04 May 2012

Misleading allocations and how to fix it–Part 2

[This is a continuation that will make very little sense to you if you don’t go back to read Part 1. Sorry.]

ACTIVITY-BASED COSTING ALLOCATIONS

Well, the partners were disappointed with these results, for sure. So, they decide to try Activity-Based Costing (or ABC) allocations. The administrative overhead is allocated based on their analysis of the amount of activity that the partners must undertake with each job type.

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The ABC allocation of non-administrative overhead was done based on production-hours ($9,000 divided by 1,000 hours = $9.00 per production-hour).

The results of the partners’ new calculations (based on the historical product mix) are shown in below where you will note that company profit remains the same ($4,100 per month).

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However, new priorities emerge: now the most profitable jobs appear to be landscaping (at $35 per job) and gutter guards (at $28 per job).

Based on these data, the partners rearrange priorities to allocate resources (i.e., the 1,000 hours or production time available) to capture the available markets for these job-types first. The results of this change in priorities may be seen in the following table:

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Like the previous example, at first things look good: “calculated profits” boost to $7,924, but after subtracting overhead not absorbed (by abandoned job-types), the results are disappointing. Only $1,300 per month in net profits.

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HOW TO FIX IT: THROUGHPUT ACCOUNTING VIEW

Throughput accounting eliminates all allocations except those that are truly variable with the changes in revenue. Typically, those costs are things like raw materials, commissions (maybe), outside processing costs, piece-rate labor—but not much else.

When you look at these Throughput Calculations, you will see two critical factors:

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  1. Throughput per Job (Revenues less Truly Variable Costs or TVCs)
  2. Throughput per Constraint-Hour (Throughput divided by the time used on the constraint—in this case, the 1,000 hours of production time from the workers is the constraint to making more money)

So, looking at the Current Business and Profitability, you will see that another column as been added that represents the company as a whole or “the system.” Throughput is totaled across the enterprise into this column and then operating expenses are deducted from Throughput.

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“Direct Labor” is not included in TVC and is included in Operating Expenses. Why?

Because in most organizations, so-called direct labor is not a TVC. Many times the payroll expense for labor will be the same whether the firm produces 10,000, 12,000, or 8,000 widgets in a month. Not to mention the fact that the payroll for “direct labor” (falsely so-called) sometimes includes payments for PTO, training or other non-productive time.

Note, again, that using Throughput Accounting, we still get the same net profit calculations ($4,100 per month).

Now, with this new information in-hand, the partners decide to prioritize sales and production to capture the market in order by T/C-Hr (Throughput per Constraint-Hour) until they run out of constraint-hours (i.e., the 1,000 hours available to them each month). The results of these new priorities are shown in the table below marked as Revised by Throughput per Constraint-Hour.

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Wow! Profits are boosted 230 percent—to $9,410 per month or $112,920 annually—after fully covering all of “the system’s” overhead. In this case, they sought out and captured the 250 plumbing jobs available to them in the market as a top priority. Their second priority was to capture the 145 gutter guard jobs available to them. They had a few of the 1,000 hours left, so they were able to also do 16 window cleaning jobs.


Hopefully, this helps you see two things:

  1. The inherent dangers in believing data coming from an ERP manufacturing (or project accounting) system where the profit figures are clouded by allocations of overhead.
  2. The simplicity and clarity provided by looking at your clients’ organizations as “a system” and helping them view their goal as optimizing the entire “system,” not trying to make decisions based on data that may imperfectly represent “system” performance.

Let me know if this is valuable to you. Thanks.

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2 comments:

Dave Schellenberg said...

I like the example your provide showing deficiencies in traditional Activity-Based Costing and how following Throughput per Constraint Unit leads to higher profits but I have always had a problem with part of the logic. In the example you provide, you indicate that there is a great deal of administrative effort required for plumbing (30%) and relatively little for landscaping (15%). If you prioritized plumbing and devoted your effort there, you could very easily run out of administrative capacity thus requiring you to add resources in this area (which is an added expense). What was considered a fixed expense would likely not remain so.
We face this same dilemma in our plant. We have one department that is our constraint with others that are either before our constraint (feeders) or after. If we try to sell products that have a high T/CU or even better, ones that bypass our constraint, it may work in the short-run but inevitably either our constraint would move or we would have to add resources to other departments. Do you have any comments on how you think TOC philosophy would respond to this?
Dave

RDCushing said...

A very cogent question, Dave, and I believe that ToC does provide an answer, or rather, answers.

First, if your constraint moves due to changes in the product mix, then you must apply Step Number 5--Don't let inertia set in. Rather reassess your situation and use the focusing steps to deal with the new situation. (Of course, even if your constraint did not move, you should be taking care to avoid the onset of inertia in the system. This should be a POOGI--process of ON-GOING improvement--after all.)

Additionally, if, at any place in your analysis, you recognize that OE (Operating Expenses) will likely change due to changes in overhead, additional employees are required, or from any other cause, then those estimates should be factored into your ROI calculations for change. You would ignore such changes to your own detriment.