Tuesday, September 23, 2014

Focus and Leverage Part 376

In my last posting I demonstrated by way of an example from Thomas Corbett's wonderful book, Throughput Accounting, how by using traditional Cost Accounting (CA) to make a decision about product mix, might cause us to make an incorrect decision.  You will recall that by using CA decision criteria relative to which product mix, this fictitious company should produce(i.e. how many women's shirts and how many men's shirts) per week. Based upon these results, the most obvious decision would be to close the company.  In this posting I want to demonstrate one of the flaws of CA when it comes to the correct product mix in this company.  Again, we are using Thomas Corbett's example from his book, Throughput Accounting published by North River Press in 1998.

You will recall from my last post,the product mix that resulted in a loss of $300 was 120 women's shirts and 60 men's shirts.  Corbett demonstrates to us what would happen if we reverse the mix and produce 120 men's shirts and, based upon the sewing time for women's shirts, we will produce 80 of these.  Remember, according to CA rules of engagement the women's shirts were thought to be the most profitable.  As Corbett points out, this is what happens if we sold all of the men's shirts (i.e. the least profitable according to CA) and then filled the remaining time with women's shirts (i.e. the most profitable according to CA).

Raw Material Cost
Gross Margin
Operating Expense
Net Profit
+$ 300

Since after producing 120 men's shirts on the sewing machine we still have 1,200 minutes left over, we can produce 80 women's shirts (i.e. 1,200 minutes/15 minutes/women's shirt = 80 women's shirts).  As a result of this mix, look what's happened to the profit margin!  As Corbett reminds us, we did not change anything in the company's conditions, yet we went from a loss of $300 to a profit of $300 a week!  The bottom line conclusion here is that Cost Accounting did not supply the correct information about which product most contributes to the company's profit!  Corbett continues, we increased the production of the least profitable product (i.e. according to CA guidelines) while decreasing the production of the most profitable product and our profits increased!  Corbett finishes this section with the following statement that I absolutely agree with, "If there is an error in this methodology, other information can be wrong as well."

In my next posting we'll look more into other problems related to Cost Accounting and then begin looking at what I believe is the best accounting methodology in the world today....Throughput Accounting.  I want to thank Thomas Corbett for writing such a wonderful and informative book, Throughput Accounting.  I absolutely encourage everyone who wants to learn more about this method to buy Thomas Corbett's book....you won't regret it!

Bob Sproull

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