Summary by Aarti Nirgudka
Master of Accountancy Program
University of South Florida, Summer 2002
The purpose of this article is to present a brief discussion about the two most popular cost accounting and production theories, Activity-Based Costing (ABC) and the Theory of Constraints (TOC), and to determine if ABC and TOC are complimentary or competing concepts. Further, the article focuses on whether both theories can be integrated with financial reporting.
Activity-Based Costing (ABC):
ABC offers improved product costing by using cost of activities as the basis of assigning costs to products. Moreover, ABC emphasizes identifying activities that cause the indirect costs to be incurred. Each activity is then associated with a cost pool. Costs are assigned to products based upon the products’ consumption of these activities.
Theory of Constraints (TOC):
TOC asserts that the product cost distortions, which ABC was designed to eliminate, are not the cause of the firms’ problems in decision-making. Moreover, TOC focuses on constraints (bottlenecks) in production flow. According to TOC, each firm has internal and/or external constraints, which prohibit the firm from making money. Thus, the TOC process recommends that a firm identify its constraints, decide how to make best use of them, and subordinate everything else to those decisions. If however, a constraint can be elevated or removed, the TOC process must be started over.
Reconciliation of ABC and TOC:
Initially, reconciling TOC with ABC seemed difficult as TOC focuses on throughput instead of cost. Throughput is simply the rate at which a system generates money through sales. Hence, from TOC’s perspective, cost allocations and cost drivers appeared worthless. Early proponents of TOC believed that “traditional cost mentality…almost invariably leads to flawed decisions" (p. 23).
Recent work in ABC and TOC however, has suggested that the two theories are in fact complementary to each other. For instance, Spoede, Henke, and Umble have stated that “the potential of ABC is its ability to generate the data necessary to support the Theory of Constraints management process (p. 23).”
Nevertheless, the time horizon of the two theories has been for a long time an issue of controversy. ABC is a long-term approach, while TOC is a short-term approach. TOC assumes fixed capacity and labor costs (a short-term approach). ABC takes the more long-term view that management can act to adjust spending on resources to reflect their usage. A few experts suggest using TOC in an ABC framework when management is unable to match resource supply with resource demand.
Integrating ABC, TOC, and Financial Reporting:
Despite the advantages of ABC and TOC, some firms are still reluctant to abandon the traditional standard cost system. Accordingly, Kaplan suggests the integration of ABC with periodic financial reporting by computing a variance reflecting the unused capacity of each resource. However, he does not address how TOC can be integrated with both product costing and financial reporting.
Initially, Kaplan used a single activity to illustrate how ABC can be integrated with financial reporting. However, the authors of the article added a second activity to demonstrate how TOC as well can be integrated with financial reporting. A second activity is able to depict both a resource at capacity and the interdependency between resources. Following is a variance analysis in an ABC system, which is used to identify binding constraints (a TOC concept).
Kaplan uses inspection as the activity (Activity Y).
|Activity Y: Operating Expenses and Activity Levels|
|Budgeted Committed (supplying capacity)||$200,000|
|Budgeted Flexible (varying with volume)||$80,000|
|Activity Level||Driver Rates|
|5,000 (Capacity)||$40 (=$200,000/5000)|
|4,000 (Budgeted)||$20 (=$80,000/4,000)|
|Activity Y expense charged to products: 3,500 @ ($40/$20)||$210,000|
|Budgeted unused capacity cost: (5,000-4,000) @ $40||$40,000 U|
|Capacity utilization variance: (4,000-3,500) @40||$20,000U|
|Spending Variance: Actual - Budgeted Expense
|Total Actual Expenses||$250,000|
|Note: Flexible Budget for Expenses: $200,000 + ($20*3,500)|
The second activity (Activity X) is a product processing activity:
|Activity X: Operating Expenses and Activity Levels|
|Budgeted Flexible (varying with volume)||$120,000|
|Activity Level||Driver Rates|
|4,000 (Capacity)||$30 (=$120,000/4000)|
|4,000 (Budgeted)||$30 (=$120,000/4000)|
|Activity X expense charged to products: 3,500 @ ($30+$30)||$210,000|
|Budgeted unused capacity cost: (4,000-4,000) @ $30||$0U|
|Capacity utilization variance: (4,000-3,500) @30||$15,000U|
|Spending Variance: Actual - Budgeted Expense ($230,000-$225,000)||$5,000F|
|Total Actual Expenses||$230,000|
|Note: Flexible Budget for Expenses: $120,000 + ($30*3,500)|
Budgeted Unused Capacity (BUC) Variance:
ABC and TOC both recognize the importance of capacity. Kaplan’s example suggests that the Budgeted Unused Capacity (BUC) is an indicator of which activity is budgeted as the binding production constraint (a TOC concept).
