Summary by Kerry A. Martin
Master of Accountancy Program
University of South Florida, Summer 2002
ABC Main Page | TOC Main Page
Many authors have discussed the dispute between ABC and TOC advocates in terms of the techniques' usefulness in making short-run and the long-run decisions. The purpose of this paper is to compare the two techniques and to argue that the focus of the debate between the ABC and TOC is not on short-term and long-term decisions, but on the underlying assumptions of the two concepts. According to Corbett, the underlying assumptions of ABC and TOC are the exact opposites and accountants cannot agree with both. Corbett argues that TOC is a better approach for long run as well as short run decisions related to profitability.
Theory of Constraints
The Theory of Constraints (TOC) views companies as systems. These systems are proposed to contain at least one constraint, but no more than a few. Every organization has at least one factor that limits its throughput; otherwise, performance would continually improve. Removing the constraints and pushing forward the performance of the organization should be the real goal of management. Five steps to help managers identify and elevate constraints are:
1. Identify the Systems Constraint - This is the point at which throughput is restricted due to lack of equipment or skills.
2. Decide How to Exploit the System's Constraint - Until the constraint can be elevated, it should be exploited.
3. Subordinate Everything Else to Constraint Exploitation.
4. Elevate the System's Constraint - Constraints inhibit an organization's ability to continually improve. Therefore, in order to improve, additional resources that are constrained must be acquired. This may mean hiring further staff, or may mean introducing more advanced technology into the production process.
5. If, in the Previous Steps, a Constraint Has Been Broken, Return to Step One - If the steps are not repeated, then the policies implemented in step two may become the constraint even though the original constraint has been broken.
Under TOC, managers need to answer three questions for sound decisions:
1. How much money is generated by the company?
2. How much money is captured by the company?
3. How much money is there to operate the company?
Throughput Accounting uses a new range of performance measures. The approach is based on three pieces of information:
Throughput is defined as the rate at which the system generates money through sales (i.e., Sales - Direct material costs).
Inventory is defined as all the money that the system invests in purchasing things the system intends to sell. (Note that inventory represents total assets or investment in TOC, not product inventory.)
Operational expense is all the money the system spends in order to turn inventory into throughput (i.e., all expenses other than direct material costs).
The above three measures are used to analyze Net Profit and Return on Investment (ROI).
Net Profit = Throughput – Operating Expense.
Return on Investment = (Throughput – Operating Expense) / Inventory.
Note that Inventory in the equation above represents total assets or investment, not product inventory. To think otherwise is to view investment as only product inventory.
Any decision that has a positive impact on ROI is considered beneficial. To measure NP and ROI, the cost of products need not be calculated.
Criticisms of Throughput Accounting (TA)
Most of the criticism of TOC and TA is aimed at its apparent short-term focus. However, Corbett points out that by considering the three questions mentioned above, throughput accounting can address long-term as well as short-term profitability.
TOC has also been wrongly accused of ignoring operating costs. In reality, with TOC, not only are operating expenses driven by decisions, but throughput and inventory are as well. Thus the main concerns of TOC have been incorrectly assessed.
Local Optima versus Global Optimum
ABC and TOC differ fundamentally in that ABC aims at improving “all” activities of a company, and TOC strives to isolate and improve only those activities considered constraining. Corbett points out that the company “system” is only as strong as its weakest link. This one link, or constraint, should be concentrated on for improvement. On the contrary, ABC focuses on identifying cost drivers and improving “all” links. In reality, improving one link without considering the others may ultimately damage another link and destroy the entire chain. ABC may improve several parts individually without improving the overall system.
Corbett provides two examples where ABC gives false performance results that throughput accounting identifies correctly. In the first example, individual cost per product is increased. Theoretically, this would decrease profit margin as the cost view assumes. However, in reality, costs traced to products may not give accurate profit forecasts. If overall costs to the company are reduced, even when cost-per-product are increased, increased profit may still be obtained as the TOC analysis reveals.
Likewise, when cost per item is decreased, theoretically an increased profit margin should be experienced. However, if additional costs are incurred that are not traced to products, profit margins may actually be reduced.
The point of these two examples is to show that ABC does not always present a clear picture of profitability. Improving a part may not benefit the whole. On the contrary, throughput accounting makes the necessary considerations to show true bottom line profitability.
| Throughput Accounting | Cost Accounting |
| Only overall cost reduction is taken into account. | Cost reduction per unit is the main focus |
| Increase in throughput is the main focus | Does not take into account the impact on throughput |
| Only increases in efficiencies that increase throughput or that reduces overall costs are acceptable | Any increase in efficiency is acceptable |
Lessons Learned
ABC’s concept of product cost does not adequately relate to profitability. The cost-per-part concept is an internal measurement only. Product costing does not consider the throughput side of profitability, nor does it consider the overall cost of the company. Throughput Accounting takes into account the factors that ABC ignores.
In the past, it has been accepted that TOC is more beneficial in short-term decision making, and ABC for long-term decision making. Corbett expresses the view that the short-run vs. long-term issue shouldn’t be the focus of the debate. Throughput accounting should be used when finance professionals believe that the company is a system with few constraints. If, however, they feel that high local efficiencies will lead to good overall performance, ABC should be the choice. According to Corbett, they cannot agree with both ABC and TOC.
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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).
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).
Coate, C. J. and K. J. Frey. 1999. Integrating ABC, TOC, and financial reporting. Journal of Cost Management (July/August): 22-27. (Summary).
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?).
Goldratt, E. M. and J. Cox. 1986. The Goal: A Process of Ongoing Improvement. New York: North River Press. (Summary).
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. Chapter7.htm
Martin, J. R. Not dated. Chapter 8: Just-In-Time, Theory of Constraints, and Activity Based Management Concepts and Techniques. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter8.htm
Martin, J. R. Not dated. Comparing Dupont's ROI with Goldratt's ROI. Management And Accounting Web. ComparingDupontGoldrattROI.htm
Martin, J. R. Not dated. Comparing Traditional Costing, ABC, JIT, and TOC. Management And Accounting Web. TradABCJITTOC.htm
Martin, J. R. Not dated. Drum-Buffer-Rope System. Management And Accounting Web. DrumBufferRope.htm
Martin, J. R. Not dated. Global measurements of the theory of constraints. Management And Accounting Web. TOCMeasurements.htm
Martin, J. R. Not dated. Goldratt's dice game or match bowl experiment. Management And Accounting Web. MatchBowlExperiment.htm
Martin, J. R. Not dated. TOC problems and introduction to linear programming. Management And Accounting Web. TOCProblemsIntroToLP.htm
McNair, C. J. 1990. Interdependence and control: Traditional vs. activity-based responsibility accounting. Journal of Cost Management (Summer): 15-23. (Summary).
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Yahya-Zadeh, M. 1999. Integrating long-run strategic decisions into the theory of constraints. Journal of Cost Management (January/February): 11-19. (Summary).