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

Summary by Michael C. Massi
Master of Accountancy Program
University of South Florida, Summer 2002

ABC Main Page | TOC Main Page

The article describes the integration of activity-based costing (ABC) and the theory of constraints (TOC) as opposing views of the nature of product costing. Product costing from an ABC perspective assumes all costs are traceable to products and vary in proportion to certain cost drivers. From a TOC perspective, costs are fixed and sunk relative to product choices and production-level decisions. Thus, ABC cost information is inputted into the TOC for product-mix decisions.

To gain a complete understanding of the integration between ABC and the TOC, Huang first defines ABC and TOC from various cost accounting analysts/theorists’ perspectives such as Robin Cooper, H. Thomas Johnson, Robert S. Kaplan, Horngren, Sundem, and Simpson. ABC was first developed in 1971 and became popular in the 1980’s. In 1971 an ABC framework was provided that included five fundamental ideas.

ABC’s Five Fundamental Ideas

1. Activity focus – accountants need to provide managers with information on the costs carrying out activities.
2. The object of costing is placed on the output of an activity (identifying cost objects that are of interest to managers).
3. Definition of cost as an economic sacrifice (outflow of wealth).
4. Cost of Activity – cost of using resources both from outsiders and internal services (internal services also termed "synthetic resource").
5. Cost-benefit test for cost accounting.

ABC is defined as a system that accumulates the costs of each activity of an organization and then applies the costs of activities to cost objects related to products, services, and other objects using drivers. Activities (cost drivers) are classified into four types: 1) Unit – costs driven by individual units, 2) Batch – costs driven by batches regardless of the units in a batch, 3) Product – costs driven by production and not the production of individual batches or units of the product. 4) Facility-sustaining – costs associated with the overall facility, not individual products. Huang describes The Consortium for Advanced Manufacturing-International’s (CAM-I) definition for ABC as a method of reorganizing causal relationships of cost drivers to cost activities by the measurement of cost and performance of process-related activities and cost objects. Thus, the influence and contributions from all the above individuals and agencies provided the seven underlying assumptions of ABC and the six-step process.

Underlying Assumptions of ABC

1. Activities consume resources.
2. Products or customers consume activities.
3. The model is consumption-based rather than spending-based.
4. Resources consumed have numerous causes.
5. Activities of a wide array can be identified and measured.
6. Cost pools are homogeneous.
7. Costs in each pool are variable.

The ABC Process

1. Review and confirm requirements
2. Define reporting entities.
3. Commence data collection of volume and values.
4. Develop an ABC System.
5. Determine costs and revenues by calculated costs and estimate revenues.
6. Review results and prioritize recommendations.

In 1994 a set of processes was introduced that improved the integration of ABC into a firm. First and foremost before any processes were implemented though, a firm needed to undergo an organizational change. To prepare a firm for the change, three interdependent phases are described:

1. education,
2. sponsorship, and
3. alignment of incentives.

Also, ABC has been described as a two-step process that breaks down into a snapshot model and a dynamic model for cost analysis. A snapshot model provides costs of products and clients at a given time. A dynamic model is a system that combines perspectives from other operational systems and provides cost data. The main goal was to evaluate customer profitability and improvement of decision quality.

Huang furthermore describes how Lindahl used an extension of ABC to cost management to develop activity-based management (ABM). ABM is the management and control of a firm’s performance using ABC information as the focus for decision-making. ABM is broken into several steps:

1. planning,
2. education and awareness,
3. process/activity definition,
4. data collection,
5. performance improvement techniques,
6. planning the ongoing system, and
7. implementation.

The key relationship between ABC and ABM is that ABC provides important information about cost drivers, activities, resources, and performance measures while ABM is a discipline that improves the value of an organization's products and services.

Three benefits from the ABC implementation are: 1) Increased cost pools used for overhead costs, 2) The changing of the base to allocate overhead costs, and 3) Allowing a manager to recognize more traceable overhead costs than merely classifying them as indirect. The improved traceability of overhead cost is the greatest benefit to implementing ABC as discussed by Huang. With all of ABC’s advantages, a major disadvantage is the inability to inform management about spending changes and profitability because ABC is set up to measure the rate of demand and not the rate of supply.

Following the ABC discussion, the author defined the theory of constraints (TOC) as a method that deals with scheduling production through a pre-existing application that maximizes profitability by maximizing output. TOC’s foundation comes from just-in-time inventory management and the pull manufacturing methodologies.