In an ABC environment, a positive BUC variance for activity Y indicates an opportunity for management to reduce resource supply or search for an additional activity for a resource. Further, with a BUC of zero (utilized fully) for activity X, management may choose not to devote any time to activity X.
In a TOC context, management with the intent of utilizing constrained resources as fully as possible, will choose not to devote any time to activity Y. The positive BUC for activity Y indicates a non-binding constraint on management. However, the zero BUC variance for activity X indicates a resource that is budgeted as a binding constraint on production. Thus, management will focus on activity X in a TOC environment.
Capacity Utilization (CU) Variance:
The unfavorable CU variance for both activities indicates an extremely low utilization of each activity. However, the interpretation of CU varies depending on the BUC variance.
If the BUC variance is unfavorable (positive), then excess capacity is available, which can later be used to recover any loss in the current period due to an unfavorable CU variance. Nonetheless, if the BUC variance is zero, capacity for that activity is a binding constraint. Under the TOC approach, for a constrained activity, an unfavorable or favorable CU variance represents a capacity loss or gain for the entire plant.
Interdependencies Among Activities:
The relationship between a constrained activity (X) and a non-constrained activity (Y) can be expressed as one of the three possibilities:
1. Bottleneck Precedes: Production flows from a constrained resource (x) to a non-constrained resource (y).
Under this circumstance, activity Y cannot occur until activity X is completed. A $15,000 unfavorable CU variance for activity X indicates a loss of production capacity. Thus, this not only causes a capacity reduction for activity X, but utilized capacity is reduced for activity Y as well, causing an additional $20,000 unfavorable CU variance.
2. Production flows from a non-constrained resource (y) to a constrained resource (x).
Under this circumstance, activity Y leads to X. As before, a $15,000 unfavorable CU variance for activity X indicates a loss of production capacity for the entire plant. However, under this possibility, the unfavorable CU variance for activity Y was expected and planned for.
3. Production flows into a non-constrained resource (z) from a constrained resource (x) and a non-constrained resource (y).
Under this circumstance, X and Y lead to Z. Both X and Y must be completed before the third activity (Z) can be performed. In terms of variance, under this possibility, both Y leads to X and X leads to Y. Thus, given an unfavorable CU variance for activity X, an unfavorable CU variance for activity Y is expected (and even encouraged to prevent an inventory build-up). However, a temporary unfavorable CU variance for activity Y should not trigger an unfavorable CU variance for activity X.
Variances and Inventory Build-up:
Variances on constrained activities are most important. Variances determine when inventory build-up is necessary and when it is unnecessary. Thus, temporary inventory build-ups may be a positive sign. The TOC helps in interpreting these variances and improving the overall control process.
By integrating ABC and TOC into the traditional cost accounting system, the resulting system combines variance analysis with three key elements of TOC: constraint identification, constraint exploitation, and interdependencies of resources. “Considering system constraints in an ABC-based variance analysis is an excellent way to coordinate cost system, TOC and Financial Reporting (p. 27).” Thus, ABC and TOC are complementary to each other and not incompatible with Financial Reporting.
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).
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).
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. https://maaw.info/Chapter7.htm
Martin, J. R. Not dated. Comparing Dupont's ROI with Goldratt's ROI. Management And Accounting Web. https://maaw.info/ComparingDupontGoldrattROI.htm
Martin, J. R. Not dated. Comparing Traditional Costing, ABC, JIT, and TOC. Management And Accounting Web. https://maaw.info/TradABCJITTOC.htm
Martin, J. R. Not dated. Drum-Buffer-Rope System. Management And Accounting Web. https://maaw.info/DrumBufferRope.htm
Martin, J. R. Not dated. Global measurements of the theory of constraints. Management And Accounting Web. https://maaw.info/TOCMeasurements.htm
Martin, J. R. Not dated. Goldratt's dice game or match bowl experiment. Management And Accounting Web. https://maaw.info/MatchBowlExperiment.htm
Martin, J. R. Not dated. TOC problems and introduction to linear programming. Management And Accounting Web. https://maaw.info/TOCProblemsIntroToLP.htm
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).