Bottlenecks, Theory of Constraints & Throughput Accounting

A bottleneck is the most limiting constraints on the system.

A bottleneck (or constraint) in a supply chain occurs at the point in the process that requires
the longest time or has the lowest rate-(a process bottleneck). The bottleneck may be a machine,
worker availability, or any other resource involved in converting inputs into outputs, or products.
A bottleneck in production is a point where an operation meets or exceeds the capacity of the
facility. In other words, the factory or department can't produce enough units fast enough to keep
the rest of the production schedule or other daily operations flowing at the same rate.
Dr. Eliyahu Goldratt developed theory of constraints, a 5 step thinking process which helps a
firm achieve optimal throughput, or the maximum rate of output possible in the current system,
by identifying the bottleneck and coordinating the system around the bottleneck’s capacity. TOC
Also helps identify ways of overcoming the bottleneck.

STEPS OF THEORY OF CONSTRAINTS –TOC_ (Continuous Process)

Subordinate & Elevate the Don’t stop

Identify the Exploit the
synchronized to performance now; find the
Constraints Constraints
the Constraints of the next
Constraints constraints

Throughput accounting and the theory of constraints

The theory of constraints is applied within an organization by following ‘the five focusing steps’
– a tool which was developed to help organizations deal with constraints.
1. Identify the system’s bottlenecks
2. Decide how to exploit the system’s bottlenecks
This involves making sure that the bottleneck resource is actively being used as much as
possible and is producing as many units as possible.
3. Subordinate everything else to the decisions made in Step 2
The production capacity of the bottleneck resource should determine the production
schedule for the organization as a whole.
Idle time is unavoidable and needs to be accepted if the theory of constraints is to be
successfully applied.
4. Elevate the system’s bottlenecks
This will normally require capital expenditure.
5. If a new constraints is broken in Step 4, go back to Step 1
The likely constraint in the system is likely to be market demand.
Ways to improve the capacity of Bottleneck Operation:
1. Add resources at the bottleneck operation
2. Always have a part for the bottleneck to process.
3. Assure that the bottleneck works only on quality parts.
4. Examine your production schedule.
5. Increase the time the operation is working.
6. Introduce Modern Technology
7. Minimize downtime.

SAZEDUL HOQ ACMA 1

 The theory of constraints (TOC) describes methods to maximize operating income when faced
with some bottleneck and some non-bottleneck operations. To implement TOC, we define and use
three measures:
Throughput Accounting is the accounting system developed based on the Theory of constraints
and JIT. It measures the Throughput contribution per hour.

1. Throughput Contribution = Sales Revenues - direct material costs.

2. Conversion Cost (in TOC) = All operating costs except direct materials Cost
3. Investment costs =Inventory, R&D costs, Equipment, building Costs and so on.

Throughput is the number of units that pass through a process during a period of time.
Throughput is the revenues generated by a production process, minus all completely variable
expenses incurred by the process. In most cases, the only completely variable expenses is direct
materials.

Concepts in throughput accounting:

1. In the short run, most costs in the factory (with the exception of materials costs) are fixed.
These fixed costs include direct labor.
These fixed costs are called Total Factory Costs (TFC) (operating expenses).

2. In a JIT environment, the ideal inventory level is zero.

Products should not be made unless a customer has ordered them.
Work in progress should be valued at material cost only until the output is eventually sold, so
that no value will be added and no profit earned until the sale takes place.

3. Profitability is determined by the rate at which sales are made and, in a JIT environment, this
depends on how quickly goods can be produced to satisfy customer orders.
Since the goal of a profit-orientated organization is to make money, inventory must be sold for
that goal to be achieved.

TA helps in:
 Bottlenecks
 Key Elements in making profit
 Inventory reduction
 Reduction the response time to customer demand
 Evenness of production process
 Overall effectiveness and efficiency.