This leads to the underlying assumptions of TOC:

1. The goal is to make money now and in the future.
2. Throughput is defined as revenue minus the variable costs of materials and energy.
3. There is always at least one constraint on each product that limits the firm’s revenue.
4. There are three types of resources: (1) scarce bottleneck resources, (2) nonbottleneck resources, and (3) capacity constraint resources.
5. Most manufacturing operations have only few capacity constraint resources and thus it is easy to control.
6. Dependent events exist that result in interactions between resources and products. Within every manufacturing environment, statistical fluctuations and random events occur.
7. The optimized production technology system is implicitly stable.

Constraints in TOC are defined as anything that impedes a system from reaching a higher level of performance toward its goal. Also, there are two types of constraints: 1) physical constraints – easy to identify and manage (i.e., capacity of machine) and 2) nonphysical constraints – hard to identify and manage unless approached through varies methods. (i.e., market demand).

TOC enables a firm to continuously improve through a five step process:

1. Identification of a system’s constraints.
2. The exploitation of a system’s constraints.
3. Subordinate everything else to decisions made in Step 2.
4. Elevate the system’s constraints by reducing the effects of the constraint, off-loading its demand, and change how a constraint is managed.
5. If a constraint is broken in Step 4, go back to Step 1.

The TOC’s foundation uses a pull-through production management system that is defined by moving products into production only as capacity becomes available for their completion. Production capacity within a pull-through system is governed by the capacity of that portion of the manufacturing process that acts as the constraint on throughput. Also, in TOC costs are assumed to be fixed to maximize throughput and profit due to contribution margins equal to unit revenue. The main purpose of TOC is its emphasis of a shift in management of an organization. A shift in perception from one that minimizes costs as top priority to a realization that the overall success of an endeavor is more important. The shift requires management to emphasize throughput, which focuses on constraints, productive capacity, and buffer management to continuously improve instead of an emphasis on cost.

Huang discusses three kinds of integration situations to combine ABC and TOC principles:

1. Short-term decision back (TOC) and long-term decision foundation (ABC)

TOC is considered a useful short-term tool because costs are fixed, meaning improving profitability is only accomplished by increasing throughput. Thus, performance is measured by effectiveness as opposed to efficiency, which is the traditional focus of standard costing. Short-run decisions require management to accurately measure the effects produced by alternative changes in inputs. While ABC is used primarily as a technique to improve long-run decisions by improving product selection and mix, facility size, and location in which all costs are considered variable. The economic concept of short-run versus long-run depends on the expansion or contraction of capacity within a production facility. TOC and ABC are best applied in their respective ranges (short-run & long-run) and are not suited to the middle range of decision types that involve a mix of fixed and variable elements. Huang comments that a possible solution to middle range decisions is to use direct costing for continuous product costing and for financial reporting along with ABC. This then does not violate ABC’s proportionality assumptions.

2. Mixed-Integer Programming Model

This optimizes an objective function subject to constraints with continuous and integer variables. An objective function is used to describe an organizational goal while a second set of equations are used to model constraints that limit the objective. Once formulated, an algorithm is used to solve the resulting set of equations. An algorithm provides variables that maximize objective functions, maximize slack variables that measure excess resources of non-constrained activities, and maximize the value of the objective function.

3. TOC and ABC and Cycle-Time Management

Managing cycle times blends ABC and TOC and involves six activities for cycle times: 1) Setup, 2) Wait, 3) Processing, 4) Inspection, 5) Unloading, and 6) Moving. Once cycle times are broken into short intervals they become manageable for processes associated with products, customer orders, or batch goods. Managing cycle times by TOC and ABC can be done through various processes. One such process is to increase productivity and then perform cost-benefit analysis. TOC helps to increase productivity by reducing cycle time without adding capacity and enables timely delivery, increasing throughput in firms that have internal manufacturing, and lowering average fixed costs per unit in the short-run. ABC facilitates the cost-benefit analysis in making quality decisions concerning cycle-time activities by answering five questions: 1) Will overall cycle-time reduction result in increased throughput? 2) What activities consume the most resources within each process? 3) What activities can be changed or reduced without compromising throughput? 4) What will it cost to change or reduce activities that contribute to cycle time? 5) What are the realizable cost savings from reduced cycle time for specific activities? The mingling of TOC and ABC answers the above questions and provides an insightful way for managing cycle-time situations.

Huang provides an example that integrates TOC and activity-based cost management (ABCM) for a silk-screen printing firm. The firm first traced costs to activities and then applied ABCM that identified the output measure for each activity. ABCM used practical capacity of activities to calculate a charging rate to be applied in determining the cost of products produced. In the example, TOC is used to: 1) Identify constraints, nonconstraints, and unused capacity of an activity, 2) Exploit the constraints, 3) Subordinate activities, 4) Elevate additional capacity acquired, and 5) Inertia is overcome by the repetition of steps.

In conclusion, Huang makes a point that by taking advantage of both TOC and ABC a firm can enhance its quality decision-making.


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

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