Case 101 Integrating ActivityBased Costing and the Theory of Constraints

1
Case 10-1 Integrating Activity-Based Costing and
the Theory of Constraints

• Aftab Usmani
• Alex Derevin
• Carla Daniels
• Shantanu Singh

2
Shortfalls of ABC

• Activity-Based Costing system is a powerful tool
  for strategic management.
• However, ABC does not take into account that
  resources can be finite

3
Enter Theory of Constraints

• Theory of Constraints goes deeper than ABC by
  examining the SUPPLY of resources.
• This is especially important when supply does not
  directly mirror firms changes in demand.

4
In-Case vs. As-Needed

• As-Needed contracts for acquisition of
  resources let the firm buy as it goes.
• Resource will be supplied at the level its used
  by the firm.
• Usage Supply
• Costs related to this input are variable
• ABC Profitability Maps apply

5
In-Case vs. As-Needed

• In-Case basis contracts provide a certain
  amount of resource.
• Supply at a certain level
• Usage lt supply
• Supply costs fixed until usage gt supply
• Costs rise by a fixed, contractually agreed-upon
  amount once capacity is reached.

6
Managing Capacity Limits

• Accept the limit and try to maximize revenue
  (and, thus, profit) given the constraint.
• Must optimize around the bottlenecks
• Change level of resource supply, and, therefore,
  the capacity limit

7
Bottleneck

• Regular ABC assumes that supply will change
  fluidly to meet demand.
• Therefore, there are no bottlenecks in ABC
• ABC doesnt take into account products that take
  up a lot of bottleneck capacity, which can lead
  to poor decisions.
• Maximum profits require bottlenecks to be
  optimally utilized.

8
A Short Example of ToC
9
What Would YOU make?

• Highest per-unit (ABC) profit is 42 for Product
  A. However, as the obvious answer, its wrong.

10
ToC Approach

• Split resources into categories
• Resources purchased on as-needed basis vary in
  cost directly with production.
• Cost of resources purchased on in-case basis
  will be incurred irrespective of their usage.
• Since these costs are always incurred, dont
  consider them in analysis

11
ToC Objective

• Maximize throughput
• Throughput Revenues minus cost of as-needed
  resources.
• Only cost subtracted is material.
• On the surface, A has the highest throughput
• However, it consumes twice as much of the
  machining resource.
• In a given amount of time, firm can manufacture
  two units of product B or C instead of one A

12
Per-Unit Throughput
ABC and TOC agree!
13
Not Quite!
14
What Happened?!

• If you look at Table 1, you will see that only
  resources USED are accounted for as costs
• Fixed capacity paid for, but not used is not
  charged
• Under TOC the costs of underutilized bottlenecks
  are charged to the products

15
Bringing ABC and ToC together
16
Long-Term Management

• ToC accounts for bottlenecks present, and,
  therefore, performs better.
• Drawback Managing expenses over the long term.
• Example ABC shows product C only half as
  profitable as A and B.
• Study indicates Inspection resource is
  dedicated to product C
• Maybe C should be discontinued?
• Avoid 50 inspection costs!

17
Lets Try it Out
18
Conclusion

• ToC and ABC are complimentary techniques
• Used together to identify short-term and
  long-term product mixes
• ToC Assumes cost structure is a given
• Optimizes throughput for short-term profits
• ABC Supply of resources can be managed over long
  term.
• Identifies long-term product mix

19
Conclusion

• ToC Formal on-going special study designed to
  make ABC profitability maps more effective for
  one class of decisions
• Decisions associated with short-term capacity use
  optimization

20
Questions
?