Management And Accounting Web

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

Summary by Manuel Pagan
Master of Accountancy Program
University of South Florida, Summer 2002

ABC Main Page | TOC Main Page

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:

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.

The TOC Approach:

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 Integration Approach:

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).



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

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


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

Under the ABC approach, because low volume products are over cost, a company may drop the incorrect product line. (*See note below).


The 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.

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.


*Note: Avoiding overcosting or undercosting products is promoted as one of the advantages of ABC. Therefore, the idea that ABC will over cost low volume products is questionable. The ABC argument is that traditional cost systems overcost high volume products and undercost low volume products. See MAAW's Textbook Chapter 7.

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).

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).

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.

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.

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

Martin, J. R. Not dated. Comparing Traditional Costing, ABC, JIT, and TOC.  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.

Martin, J. R. Not dated. TOC problems and introduction to linear programming.  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).