Management Accounting:
A Road of Discovery
Management Accounting:
A Road of Discovery
Chapter 12 Which process should we improve first?
Decision-focused management using the theory of constraints
Key Learning Objectives
Overview
Consider a company that processes and sells peanuts. It has these characteristics:
Traditional management
Functional areas of specialization
Areas of responsibility
òOne best way’ work standards
Cheap labor, easy to learn activities
Cost centers
òEach manager has their own budget’
Overview (Continued)
The company has three functional departments.
Husk Pack Sales
& &
Bake Ship
Each department is like a òsilo’ surrounded by walls of inventory or time buffers.
Each department has separate budgets, responsibility centers, and variance reports that promote a strategy to optimize each individual department.
Coordination using budgets creates and maintains the value of the whole company.
Creating a Cost World
You are the manager of the òhusk and bake’ department.
Your objective as a good manager is to create and maintain value.
Your problem:
You have no influence on the òSales’ or òPack&Ship’ departments.
You can only influence your costs.
How does this fit into your TQM efforts?
TQM Says:
DO IT RIGHT THE FIRST TIME
CONTINUOUS IMPROVEMENT
ELIMINATE NONVALUE ADDING ACTIVITIES
FIX òALL’ ACTIVITIES NOW
What Can I Do?
What can you as the manager of the òHusk & Bake department do under TQM? The only thing you control is costs.
You can only decrease costs while providing the same level of production or service.
The objective is to increase productivity or òdo the same for less’ .
TOC argues that accounting systems create a òcost world’ approach to improvement.
The Problem
The problem is that in most cases the largest cost savings to improve productivity is to reduce labor content.
òJust-in-Time’ becomes interpreted by workers as òJobs-in-Trouble’ .
Creating a Value World
TOC supporters argue that this cost world emphasis is inefficient, wasteful and undermines support for continuous improvement.
Managers need to focus on creating value for the company and not necessarily decreasing costs.
How Can This be Done?
Pareto management, or the 80:20 rule, claims that only a few activities are responsible for most of a company’ s profits.
The TOC version is that there is always some activity that limits or constrains increasing value.
Continuous improvement with TOC management focuses on increasing value by finding and improving constraints limiting throughput.
Throughput is defined as sales revenue less direct materials.
Constraint activities limit short-term value. Thus removing constraints converts us from a òcost world’ to a òvalue world’ .
TOC
TOC ARGUES THAT òSILO’ MANAGEMENT ACTUALLY LEADS TO CONSTRAINTS, ESPECIALLY WHEN PRODUCTION PROCESSES VARY FOR DIFFERENT PRODUCTS.
Our Peanut Company
Remember we fist òhusk&bake’ , then we òpack&salt’ and finally we òsell’ our peanuts.
We must complete one activity before we can start the next activity.
TOC assumes there is always one activity that constrains value.
Question and Answer
Question.
What is the company’ s maximum daily production and sales?
Answer.
Sales sets the capacity for the company at 100 lbs per day. Sales is the constraint. The constraint sets the capacity (short-term value) for the entire company.
Discussion.
The first steps for TOC continuous improvement is to identify the activity that is the constraint to increasing immediate value (not necessarily long-term value).
Improving this constraint is the only way to guarantee immediate value improvement.
Let’ s Improve the Constraint
If peanuts sell for $10 per pound, then what is the maximum daily revenue?
100 lbs @ $10 per lb = $1,000 per day.
Suppose that for spending $1,000 for training in each department, we can increase productivity by 10%.
How much money should we spend to maximize short term value, $3,000, $2,000, or $1,000?
The Improvement
Rather than spending $3,000, TOC says only spend $1,000. The extra $2,000 is wasted in the short-term.
Using TQM logic, we would improve all three departments for $3,000 and justify this based upon long-term value creation.
TOC Rule: only increasing capacity at the constraint will guarantee short-term value increases.
TQM Rule: Long-term value improvements will justify all $3,000.
Both are correct!
Results
If we spend the $1,000, how much value have we added daily?
10 extra pounds x ($10 – $2) = $80 per day.
What is the appropriate value added per unit of production?
Value Added
Explanation
Results
Throughput from the productivity improvement = 10 lbs x $8 = $80 per day.
Should we make the productivity improvement at the constraint?
The cost of the productivity investment is $1,000.
How long will it take to recover or payback the investment?
Payback period = $1,000/$80 per day = 12.5 days
TOC’ s Five Steps for Continuous Improvement
Identify the most important constraint.
Exploit it by optimally using the current constraint to maximize profits (drum-buffer-rope management).
Don’ t worry too much about the non-constraints.
Eliminate the constraint.
A new constraint will exist, so start all over.
Definitions
The constraint activity is the DRUM that sets the pace for all operations.
The BUFFER is the inventory maintained in front of the constraint to insure all available capacity will be utilized.
The ROPE is the schedule for work activity that is based upon the needs of the constraint. Thus, the pace of the constraint pulls work through the activities in front of it.
Control: What Do We Want People to Do?
TOC Decisions and Cost Categories
Decisions are limited to the comparison of Throughput against the cost of increasing the Throughput. Positive Throughput dollars will increase value. Projects are ranked by Throughput value.
Costs that will continue are grouped together as òOperating Expenses’ . If Throughput is greater than the Operating Expenses then value will increase.
Costs that will not continue are grouped together as òInvestments’ (sometimes called òInventories’ ). The Payback period will determine how long it takes for the increase in Throughput to recover the investment.
Goals for the TOC Accounting System (Keep your eye on the ball.)
Measure how well we use the constraint.
Management goal î maximize constraint output.
TOC accounting provides information for improving the constraint’ s value only.
Don’ t emphasize efficiency measures in the bottlenecks.
Management goal î non-constraints should work only to the beat of the drum, not at their own maximum rates.
Accounting provides overall budget-to-actual department costs only.
WIP information should be for the buffer inventory in front of the constraint
Management goal î monitor the buffer and minimize WIP at the non-constraints.
Cost Organization in Different Income Statements
Exhibit 12-9, p. 444, provides a comprehensive illustration of the relationship of TOC, Functional, and Activity-based Income Statements.
Review and assure an understanding of the different structure of the statements and how they contain essentially the same information, structured and formatted differently.
Payback Period for Nailing Machine Improvement
TOC Continuous Improvement Ratios
TOC Performance Ratios î Short-Term Measures
TOC Performance Ratios î Long-Term Performance Measures