Integrating Activity-Based Costing and Theory of Constraints: Maximizing Profit Potential

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 firm’s 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 it’s 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 <= supply • Supply costs fixed until usage > 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 doesn’t 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, it’s 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, don’t 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. Let’s 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 ?