Can Businesses Integrate ABC and Theory of Constraints (TOC) with both Product Costing and Financial Reporting?

INTRODUCTION

Activity-based costing is one of the methods through which the accuracy of the product costing is improved by organizations. The traditional costing system has been based on primarily the direct labor hours allocated the overhead costs arbitrarily. Even though the direct labor hours are not considered a better representative of the consumption of the indirect resources by a certain cost object, it is used for the allocation. The resultant is the distortion in the product cost. Activity-based costing provides the solution for this problem through viewing the system as the composite of several activities. It enables it to assign the costs of activities to specific cost objects through the use of the cost drivers which are the true representative of the use of the indirect assets by these cost objects. Thus, the activity-based costing provides better allocation bases as compared to the traditional costing.

The real strength of the activity-based costing is seen in the ability to support the managerial decisions. Precisely, activity-based costing provides the data which is needed for supporting the theory of constraints. This theory is the management concept which is based on the goal of making money. It views the constraints of limiting the money earning ability of a company as the bottlenecks. And it emphasizes on the prevention and removal of these constraints for reaching the objective of a company, i.e. the revenue making.

There have been different studies conducted on the combination of the activity-based costing and constraints theory to use it together for product costing and financial reporting decisions. The following paper discusses this aspect in detail (Alsmadi, Khan and Almani 907).

OVERVIEW OF ACTIVITY-BASED APPROACH OF COSTING

The Activity Based costing is designed to provide preventions for any distortions and ambiguity in the product costs and gives a process view which is lacked by the traditional costing system. The distortion in the product cost was originated by the use of a single allocation base for all the products of a company, usually the direct labor hours. Activity-based costing provides homogenous cost pools by using specific, unique cost drivers for each of the production costs. The resources drivers are used to allocate the resources to the activities. Then there are activity cost drivers who calculate the demands raised for activities through each cost object. Thus, costs are allocated dependent on their usage of the assets and then allocated to the cost activities objects depending on the usage of the activities. The usage of the multiple hierarchies and multiple drivers makes it possible for the Activity-based costing to more precisely and accurately define the relationship among the used resources by the activities and cost objects. The Activity-based costing records the usage of the resources as compared to the spending of the resources. It shows that this costing method uses the cost of the resources that are used in the process for the production of outputs (Huang, Chen and Chiu 535).

OVERVIEW OF THEORY OF CONSTRAINTS

The Theory of Constraints is a very organized method which has been developed for supporting the organizations in thinking about their problems. This method identifies the system problems which has been limiting the system performance and also provides concepts for the management of these problems or constraints. The theory of constraint is put up on the concept which every organization always has at least one limitation or constraint. This constraint is defined as a limitation of the system performance regarding the set goals. The focal point of this theory is the constraint as the improvement in the area of non-constraints do not improve the whole system/ As per the theory of constraint, the goal of any organization is to make money taking into consideration some necessary conditions like the employee security, customer and employee satisfaction (Alsmadi, Khan and Almani 909). The theory provides three measures of performance as the 1) throughput, it is the rate on the system of the company generates revenue from sales computed as the revenue minus direct expenses 2) inventory, the resources spent on the purchasing of the things which are intended to be sold, 3) operating expenses, the expenses incurred in the operations of revenue generation. The theory suggests that the improvement of the system can be made through focusing the improvement on the weakness or the constraint of the system. The implementation of the theory of constraints can aid in providing a company with the opportunity of competing for a leading eventually. The steps included in the implementation process of the theory of constraints are;

1. 1. recognition of the limitations of the system
   2. Exploitation of the constraints of the system
   3. Subordination of everything to the above decision
   4. Elevation of the constraints of the systems
   5. Restarting from the step 1

POTENTIALS AND CONSTRAINTS OF THEORY OF THE CONSTRAINTS

The concepts of the theory of the constraints are seen to be at odds with the traditional costing approach. The limitation of the theory of constraints is that by focusing on constraints activities, the non-constrained resources are pushed to work below their capacity causing in lower local efficiency. The theory of constraints is based on the notion of considering the global efficiency more beneficial than the local efficiency. It can create a reduction in the profits because of the maximization of the throughput. Traditional systems of costing, on the other hand, look for improving the local efficiencies by lowering the overhead costs used in the products. The procedure results in the raising of the unrecognized holding costs of the WIP and more write-offs for the unsalable inventory stock.

The potential of the theory of constraints lies within the theory of transformation. Through this, it informs managers for deciding on what, how and why the changes of the existing practices causing the reducing of the lead times, inventory and cycle time improving the quality and productivity as well. The quality is improved by increasing the capacity of the bottleneck and reducing production of defective parts. The lead time is improved through the production of products as per the customer orders (Alsmadi, Khan and Almani 910).

APPLICATION OF ABC AND TOC FOR BUSINESS EXCELLENCE

A study has been conducted in the mainstream of the industry, i.e. the manufacturing of the low-cost and high-quality, cost by designing of a set of integrated activity-based costing system which is also time driven utilizing the bottleneck breaking the concept of the theory of constraints. It has been used to provide for the timely and accurate information on the cost management and operational resources. The application of the activity-based time-driven costing system has enabled to achieve the objectives;

1. Through this, the company can focus its limited resources on the main of the system, e. the bottleneck operations for solving of the inconsistency effectively between the overall aims of the company and within the departments as well.
2. Another objective which has been achieved through the integration of the activity-based costing ABC and the theory of the constraints TOC is in the field of the business process management the company has to lead all of the operational processes regarding three major indicators.
3. Another objective which has been achieved through the adaptation of both approaches is that the units of product planning are supported in the application of the definition and specifications of the product to the cost analysis of the new product and its manufacturing process regarding its development.
4. The objective which is also achieved through this is in the improvement of the delivery time. It is achieved through the focus being put on the bottleneck activities during the rush hours of the manufacturing
5. Lastly, the process improvement is made efficient by improving the bottleneck operations, which is also the key to the overall moneymaking or profit-earning ability of a firm.

