Management Accounting: A Road of Discovery

Management Accounting : A Road of Discovery James T. Mackey Michael F. Thomas Presentations by: Roderick S. Barclay Texas A&M University - Commerce James T. Mackey California State University - Sacramento © 2000 South-Western College Publishing

Chapter 12 Which process should we improve first? Decision-focused management using the theory of constraints

Key Learning Objectives 4. Show how to eliminate a constraint by using throughput with the payback period and make-buy analyses.. 2. Maximize profits by using throughput to schedule production. 5. Demonstrate four ratios for continuous improvement management. 3. Calculate the minimum sales price to break even when a constraint exists. 1. List TOC’s continuous improvement steps and relate them to Pareto management using drum-buffer-rope scheduling.

Part I The Theory of Constraints (TOC) Way to Continuous Improvement

Overview Consider a company that processes and sells peanuts. It has these characteristics: Traditional management Functional areas of specialization Areas of responsibility ‘One best way’ work standards Cheap labor, easy to learn activities Cost centers ‘Each manager has their own budget’

Overview (Continued) The company has three functional departments. Husk PackSales & & Bake Ship Each department is like a ‘silo’ 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 ‘husk and bake’ department. Your objective as a good manager is to create and maintain value. Your problem: You have no influence on the ‘Sales’ or ‘Pack&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 ‘ALL’ ACTIVITIES NOW

What Can I Do? What can you as the manager of the ‘Husk & 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 ‘do the same for less’. TOC argues that accounting systems create a ‘cost 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. ‘Just-in-Time’ becomes interpreted by workers as ‘Jobs-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 ‘cost world’ to a ‘value world’.

TOC TOC ARGUES THAT ‘SILO’ MANAGEMENT ACTUALLY LEADS TO CONSTRAINTS, ESPECIALLY WHEN PRODUCTION PROCESSES VARY FOR DIFFERENT PRODUCTS.

Part II An Illustration

Our Peanut Company Remember we fist ‘husk&bake’, then we ‘pack&salt’ and finally we ‘sell’ our peanuts. We must complete one activity before we can start the next activity. TOC assumes there is always one activity that constrains value. Sales Capacity of 100 lbs per day Pack & Ship Capacity of 150 lbs per day Husk & Bake Capacity of 200 lbs per day

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 $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! Sales 100 lbs Increase 10% to 110 lbs Pack & Salt 150 lbs Increases 10% to 165 lbs Husk & Bake 200 lbs Increases 10% to 220 lbs

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 $ $ 2 $10 GAAP $ 8Throughput $ 7Contribution margin Gross margin Fixed overhead 1Direct labor $ 2 Direct material Less: $10 Selling price ThroughputContribution Margin ‘Different costs for different purposes’. Which cost is correct? Which best reflects the change in value from our productivity improvements?

Explanation This is the cash available from productivity improvements. Producing more products with the same level of labor and overhead. Throughput is defined as Sales revenue less the costs of materials and any additional power, etc. Throughput This is the incremental cash available to cover fixed costs and profit within the relevant range for the current capacity. Contribution Margin This is the GAAP inventory valuation for financial statements. This is absorption costing. In the long run all the costs necessary for production must be recovered. Gross Margin per unit

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

Part III TOC’s Five Step Process to Continuous Improvement

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.

Part IV Managing the Constraint with Drum- Buffer-Rope Scheduling

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?  Note: Meet the production needs of the constraint.  Maximize the output of every department to minimize the average cost per unit. Means think outside the box. (Constraints management — maximizing the constraint’s output will optimize overall value.)  Means thinking within the box. (Functional silo management — maximizing each department’s output will optimize overall value.) Focus on increasing constraint capacity to increase firm value.  Don’t have unfavorable cost variances Maintain current expenses in every non-constraint.  Minimize costs in each department TOCTraditional Management

Part V 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 ‘Operating Expenses’. If Throughput is greater than the Operating Expenses then value will increase. Costs that will not continue are grouped together as ‘Investments’ (sometimes called ‘Inventories’). The Payback period will determine how long it takes for the increase in Throughput to recover the investment.

Part VI Performance Evaluation and Control Measures

Goals for the TOC Accounting System (Keep your eye on the ball.) Measure how well we use the constraint. Management goal — maximize constraint output. TOC accounting provides information for improving the constraint’s value only. Don’t emphasize efficiency measures in the bottlenecks. Management goal — 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 — 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 $29,000 (440) $29,440 x 8 $3, (7.50) $3, per month= Cashflow generated per month- Incremental operating expenses per month= Additional contribution margin trusses per monthx Increased capacity per truss=Throughput from investment - Incremental variable costs per trussThroughput Investment cost $350,000 Payback period = == months Cashflow generated $ 29,000

TOC Continuous Improvement Ratios Product mix Standard homes Custom homes 90 houses 20 houses = 4.5 to 1 Improvement efficiency D (Variable costs + operating expenses DConstraint capacity $440 per month 8 extra trusses $55.00 per truss var. cost = $62.50 each Throughput efficiency Throughput Constraint run time $700 per day 7 hrs. per day = $100 per hour Constraint utilization rate Constraint run time Time available 7 hrs. per day 8 hrs. per day = 88% efficiency

TOC Performance Ratios — Short-Term Measures This is controlled by the workers and by management. Only to the extent the workers can influence activities that keep the constraint running. Controllability — Can the workers significantly influence the activities that change the measure? For workers— move materials through the constraint faster. For management— obtain better prices for constraint capacity. The action directed is to keep the constraint running as much as possible. Direction — Does the measure identify or guide workers to actions that will increase value? The greater the return for each hour of operations, the larger the profits and cashflow. As utilization of the constraint increases, profits and cashflow increase. Value — Does a change in the measure correlate with changes in company value? Throughput EfficiencyConstraint Utilization Rate Performance Measure Criteria

TOC Performance Ratios — Long-Term Performance Measures Managers set the production schedules. The workers are empowered to continuously improve. Controllability — Can the workers significantly influence the activities that change the measure? Management — Maintain long-term value and current cashflow. They must assure the mix of orders matches these goals. Workers need to increase capacity at the constraint, but not at any cost. Payback period may need to be considered as well. Direction — Does the measure identify or guide workers to actions that will increase value? The strategic plan is to maximize long-term value. If the product mix changes, it will not. The relative efficiency of any added capacity will influence long- term competitiveness. Value — Does a change in the measure correlate with changes in company value? Product MixImprovement Efficiency Performance Measure Criteria