Monday, March 17, 2014

Focus and Leverage Part 323



This will be my final posting on Steven Bragg’s wonderful book, Throughput Accounting – A Guide to Constraint Management.  I hope you have enjoyed this series and I hope it compels you to go buy his book.  I also hope it has opened your eyes to how much better Throughput Accounting is for making real time financial decisions.  I want to finish this series by discussing two distinctly different views that exist between how Throughput Accounting and traditional Cost Accounting treat Direct Labor and Inventory Valuation, two areas of accounting with divergent viewpoints.  I will finish this series with a discussion on how allocating costs to individual products can lead to potentially devastating results for a company.
 

As Bragg rightfully points out, the treatment of direct labor varies considerably between traditional cost accounting and throughput accounting.  Using traditional cost accounting methods, direct labor is charged to each product as a variable cost even though in almost every company, it is a fixed cost.  Direct labor does not vary proportionally to the volume of product produced or the number of patients treated.  Instead, direct labor usually constitutes a pool of skilled laborers who typically work the same number of hours every day regardless of the volume of work to be completed.  It’s not typical that when the work is completed, the workers get sent home.  If that were the case, I think companies would have lots of difficulty keeping their workers employed because they would be out looking for new jobs.  The fact is, people need a stable source of employment and income.
 

In addition, traditional cost accounting designates direct labor as the basis upon which overhead expenses will be allocated to inventory.  This is not a good practice for two basic reasons.  First, direct labor does not vary directly with the level of production, so it forms a very poor basis upon which to allocate inventory.  Secondly, overhead costs are not allocated under throughput accounting since these costs have absolutely nothing to do with the incremental cost to produce a product or deliver a service…..they only represent the cost of maintaining a certain level of capacity for the system as a whole.  Throughput accounting takes a much simpler view of direct labor, which is that it is essentially a fixed cost for maintaining the level of required throughput, it’s cost is not charged to products or services.
 

As far as inventory valuation goes, traditional cost accounting and throughput accounting treat this in very different ways.  Traditional costing mandates that some portion of direct labor and overhead expenses be assigned to all inventory.  In doing so, these expenses are removed from the income statement and stored on the balance sheet until the inventory is consumed, when the expenses are recognized on the income statement.  There are at least two problems when using this approach.  First, the assumption that operating expenses are related to the volume of inventory produced is blatantly false.  Instead, operating expenses represent the ability of the system to create throughput during a specified period of time.  It matters not whether the system operates at 0 or 100% utilization during that period because it has minimal impact on the amount of operating expense actually incurred, so the entire expense should be written off during the current reporting period.
 

Secondly, because traditional cost accounting allows inventory to absorb costs, managers have a tendency to produce more inventory than is needed so as to artificially improve their apparent level of profitability.  This, of course, has adverse side effects of increasing both inventory storage costs and the company’s investment in working capital.  Throughput accounting uses the approach of only assigning the cost of the materials consumed to the inventory on the grounds that only totally variable costs are involved.  This method results in the complete elimination of any incentive to over-produce because it no longer improves their financial results by storing operating expenses in inventory.  Now let’s look at how both accounting systems treat low-margin products.
 

Bragg tells us that there is a substantial difference in the manner in which low-margin are treated under the traditional and throughput accounting systems.  In traditional cost accounting systems a great many overhead costs are assigned to each product.  In doing so, product margins will be significantly reduced and sometimes margins will actually be seen as negative.  This typically results in managers eliminating these products under the false assumption that they are not earning a profit.  The best way to demonstrate the potential impact of using this methodology is by looking at an example that Bragg includes in his book, which I will quote word-for-word.

 “Acorn Company has three products, whose margins are shown in the following table.



 

Product Alpha

Product Beta

Product Charlie

Totals

Units sold

1,500

3,500

10,000

15,000

Price each

$  8.00

$12.00

$ 15.00

-

Variable cost

$  3.00

$5.00

$ 6.00

-

Overhead Allocation

$  6.66

$6.66

$ 6.66

-

Gross Margin each

$  (1.66)

$ 0.34

$ 2.34

-

Gross Margin total

$ (2,490)

$1,190

$23,400

$22,100

 The company has $100,000 of overhead costs, which it allocates based on the number of units sold.  Acorn sells a combined total of 15,000 units of all three products, so each one receives an overhead charge of $6.66 ($100,000 0verhead expense/15,000 units).  Based on this analysis, Acorn elects to stop selling Product Alpha, which has a fully burdened loss of $2,490.  The company does not lose any overhead expenses as a result of the product elimination, so the same $100,000 must now be allocated among products Beta and Charlie, resulting in an increased overhead charge per unit of $7.41 ($100,000 overhead expense/13,500 units).  The results of this reallocation appear in the following table.



 

Product Beta

Product Charlie

Totals

Units sold

3,500

10,000

13,500

Price each

$12.00

$ 15.00

-

Variable cost

$5.00

$ 6.00

-

Overhead Allocation

$7.41

$ 7.41

-

Gross Margin each

$ (0.41)

$  1.59

-

Gross Margin total

$(1,435)

$15,900

$14,465

Now the Product Beta margin has become negative, with a fully burdened loss of $1,435.  Acorn now stops selling Product Beta.  Overhead expenses do not decline as a result of this product cancellation, so now the entire cost is allocated to Product Charley, at a rate of $10.00 per unit ($100,000 overhead expense/10,000 units).  The result is shown in the table below.


Based upon the new cost allocation, Acorn cancels Product Charlie as well, and now finds itself out of business!!!  Thus we have gone from a profitable company to a bankrupt one, just because a fixed pool of overhead costs is being allocated to individual products.  Under Throughput Accounting, a product is only eliminated if its price is lower than its totally variable costs.



 

Product Charlie

Units sold

10,000

Price each

$ 15.00

Variable cost

$ 6.00

Overhead Allocation

$ 10.00

Gross Margin each

$  (1.00)

Gross Margin total

$(10,000)



This completes my series on Throughput Accounting by Steven M. Bragg.  I hope you found these postings to be helpful.  In closing, I want to recommend that you read Chapter 4 of this book as it contains various financial analysis scenarios that accountants face on a regular basis.  Bragg explains scenarios all the way from low price, high volume decisions to plant closing decisions.  It is important to remember that the throughput accounting model only works properly if the constrained resource has been correctly identified; otherwise, incorrect production scheduling decisions will yield suboptimal throughput and profits.
 

Bob Sproull

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2 comments:

Stuart M. Rosenberg said...

Hi Bob,

Enjoyed the article. I too am a fan of Steven Bragg as I have one of his books. I agree with your input on cost accounting but most of the issues I see stem from the use of standard costing used in traditional cost accounting. I prefer to use Lean Accounting Principles.

Regards
Stuart

Bob Sproull said...

Hi Stuart. I'm happy that you enjoyed the article and I agree with you that most of the issues stem from the use of standard costing. I find it amazing that so many companies are still using standard cost accounting to make financial decisions.
Bob