This website covers knowledge management, personal effectiveness, theory of constraints, amongst other topics. Opinions expressed here are strictly those of the owner, Jack Vinson, and those of the commenters.

Favorite topics … accounting

Accounting the old wayAnd now for everyone's favorite topic … accounting.  (Sorry Mom, it is not one of my favorite topics, even if you are a CPA-for-life.)

There has been a long inside-baseball conversation* on the Throughput Accounting For You group in LinkedIn.  One element of the topic has to do with why the Theory of Constraints view of accounting is so different from other takes.  Many people in the group have provided useful comments, but I thought I'd post a version of my thoughts here for wider distribution.

TOC is interested in how we use financial information to make decisions. Specifically, how do we look at proposed changes and decide whether they are good ideas or bad ideas?  (Make or Buy sub-component X. Change vendors. Buy a machine. Hire more of skill set Y. etc. etc. etc.)

From the TOC perspective, the biggest challenge on the financial end of these decisions is allocations - the practice of spreading the cost of labor or corporate overhead across the products/services provided by a company or a location. (My understanding is that these calculations are standard for financial reporting - but that doesn't mean they are required for business decisions.) The trouble is that the allocations end up causing these decisions to be more or less attractive than they really are. There are just some expenses that don't change significantly when you provide more/less of a given product/service. Why should we try to allocate these to individual items? It should be part of the calculation of course, just not in the "per item" column. 

The simple example I look at is in deciding where to produce a new product across multiple locations. I have seen companies decide to produce at their "low cost" provider when that location is subject to backorders due to the workload but the "high cost" location has plenty of capacity.  This new product wouldn't require additional investment, nor would additional people be required (particularly at the "high cost" location).  But because it is "high cost," management decisions are driven to avoid that location.  And of course, this leads to a vicious cycle of that location becoming more "expensive."

Decision making guidance of this type needs to be fairly simple, and Theory of Constraints suggests that decision-makers focus on incremental changes.  How will sales (dollars) change? What changes to variable expenses will be incurred ("totally variable costs" - usually raw materials)?  What changes to fixed expenses will be incurred (labor, maintenance, rentals)? How will the level of investment change (equipment, raw materials)? TOC ties these incremental changes to some fairly simple calculations.  But the key in this discussion is that we remove any sense of allocation or internal cost transfers from consideration. They don't help the decision makers.

The classic example of this is the P&Q Example, and Kelvyn Youngman has an excellent accounting of it.

* If you are really curious about the conversation it has to do with a standard-writing process, sponsored by the Institute of Management Accountants, for The Conceptual Framework for Managerial Costing "exposure draft" which is open for comment until the end of August.

[Photo: "Accounting the old way" by GenBug]

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