Management And Accounting Web

Louderback, J. and J. W. Patterson. 1996. Theory of constraints versus traditional management accounting. Accounting Education 1(2): 189-196.

Summary by Jennifer Ryan
Master of Accountancy Program
University of South Florida, Fall 2000

Contribution Margin/Direct Costing Main Page | TOC Main Page

The Theory of Constraints, or TOC, was developed by Eli Goldratt in the early 1980s.

GOAL = Higher Profit and Throughput Maximization

Constraints 101

Constraints are anything that limits a system from achieving its goal. They can be external, such as market demand or vendor quality. They can be internal, such as capacity of a plant or single machine limitations, behavior of manager or workers, logistics, or management policy.

A system can have many constraints, but only one is critical or dominant at a given time. Things that seem to be constraints are often proven not to be once the critical constraint is broken. The most common constraint is lack of capacity.

Steps to Break Constraints (Focusing Steps)

1. Identify the system’s constraints – determine what is limiting performance.

2. Decide how to exploit the dominant constraint, and develop a plan for overcoming the limitation.

3. Subordinate everything else to the plan in Step 2. Effective management of current constraint should be the top priority. Performance should be measured by reference to meeting the plan, not by reference to meeting local objectives. Improvements in non-constraining activities should not be done.

4. Elevate the system’s constraint. Improve the system to break the constraint.

5. Once the constraint is broken, return to Step 1 and find the new constraint.

Throughput is selling price less cost of materials, also called contribution margin or throughput contribution.

Operating Expenses - All other costs, including all employee time. (Materials are the only costs included in throughput.)

Successes using the Theory of Constraints
Company Constraint Results
General Motor's Saginaw Division Too much work in progress as a result of producing large batches Reduced lead time by 30%, produced smaller batches of components, and improved quality
General Electric Managerial – relied on efficiency measures for non-constraining activities Cycle time reduction, along with related reductions to WIP inventory and direct labor.
American Lighting Standard Corporation’s Valmont Plant Controller hounded manufacturing department about efficiencies and standard cost variances, often moving company away from goals. Earnings 40% higher than operating plan, return on equity increased, cash flow 60% over plan; all despite a 9% decrease in unit volume.
Southwestern Ohio Steel Various capacity related constraints Stressed elevating constraints and not worrying about other matters; used TOC in pricing and improved its operations.

TOC VS. Traditional Accounting

TOC and the traditional approach differ, and both cannot be correct.

The traditional management accounting approach is to maximize contribution margin per unit of the scarce resource, but TOC does not consider many of traditional accounting’s variable costs as truly variable.

TOC defines contribution margin as Selling Price minus Cost of Materials, while traditional accounting defines contribution margin as Selling Price less All Variable Costs.

Textbooks do not state whether or not the TOC approach is correct when costs other than materials vary.


Related summaries:

Atwater, B. and M. L. Gagne. 1997. The theory of constraints versus contribution margin analysis for product mix decisions. Journal of Cost Management (January/February): 6-15. (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. 1992. From Cost world to throughput world. Advances In Management Accounting (1): 35-53. (Summary).

Goldratt, E. M. and J. Cox. 1986. The Goal: A Process of Ongoing Improvement. New York: North River Press. (Summary).

Hall, R., N. P. Galambos, and M. Karlsson. 1997. Constraint-based profitability analysis: Stepping beyond the Theory of Constraints. Journal of Cost Management (July/August): 6-10. (Summary).

Luther, R. and B. O’Donovan. 1998. Cost-volume-profit analysis and the theory of constraints. Journal of Cost Management (September/October): 16-21. (Summary).

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.

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).