Accounting and the theory of constraints

Accounting and the Theory of Constraints
Charlene W. Spoede, Ph.D., CPA, CMA

Until recently, Theory of Constraints proponents have paid far more attention to criticizing cost accounting than to encouraging its adaptation to support TOC decisions. At best, practitioners were told to "forget costs" and to concentrate on throughput. However, no firm can afford to ignore costs. And most of ourperformance measures reinforce the importance of costs. Fortunately, there is a way that cost accounting can be adapted to generate information that focuses on throughput as well as costs.
This paper will try to reconcile cost accounting and the Theory of Constraints. The first section will review a bit of the history of cost accounting, so that we know how we arrived where we are today and why ourtraditional cost systems no longer provide the information we need. To validate this section and to clarify your own cost accounting beliefs, you should take the Accounting True/False Test included in Appendix 1 to this paper.
The second section of this paper will discuss "throughput" accounting as it is being used today, and how it might be integrated with activity-based accounting. Thissection also reviews a model for presenting the income statement in a segmented format. Segments might be defined as products, business lines, geographic areas, customers, or any other cost object of interest.
The subject of the final section is using appropriate costs in decision making. Capacity availability and utilization are critical pieces of necessary decision information. This section includessuggestions for identifying relevant items and some simple examples of relevant items for some common decisions.
TRADmONAL COST ACCOUNTING
Assumptions upon Which Cost Accounting Was Buift
Cost accounting was originally designed to give decision makers relevant information to make informed decisions regarding adding additional products, automating operations, making or buying component parts,increasing capacity and many other decisions we still make today. The assumptions underlying the system as it was developed reflected the reality of that time period. The assumptions were that direct materials were a purely variable cost; direct labor, which was paid on a piece-work basis, was a purely variable cost; and overhead existed primarily to support direct laborers and was a small portion(less than 10%) of total product cost
With these assumptions and some reordering of record keeping, F. Donaldson Brown, in the early part of this century, was able to develop a system for Du Pont and later General Motors that gave them a tremendous advantage over competitors.1 Overhead was firmly established as a function of direct labor, and total production costs were carried down to the unitlevel At some point, we became enamored of "cost per unit" and forgot the basic assumptions upon which it was built.
A basic truth about cost allocation is that the relative total of whatever base is used to allocate a total cost, over time, will decrease. All that is required for this "truth" to hold is that people are rational. That is, once people know that they will be "charged" for their useof the base, they will try to decrease their consumption of the base. Because the original base was direct labor, there was tremendous incentive for all parties (engineers, operating managers, etc.) to reduce the quantity of direct labor in all operations. Hence, automation almost was assured once the base was chosen.
Also, because overhead was spread over all users and no one decision-makingmanager was directly responsible for all overhead items, there was every incentive not to expend considerable effort to control or reduce overhead spending. Thus, we might logically have predicted the occurrence of the current situation of greatly decreased direct labor and tremendously increased overhead.
Violation of Basic Assumptions
Today, labor is not a significant part of total product cost...