The Throughput Accounting Ratio (TAR):

Throghput contibution per time period

TAR =
Conversion cost per time period

(𝐒𝐚𝐥𝐞𝐬 − 𝐌𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐜𝐨𝐬𝐭)𝐩𝐞𝐫 𝐡𝐨𝐮𝐫

𝐓𝐀𝐑 =
(𝐋𝐚𝐛𝐨𝐫 + 𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝)𝐩𝐞𝐫 𝐡𝐨𝐮𝐫

𝐓𝐡𝐫𝐨𝐮𝐠𝐡 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭

[𝐓𝐡𝐫𝐨𝐮𝐠𝐡𝐩𝐮𝐭 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐭𝐢𝐦𝐞 = ]
𝐏𝐫𝐨𝐝𝐮𝐜𝐭 𝐭𝐢𝐦𝐞 𝐨𝐧 𝐁𝐨𝐭𝐭𝐥𝐞𝐧𝐞𝐜𝐤 𝐫𝐞𝐬𝐨𝐮𝐫𝐜𝐞𝐬

𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐜𝐨𝐬𝐭𝐬

[𝐂𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐂𝐨𝐬𝐭 𝐩𝐞𝐫 𝐭𝐢𝐦𝐞 = ]
𝐓𝐨𝐭𝐚𝐥 𝐭𝐢𝐦𝐞 𝐨𝐧 𝐁𝐨𝐭𝐭𝐥𝐞𝐧𝐞𝐜𝐤 𝐫𝐞𝐬𝐨𝐮𝐫𝐜𝐞𝐬

SAZEDUL HOQ ACMA 2

Exmaple-01: Each unit of product B requires 4 Machine hours. Machine time is the bottleneck
resources, there being 650 machine hours available per week.

B is sold for Tk. 120 per unit and has a Direct Materials cost of Tk. 35 per unit. Total Conversion
cost are Tk. 13,000 per week.

Required: calculate the return per factory hours and The TAR for product B.

Example-02: ABC Company produces three products, X, Y and Z. the Capacity of ABC plant is
restricted by process Alpha. Process Alpha is expected to be operational for 8 hours per day and
can produces 1,200 units of x per hour, 1,500 units of Product y per hour, and 600 units of
Product Z per hour.

Product X Y Z

Selling price per unit 150 120 300

Material Cost 70 40 100

Conversion Cost ate Tk. 720,000 per day

Required:

1. Calculate the profit per day if daily output achieved is 6,000 units of X, 4,500 units of Y
and 1,200 units of Z.
2. Determine the efficiency of the bottleneck process given the output in (1)
3. Calculate the TAR for each product.
4. In the absence of demand restrictions for three products, advise the management on the
optimal production plan.

Example-03: 4H Company manufactures two products X & Y. The Budget statement below was
produced using a traditional absorption costing Approach. It shows the profit per unit for each
product based on the estimated sales demand for the period.

Product-X (Tk.) Product-Y (Tk.)

Selling price per unit 46 62

Production Cost Per unit:
Material Cost 18 16
Labor costs 4 10
Overhead costs 8 12
Profit per Unit 16 24
Estimated sales demand (units) 6,000 8,000
Machine hours per unit 0.5 0.8

It has now become apparent that the machine which is used to produce both products has a
maximum capacity of 8,000 hours and the estimated sales demand cannot be met in full. Total
production costs for the period, excluding direct material cost, are Tk. 248,000. No inventories
are held of either product.

Required:
1. Calculate the return per machine hour for each product if a through Accounting approach
is used.
Calculate the profit for the period, using a throughput accounting approach, assuming the
company prio

SAZEDUL HOQ ACMA 3

 Activity Based Costing-ABC

Activity Based Costing (ABC) is a costing method that identifies activities in an organization
and assigns overhead and indirect costs of each activity to all product or services according to
the actual consumption by each.

Activity Based Management-ABM: A management Approach that focuses on managerial

activities as a way of eliminating waste, reducing delays and defects.

Steps for Implementing Activity Based Costing:

1. Identify and define activities and activity cost pools

2. Wherever possible, directly trace costs to activities and Cost objects.
3. Assign Costs to Activity Cost pools-( First Stage allocation)
4. Calculate Activity rates
5. Assign costs to Cost Objects using the Activity rates and Activity Measures. (Second Stage
Allocation)
6. Prepare Management Reports & Comments.

STEPS OF ACTIVITY-BASED-COSTING-ABC

Directly
Identify traces or Assign Assign
estimated
Calculate
Activities Costs to Cost to Prepare
costs to Activity
& Activity Activity Cost Report
activities rates
Pools and Cost
Cost pools Object
objects

ABC Differs in a number of ways from traditional cost accounting.

