Management And Accounting Web

Campbell, R., P. Brewer and T. Mills. 1997. Designing an Information System Using Activity-Based Costing and the Theory of Constraints. Journal of Cost Management (January/February): 16-25.

Summary by Jennifer Zelski
Master of Accountancy Program
University of South Florida, Fall 2001

ABC Main Page | TOC Main Page

Accountants often argue over whether businesses should use an activity-based costing (ABC) method or the theory of constraints (TOC) method to assign product or customer costs, considering them to be mutually exclusive. In manufacturing information systems, though, these two methods can compliment each other. These cost methods should be chosen on a department-by department basis rather than on an entity-wide, all encompassing basis.

Activity-Based Costing (ABC)

ABC assigns product costs to activities, and then assigns these activity costs to products using activity cost drivers. Under ABC, product mix and volume decisions are made in the long run, leading to better decision making over time. However, resources in an ABC system can be rearranged or eliminated during the short run for more immediate improvements.

ABC is most effective in people-intensive areas of a company. People-intensive areas are areas in which a large source of the resources are deployable, employees sustain the pace of work, and resource costs are predominantly salary-oriented. As mentioned above, ABC improvements are made by rearranging or eliminating resources, which are easily rearranged in people-intensive areas. If resources are determined to be non-value added they can be moved to an area where they will become value-added or they can be removed.

Theory of Constraints (TOC)

Under TOC, decision making is done to maximize the throughput of products that can be produced within the available capacity of the business processes. Throughput, which is limited by the constraints of the processes, is the difference between net revenues and direct material costs. Throughput can be maximized by minimizing the effects of external constraints and wisely using the constrained resources within a company. TOC assumes operating expenses to be fixed at a fixed capacity.

The TOC method is best used in machine-intensive departments. In machine-intensive departments, machines set the work pace, resource costs are mainly machine-oriented and employee tasks rely on machine technology. Costs in these areas are typically associated with creating long-term capacity. The greater the available capacity is, the greater the throughput can be. In these areas, the machines are fixed and cannot be redeployed to other areas and idle machine time does not create any additional expenses. Charging per setup cost, as might be done in ABC, has no relevance to machine-intensive areas because there are no additional costs incurred if an extra setup takes place when the machine would otherwise be idle. Any costs associated with the extra setup would relate to lost throughput during setup time.

Customer Profitability Model

A Square D plant in Oxford, Ohio serves as a customer profitability model to illustrate the complementary use of ABC and TOC methods. The plant has six production centers, including four manufacturing cells and two support centers.

People-intensive departments, such as customer service, charge customers by activities performed. This process begins by grouping general-ledger accounts into manageable categories for each organizational unit. The customer service department then assigns its unit costs to each of its activities based on estimated time spent on each activity. Then cost drivers are determined for each activity, and activity costs are assigned to customers using these cost drivers as a proportion of planned activity.

The plant’s constraints are primarily internal (related to resources). The plant often operates near capacity. In the machine-intensive departments, the plant assigns annual department costs to customers by multiplying the department costs by the number of minutes spent on the constrained resource and dividing by the annual available capacity in minutes of the constrained resource. The department chooses which customer orders to work on first by determining the revenue generated per hour on the constrained machine for each job. If a $4,000 job will use the constrained machine for 40 hours, $100/ hour is the measurement used to compare this job with others.

Customer profitability is determined by first netting revenues against material costs, which equals throughput. Then machine-intensive departments assign their costs. At this point a throughput margin is assigned, which is used to prioritize the customer orders for scheduling purposes and determining what types of jobs are most profitable. Next, costs are assigned by the people-intensive departments. Once the corporate overhead costs are deducted the customer profitability has been determined.

The throughput margin and costs as a percent of throughput can be used to benchmark across average customers or most profitable customers to identify profitability patterns.


Both ABC and TOC provide useful costing information, as long as they are used in the appropriate areas. Ultimately in a manufacturing environment both will be used. Using both methods provides the best compilation of cost information when people-intensive departments use ABC and machine-intensive departments use TOC. It almost seems ridiculous to use the same costing method for such uniquely different areas of a business.


Related summaries:

Baxendale, S. J. and P. S. Raju. 2004. Using ABC to enhance throughput accounting: A strategic perspective. Cost Management (January/February): 31-38. (Summary).

Campbell, R. J. 1995. Steeling time with ABC or TOC. Management Accounting (January): 31-36. (Summary).

Coate, C. J. and K. J. Frey. 1999. Integrating ABC, TOC, and financial reporting. Journal of Cost Management (July/August): 22-27. (Summary).

Corbett, T. 2000. Throughput accounting and activity-based costing: The driving factors behind each methodology. Journal of Cost Management (January/February): 37-45. (Summary). (According to Corbett, the underlying assumptions of ABC and TOC are the exact opposites and accountants cannot agree with both).

Demmy, S. and J. Talbott. 1998. Improve internal reporting with ABC and TOC. Management Accounting (November): 18-20, 22 and 24. (Summary).

Goldratt, E. M. 1990. What is this thing called Theory of Constraints. New York: North River Press. (Summary). (In Chapter 4 Goldratt says that the word "cost" is a dangerous and confusing multi-meaning word and that the word "product cost" is "an artificial, mathematical phantom" p. 49).

Goldratt, E. M. 1990. The Haystack Syndrome: Sifting Information Out of the Data Ocean. New York: North River Press. (Summary). (In Chapter 7 Goldratt tells us that the business world today has changed and cost accounting has been slow to react. They have not reexamined the fundamentals, the financial statement logic, to create new solutions. Instead, they have formulated ineffective answers like “cost drivers” and “activity-based costing.” We can no longer allocate based on direct labor. So allocating expenses at the unit level, batch level, group level, and company level is meaningless. These cannot be aggregated at their respective levels nor at the top. So why do it?).

Holmen, J. S. 1995. ABC vs. TOC: Its a matter of time. Management Accounting (January): 37-40. (Summary).

Huang, L. 1999. The integration of activity-based costing and the theory of constraints. Journal of Cost Management (November/December): 21-27. (Summary).

MacArthur, J. B. 1993. Theory of constraints and activity-based costing: Friends or foes? Journal of Cost Management (Summer): 50-56. (Summary).

MacArthur, J. B. 1996. From activity-based costing to throughput accounting. Management Accounting (April): 30, 34, 36-38. (Summary).

Martin, J. R. Not dated. Chapter 7: Activity Based Product Costing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web.

Martin, J. R. Not dated. Comparing Dupont's ROI with Goldratt's ROI. Management And Accounting Web.

Martin, J. R. Not dated. Drum-Buffer-Rope System. Management And Accounting Web.

Martin, J. R. Not dated. Global measurements of the theory of constraints. Management And Accounting Web.

Martin, J. R. Not dated. Goldratt's dice game or match bowl experiment. Management And Accounting Web.

Rezaee, Z. and R. C. Elmore. 1997. Synchronous manufacturing: Putting the goal to work. Journal of Cost Management (March/April): 6-15. (Summary).

Ruhl, J. M. 1996. An introduction to the theory of constraints. Journal of Cost Management (Summer): 43-48. (Summary).

Ruhl, J. M. 1997. The Theory of Constraints within a cost management framework. Journal of Cost Management (November/December): 16-24. (TOC Illustration).

Westra, D., M. L. Srikanth and M. Kane. 1996. Measuring operational performance in a throughput world. Management Accounting (April): 41-47. (Summary).

Yahya-Zadeh, M. 1999. Integrating long-run strategic decisions into the theory of constraints. Journal of Cost Management (January/February): 11-19. (Summary).