How throughput accounting can help to make effective growth in a business?

 

How effective growth in a business can be achieved by Throughput Accounting (TA)?

Throughput accounting (TA) can help to make an effective growth in a business because  it is essential to know that what you should produce for effective utilisation of your resources. TA is an approach to production management where aim is to maximise throughput contribution while also reducing inventory & operational expenses.

TA is a management accounting technique which is based on Theory of Constraint ( ToC ) and is consistent with the use of just in time production method.

What is the Basic concept of TA?

Under TA organisation should seek to maximise throughput by identifying and eliminating bottlenecks. All operational expenses except materials are assumed to be fixed costs.

How to calculate throughput?

throughput = Sales revenue - Direct material cost.

 What is Theory of Constraint ( ToC ) ?

ToC is a production system where key financial concept is to maximise throughput while keeping conversion & investment costs to a minimum. Five steps of ToC has been mentioned in the image above.

It is an approach of production management & optimising production performance that was developed by Goldratt & Cox in 1986. Its key role to turn material into sales as quickly as possible.

ToC also states that at all times there will be a bottleneck resource and it can be sales demand in theory but it is more likely to be a resource that an organisation uses.

Bottleneck resource / binding constraint is a process which has lower capacity than preceding or subsequent activities, thereby limiting throughput.

In the above diagram, Process 2 is bottleneck because this process is slow as only 50 units per hour can be processed as compare to the Process 1 & Process 3 as 100 units per hour can be processed. So Process 2 is bottleneck.

Note: Once the capacity of Process 2 is increased then Other Processes may become bottleneck resource.

Example 
Cat Co makes a product using three machines – X, Y and Z. The capacity of each machine is as follows:

The demand for the product is 1,000 units per week. For every additional unit sold per week, net present value increases by $50,000. Cat Co is considering the following possible purchases (they are not mutually exclusive):

Purchase 1: Replace machine X with a newer model. This will increase capacity to 1,100 units per week and costs $6m.

Purchase 2: Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this machine would be $6.8m.

Purchase 3: Upgrade machine Z at a cost of $7.5m, thereby increasing capacity to 1,050 units.

Required:
Which is Cat Co’s best course of action?

Solution:
First, it is necessary to identify the system’s bottleneck resource. Clearly, this is machine Z, which only has the capacity to produce 500 units per week. Purchase 3 is therefore the starting point when considering the logical choices that face Cat Co. It would never be logical to consider either Purchase 1 or 2 in isolation because of the fact that neither machines X nor machine Y is the starting bottleneck. Let’s have a look at how the capacity of the business increases with the choices that are available to it.

From the table above, it can be seen that once a bottleneck is elevated, it is then replaced by another bottleneck until ultimately market demand constrains production. At this point, it would be necessary to look beyond production and consider how to increase market demand by, for example, increasing advertising of the product.

In order to make a decision as to which of the machines should be purchased, if any, the financial viability of the three options should be calculated.

The company should therefore invest in all three machines if it has enough cash to do so.

The example of Cat Co demonstrates the fact that, as one bottleneck is elevated, another one appears. It also shows that elevating a bottleneck is not always financially viable. If Cat Co was only able to afford machine Z, it would be better off making no investment at all because if Z alone is invested in, another bottleneck appears too quickly for the initial investment cost to be recouped.