress as a result of producing large batches	Reduced lead time by 30%, produced smaller batches of components, and improved quality
General Electric	Managerial – relied on efficiency measures for non-constraining activities	Cycle time reduction, along with related reductions to WIP inventory and direct labor.
American Lighting Standard Corporation’s Valmont Plant	Controller hounded manufacturing department about efficiencies and standard cost variances, often moving company away from goals.	Earnings 40% higher than operating plan, return on equity increased, cash flow 60% over plan; all despite a 9% decrease in unit volume.
Southwestern Ohio Steel	Various capacity –related constraints	Stressed elevating constraints and not worrying about other matters; used TOC in pricing and improved its operations.

The traditional management accounting approach is to maximize contribution margin per unit of the scarce resource, but TOC does not consider many of traditional accounting’s variable costs as truly variable.

TOC defines contribution margin as Selling Price minus Cost of Materials, while traditional accounting defines contribution margin as Selling Price less All Variable Costs.

Textbooks do not state whether or not the TOC approach is correct when costs other than materials vary.

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