In Activity based Costing:
1. Nonmanufacturing as well as manufacturing costs may be assigned to products
2. Some manufacturing Costs may be excluded from product Costs.
3. A number of Overhead cost pools are used, each of which is allocated to products and
other costing objects using its own unique measure of activity.
4. The allocation bases often differ from those used in traditional Costing
5. The overhead rates, or Activity rates, may be based on the level of activity at capacity
rather than on the budgeted level of Activity.

Four decisions for which ABC information is useful are

1. pricing and product mix decisions,
2. cost reduction and process improvement decisions,
3. product design decisions, and
4. Decisions for planning and managing activities.

SAZEDUL HOQ ACMA 4

 Four levels of a cost hierarchy are
i. Output unit-level costs: costs of activities performed on each individual unit of
a product or service.
ii. Batch-level costs: costs of activities related to a group of units of products or
services rather than to each individual unit of product or service.
iii. Product-sustaining costs or service-sustaining costs: costs of activities
undertaken to support individual products or services regardless of the number of
units or batches in which the units are produced.
iv. Facility-sustaining costs: costs of activities that cannot be traced to individual
products or services but support the organization as a whole.

Problem-01: X Furniture Limited makes a single product-a fire resistant commercial filling
cabinet-that it sells to office furniture distributors. The company has a simple ABC system that it
uses for internal decision making. The Company has two Overhead Department:

Manufacturing Overhead Tk. 5, 00,000

Selling & administrative Overhead Tk. 3, 00,000

The Company’s ABC system has the following activity cost pools and activity measures:

Activity Cost pool Activity Drivers

Assembling Units No. of Units
Processing Orders No. of Orders
Supporting Customers No. of Customers
Other Not Applicable

Cost assigned to the Other activity cost pool have no activity measures; they consist of the costs
of unused capacity and organization-sustaining Costs-Neither of which are assigned to products,
orders, or Customers.
X Furniture distributes the Overhead to the Activity Cost pool based on their employee interviews,
the result of which are reported below:

Distribution of resource Consumption across Activity Cost Pools

Assembling Processing Supporting Other Total
Units Orders Customers
Manufacturing Overhead 50% 35% 5% 10% 100%
Selling & administrative 10% 45% 25% 20% 100%
Overhead
Total Activity 1000 Units 250 Orders 100
Customers

Required:
1. Calculate the product margin for one of X Furniture Limited Clients office Mart who order
80 filling cabinet and four Orders under ABC system.
2. The selling price of a filling Cabinet is Tk. 595. The Cost of Direct Materials is Tk. 180 per
filling cabinet & Direct Labor cost is Tk. 50 per filling cabinet. What is the product margin
on the 80 filing cabinets ordered by office Mart?
3. Calculate how profitable is office mart as a Customer?

SAZEDUL HOQ ACMA 5

Problems-02: Marks Distributors works as an independent wholesaler of cosmetic goods
manufactured by Xenon care and cosmetics in Dakota. It generally sells to three different outlets;
Supermarket, chain store & departmental store. The latest data for the month of December 2019
of marks is presented below:

Particulars Supermarket Chain Store Dept. Store

Average Revenue per delivery Tk. 30,900 Tk. 10,500 Tk. 1,980
Average COGS Per delivery Tk. 30,000 Tk. 10,000 Tk. 1,800
No. of Deliveries 120 300 1,000
Total No. of orders 140 360 1,500
Average No. of line items per order 14 12 10
Total no. of Stores Deliveries 120 300 1,000
Average No. of cartoon shipped
Per store delivery 300 80 16
Average no. of hours of shelf stocking
Per store delivery 3.0 0.6 0.1

As per the statement of finance manager, marks has five different activities in its distribution
function. The activities and the cost against such activities for the concerned month is given
below:

Activities Activity Cost (Tk.)