Thus, it can be said that process improvement, efficiency, productivity, accurate and relevant information for decisions making and delivery time is improved through the adaptation of the integration of theory of the constraints TOC and activity-based costing ABC in the manufacturing of automotive sectors. Hence, business excellence is achieved through this adaptation (Huang, Chen and Chiu 538).

INTEGRATION OF ABC, TOC AND FINANCIAL REPORTING

The integration of the theory of the constraints TOC and activity-based costing ABC has been seen as a difficult activity as the theory of constraints focused on the throughput and the activity-based costing focused on the costs. As per the perspective of the theory of constraint, the cost drivers and the cost allocation all appear to be worthless. The theory of constraints was earlier believed to be based on the concept that the traditional cost mentality has almost led to wrong decisions.

Even though with all the differences, recent studies have suggested that the theory, in fact, complements each other (Alsmadi, Khan and Almani). It has been said that the potential of the activity-based theory is to generate the data which is needed to implement the theory of constraint implementation. However, the time range for the relevance of both theories has always remained an issue. While the activity-based costing is more of a long-term approach, the theory of constraints is a short-term methodology. The theory of constraints focuses on the fixed labor costs and capacity, whereas the activity-based costing looks at the longer view of giving the information of the spending on the resources by reflecting their usage for making any adjustments by the management. However, the experts have suggested usage of the theory of constraints with the integration of the ABC activity-based approach of costing at the time when management is unable to match the resource demand with its supply (Alsmadi, Khan and Almani 915).

Even with all the advantages that the theory of the constraints TOC and activity-based approach of costing ABC offers, organizations have been reluctant in adopting it and abandoning the use of the traditional costing approach. Kaplan has suggested the integration of the activity-based costing for periodic financial reporting by computation of the variance reflected in the unused capacity of each resource. However, he has not given any methodology for the integration of the theory of constraints for the financial reporting and product costing.

Kaplan has given the use of the single activity for showing the integration of the activity-based costing with the financial reporting initially. However, the use of another activity has also been shown to show the integration of the theory of constraints with the financial reporting and product costing as well. The variance analysis of the activity-based costing has been utilized to identify the limiting constraints. The variance analysis is the concept of activity-based costing whereas the binding constraint identification is the concept of theory of constraints. Both theories relate to the importance of capacity. The example shown by Kaplan shows the budgeted unused capacity is the indicator of the activity that is budgeted and is considered the binding production constraint. Any favorable variance of the system shows the opportunity for reduction in the resource supply or utilization of the resource in another activity. Similarly, the unfavorable variance shows the opportunity for improvement in the better supply of resources for this activity. The zero variance shows that the activity is fully utilizing the resources and thus the management can choose not to devote any further efforts on this activity (Huang, Chen and Chiu 540).

THE RELATIONSHIP BETWEEN CONSTRAINED AND NON-CONSTRAINED ACTIVITIES

The relationships in the non-constrained and constrained activities are considered as one of the possibilities of the incorporation of the activity-based approach of costing and TOC the theory of constraints for product costing and financial reporting. These possibilities can be:

Bottleneck Precedes

1. The flow of production from the constrained resource of the non-constrained resources. The unfavorable variance of the constrained resources will affect the capacity of the non-constrained resources. As the non-constrained resource is dependent on the constrained resources in the production flow process.
2. Production flow process starting from the non-constrained resources to the constrained resources. In this situation, the unfavorable variance of the non-constrained resource is expected and planned ahead.
3. Production flow process flows from the constrained, and non-constrained resources to a non-constrained resource. Under this situation, both resources (constrained and non-constrained) on which the non-constrained resource is dependent is to be completed first for the completion of the dependent non-constrained resource.

Thus, the variances on the constrained activities are important in this process. The variances determine if the inventory buildup is needed or not. It shows that the inventory buildups can be a positive sign. The theory of constraints aids in the interpretation of the variances and improvement in the control process (Huang, Chen and Chiu 543).

CONCLUSION

In the end, it is concluded that the incorporation of the theory of constraints TOC and activity-based approach of costing into the traditional costing system results in a system which combines the variance analysis with the three elements of the theory of constraints; constraint identification, exploitation and the dependencies of the resources on each other. The consideration of the constraints in the light of the activity-based variance analysis is an effective way to coordinate the cost system, financial reporting, and theory of constraints. Therefore, it can be said that the theory of constraints TOC, ABC activity-based costing complements each other and offers compatibility with the financial reporting.

Work Cited

Alsmadi, Majed, Zulfiqar Khan and Ahmad Almani. “Implementing an integrated ABC and TOC approach to enhance decision making in a Lean context.” International Journal of Quality & Reliability Management 31.8 (2014): 906-920.

Huang, Shaio-Yan, et al. “The application of the theory of constraints and activity-based costing to business excellence: the case of automotive electronics manufacture firms.” Total Quality Management 25.5 (2014): 532-545.