Customer Purchase order processing 80,000
Line-item order 63,840
Store delivery 71,000
Cartoons shipped to stores 76,000
Shelf-stocking at customer store 10,240
301,080

The finance manager has also identified five different activity drivers with the driver data but not
expert enough to trace the right driver for right activity. He needs help in this regard to install an
activity based costing as he believes that such a costing cost traces cost more accurately with the
product. Driver data is presented below:

Cost Drivers Base Data

Store deliveries 1,420
Hours of shelf stocking 640
Cartoons shipped 76,000
Purchase orders by customers 2,000
Line items per purchase orders 21,280

Required:
1. Compute the operating income, Gross margin & Gross margin% for each outlets using
Traditional Costing system.
2. Compute the operating income & Operating income% for each outlets using Activity Based
Costing system.
3. Comments on your Answer in Requirement 1 & 2

SAZEDUL HOQ ACMA 6

 JIT-(Just-in-Time)
Just-in-Time (JIT) A production and inventory control system in which materials are purchased
and units are produced only as needed to meet actual customer demand.

Features of JIT production systems:

What it is:
 Management philosophy
 Pull System through the plant
What it does:
 Reduced time, waste, inventory & scrap
 Exposes problems and Bottleneck
 Achieves streamlined production
What it requires:
 Employee participation
 Industrial engineering
 Continuing improvement
 Total quality control
 Small lot sizes
What it assumes:
 Stable Environment

JIT Goals:
 Eliminate disruptions
 Total quality Control
 Make system flexible by reduce setup and lead times
 Eliminate waste, especially excess inventory
Benefits of JIT
 Funds that were tied up in inventory can be used elsewhere.
 Reduced space requirements.
 Shorter lead times.
 Reduced defect rates, resulting in less waste & greater customer satisfaction
 Throughput time is reduced
 Small investment
 Productivity increase
 Improved Quality

JIT purchasing has many benefits but also some risks:

Just-in-time (JIT) purchasing is the purchase of materials (or goods) so that they are delivered
just as needed for production (or sales). Benefits include lower inventory holdings (reduced
warehouse space required and less money tied up in inventory) and less inventory obsolescence
and spoilage. The risk in JIT purchasing is:

 Risk of running out of stock

 Lack of control over time frame
 More Planning required.
 Materials (goods) not being available when needed for production (or sales).

Zero Zero Lead

Inventory Time

JIT
Zero
Zero Delay
Defects
SAZEDUL HOQ ACMA 7
JIT CONCEPT: A
A pull
Management
system
philosophy
Strong
relation
with
suppliers Exposes
problems
JIT &
Lower
Bottleneck
Inventory Concept
s
Level

Employee
Empowerment
Waste
Elimination Guaranteed
delivery
Time

Example: JIT production, relevant benefits, relevant costs. The Knot manufactures men’s
neckwear at its Spartanburg plant. The Knot is considering implementing a JIT production
system. The following are the estimated costs and benefits of JIT production:

a. Annual additional tooling costs Tk. 250,000 annually.

b. Average inventory would decline by 80% from the current level of Tk. 1,000,000.
c. Insurance, space, materials-handling, and setup costs, which currently total Tk. 400,000
Annually, would decline by 20%.
d. The emphasis on quality inherent in JIT production would reduce rework costs by 25%.
The Knot currently incurs Tk. 160,000 in annual rework costs.
e. Improved product quality under JIT production would enable The Knot to raise the price
of its product by tk. 2 per unit. The Knot sells 100,000 units each year.

The Knot’s required rate of return on inventory investment is 15% per year.
Required:
1. Calculate the net benefit or cost to The Knot if it adopts JIT production at the
Spartanburg plant.
2. What nonfinancial and qualitative factors should The Knot consider when making the
decision to adopt JIT production?
Ans-01: Class
Ans-02: Other nonfinancial and qualitative factors that The Knot should consider in deciding
whether it should implement a JIT system include:
a. The possibility of developing and implementing a detailed system for integrating the
sequential operations of the manufacturing process. Direct materials must arrive when
needed for each subassembly so that the production process functions smoothly.
b. The ability to design products that use standardized materials and reduce
manufacturing time.
c. The ease of obtaining reliable vendors who can deliver quality direct materials on time
with minimum lead time.
d. Willingness of suppliers to deliver smaller and more frequent orders.
e. The confidence of being able to deliver quality products on time. Failure to do so would
result in customer dissatisfaction.
f. The skill levels of workers to perform multiple tasks such as minor repairs,
maintenance, quality testing and inspection.

SAZEDUL HOQ ACMA 8

 Back flush Accounting
A sequential-tracking costing system has four trigger points, corresponding to Stages A, B, C,
and D. A trigger point is a stage in the cycle, from the purchase of direct materials and incurring
of conversion costs (Stage A) to the sale of finished goods (Stage D), at which journal entries are
made in the accounting system.
Back flush costing is a costing system that omits recording some of the journal entries relating
to the stages from the purchase of direct materials to the sale of finished goods.
Three different versions of back flush costing.
Versions of back flush costing differ in the number and placement of trigger points at which
journal entries are made in the accounting system:

Number of Location in Cycle Where

Journal Entry Journal Entries Made
Trigger Points

Version 1 3 Stage A. Purchase of direct materials

Stage C. Completion of good finished units of product
Stage D. Sale of finished goods

Version 2 2 Stage A. Purchase of direct materials

Stage D. Sale of finished goods

Version 3 2 Stage C. Completion of good finished units of product

Stage D. Sale of finished goods

Costs are tracked sequentially as products pass through each of the following four
stages:

Stage-A Stage-B Stage-C Stage-D

Purchase of Direct Production Completion of

Materials & Sale of Finished
Resulting in Work- Good finished Goods
Incurring of in-process units of Production
Conversion Cost

Distinguish inventory-costing systems using sequential tracking from those using back
flush costing.
Traditional normal and standard costing systems use sequential tracking, in which journal entries
are recorded in the same order as actual purchases and progress in production, typically at four
different trigger points in the process.
Back flush costing omits recording some of the journal entries relating to the cycle from purchase
of direct materials to sale of finished goods, i.e., it has fewer trigger points at which journal
entries are made. When journal entries for one or more stages in the cycle are omitted, the
journal entries for a subsequent stage use normal or standard costs to work backward to ―flush
out the costs in the cycle for which journal entries were not made.

SAZEDUL HOQ ACMA 9

Limitation of back flush Costing:
1. This system does not strictly adhere to Generally Accepted Accounting Principles (GAAP).
For example, work in process exists, but is not recognized in the financial statements.
2. There is absence of audit trails, i.e. the inability of the accounting system to pinpoint the
uses of resources at each step of the production process. If there is large amount of
inventory, there is possibility of manipulation of income.

Example-Back flush Costing: MP3 Corporation assembles handheld Computers that have
scaled-down capabilities of laptop computers. Each handheld computer takes 6 hours to
assemble. Mp3 uses a JIT production system and a back flush costing System with three trigger
points:

Purchase of direct materials

Completion of good finished units of product
Sale of finished goods

There are no beginning inventories of materials or finished goods and no beginning or ending
Work-in-process inventories. The following data are for August 2019:
Direct materials purchased Tk. 5, 50,000
Conversion costs incurred Tk. 4, 40,000

MP3 records direct materials purchased and conversion costs incurred at actual costs. It has no
direct materials variances. When finished goods are sold, the back flush costing system ―pulls
through standard direct materials cost Tk.25 per unit and standard conversion cost Tk.20 per
unit. MP3 produced 21,000 finished units in August 2019 and sold 20,000 units.
Required:
1. Prepare summary journal entries for August 2019 without disposing of under- or over
allocated conversion costs.
2. Under an ideal JIT production system, how would the amounts in your journal entries differ
from those in requirement 1?
Assume the same facts as in above example except that MP3 now uses a back flush costing
system with the following two trigger points for making entries in the accounting system:
Purchase of direct materials
Sale of finished goods
The Inventory Control account will include direct materials purchased but not yet in production,
materials in work in process, and materials in finished goods but not sold. No conversion costs
are inventoried. Any under- or over allocated conversion costs are written off monthly to Cost of
Goods Sold.
Required:
1. Prepare summary journal entries for August, including the disposition of under- or over
allocated conversion costs.

Assume the same facts as in above example, except now MP3 uses only two trigger points for
making entries in the accounting system:
Completion of good finished units of product
Sale of finished goods
The inventory account is confined solely to finished goods. Any under- or over allocated
conversion costs are written off monthly to Cost of Goods Sold.
Required:
1. Prepare summary journal entries for August, including the disposition of under- or over
allocated conversion costs.

SAZEDUL HOQ ACMA 10