Theory of ConstraintsActivity-Based

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ost accounting is “enemy number one of productivity”, claims Eliyahu Goldratt,

creator of the Theory of Constraints (Noreenet al 1995, iii).

Goldratt argues that focusing on product cost cannot promote the global performance of a business. Indeed

his books, including The Goal, aim to illustrate how his Theory of Constraints (TOC) can lead to dramatic

improvement in both financial and operationalperformance without the use of product costinformation.

Because the central premise of TOC is that abusiness’ goal is to “make more money now aswell as in the future” (Goldratt 1990, 12), TOCgives primary importance to throughput, or“sales”, rather than expenses or inventory.

However, many businesses in manufacturingand service industries regularly use product costinformation in their decision-making process.The use of activity-based costing (ABC) is shown

to improve the quality of both strategic and operating decisions (e.g. see Swenson 1995).

Can these two apparently conflictingapproaches – TOC and ABC – be combined to

improve the financial and operational performanceof businesses?

Studies have shown some remarkable improvements inperformance after implementation of TOC (see Mabin and

Balderstone, 1998). Similarly, numerous implementation studies(e.g. Kaplan 1989a and 1989b) have shown a growing, andsuccessful, use of ABC.

Both philosophies contain compelling arguments for their adoption and the possibility of integrating TOC and ABC into asingle system containing the strengths of each is very attractive.

To analyse the possible integration of the two philosophies, it isimportant to understand the ideas behind them, their relevance tobusinesses and the main areas of contention between them.

and Costing:

Can we get the best of both worlds?By Annabella Fu

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Goldratt and Cox (1986) first popularisedTOC whose primary performance

measure is throughput per constraint unit. TOCfocuses on improving throughput by managingbottlenecks or constraints in the system.

The TOC philosophy is built on the premisethat every organisation faces at least oneconstraint. A constraint is anything that limitsthe performance of a system relative to its goals.The constraint is the focal point becauseimprovements in non-constraints do nottranslate to improvements in the whole system.

TOC provides five focusing steps for managingconstraints:

• Identify the system’s constraints.

• Exploit the system’s constraints.

• Subordinate everything else to the

above decision.

• Elevate the system’s constraints.

• Go back to Step 1.

As a company’s goal is to make more moneynow as well as in the future, measurementsmust directly relate to money (Goldratt 1992,41). Goldratt proposes three measurements toevaluate whether a company is achieving thisgoal. These are:

• Throughput (“the rate at which the system

generates money through sales”) represents

sales revenue less direct materials.

• Inventory (“all the money that the system invests

in purchasing things which it intends to sell”)

is defined as including plant and building.

• Operating expense (“all the money the

system spends in order to turn inventory

into throughput”) (Goldratt 1992, 42) covers

all costs of conversion. No attempt is made

to allocate these expenses to products.

Goldratt claims that conventional costaccounting focuses on operating expenses andplaces little emphasis on throughput. Headvocates a new importance ranking andreasons that both inventory and operatingexpense reductions present only limitedopportunities for ongoing improvement as theyare inherently limited by zero.

An important performance measure under TOC is throughput per constraint unit (e.g.throughput per machine minute, if machinetime is the constraint).

Goldratt maintains that throughput is the mostimportant measure because it can, in concept, beincreased without limit. Inventory should beranked second in importance and operatingexpenses only as a close third (Goldratt 1992, 52).

Over the years, TOC has developed from aproduction scheduling tool into a “managementphilosophy”, incorporating the TOC ThinkingProcesses that allow users to develop solutionsto complex problems.

Goldratt’s TOC has expanded from the jobshop setting (Goldratt and Cox 1986) tomarketing (Goldratt 1994) and projectmanagement (Goldratt 1997). Substantialreductions in lead times, cycle times andinventory levels, and significant improvement indue-date performance and throughput have beenreported by users (Mabin and Balderstone 1998).

TO SUMMARISE, TOC:

• Manages constraints through the five

focusing steps.

• Focuses on throughput, which is sales

revenue less direct materials.

• Does not allocate operating expenses

to products.

• Uses throughput per constraint unit as

a major performance measure.

Theory of Constraints

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CAM-I (Consortium for AdvancedManufacturing – International) defines

ABC as a method which recognises the causalrelationship of cost drivers to cost activities bymeasuring the cost and performance of process-related activities and cost objects. Costs areassigned to activities based on their use ofresources, then assigned to cost objects (i.e. theobjects we want to calculate the costs for)based on their use of activities (Raffish andTurney 1991).

ABC is designed to remove distortions inproduct costs caused by allocatingmanufacturing overhead over a single overheadallocation base, such as direct labour hours(Anderson 1995, 14).

ABC establishes costs pools that are eachhomogeneous, in that each of them is caused bya single driver. Resource drivers assignresources to activities and activity driversmeasure the demands placed on activities bycost objects.

Figure 1 illustrates the relationship betweenresources, activities and cost objects:

ABC assigns costs on the basis of thehierarchical level at which the costs are incurredin the production process. The standard caseincludes four levels: unit-level, batch-level,product-sustaining, and facility-sustaining.

The use of multiple drivers and costhierarchies enables ABC to more accuratelymodel the relationship between resources usedby activities and cost objects.

ABC models resource consumption, ratherthan resource spending. This means that ABCestimates the cost of resources used inorganisational processes to produce outputs.Where resources are acquired as needed, thecost of resources supplied would generallyequal the cost of resources used.

However, organisations may acquireresources that are supplied in advance of usage.Consequently, the expenses of supplying theservice capacity from these resources areincurred independent of usage (Cooper andKaplan 1992, 5).

While the cost of acquiring the resources maybe fixed in the short run, the quantity ofresources used each period fluctuates accordingto the activities performed for the outputsproduced. Any resource acquired that is notconsumed is classified as unused capacity.

Two conditions favour the adoption of ABCsystems: a relatively high proportion ofoverhead in the firm’s cost structure (Cooper1992) and high diversity or complexity inorganisational processes or products.

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Resources Activities Cost Object

Activity 2 Cost Object

Resource Drivers Activity Drivers

Resource 1

Resource 2

Resource 3

Resource 4

Activity 1

Activity 3

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FIGURE 1

Activity-BasedCosting

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ABC is not just a product-costing tool. Forexample, Swenson (1995) reports the use ofABC in strategic decision making (such assourcing, pricing and product mix decisions) aswell as operating decisions (such as processimprovement and product design). It is alsosometimes incorporated into firms’ perform-ance measurement systems.

SO ABC:

• Models the consumption of resources.

• Refines product cost calculation by the use

of multiple-cost pools and drivers.

• Can play a role in strategic decision making.

TWO MAJOR POINTS OFCONTENTION

Goldratt argues that cost allocation andthe common practice of adding overhead

into stock as goods are produced, irrespectiveof whether they have been sold, can encouragesub-optimal behaviour. TOC does not seek toachieve the local optima, because it argues thatglobal performance is not merely a sum oflocal performance.

This focus on global performance isdifferent from ABC, as ABC has nomechanism to link the various cost pools toensure global optima is achieved. Therefore,cost reduction can be achieved for one costpool at the expense of other cost pools orother concerns such as quality.

This is an example of what Goldratt regardsas “cost world thinking”, which, he claims, canlead to a declining spiral of cost cutting, fallingoutput and more cost cutting.

TOC concentrates on maximising through-put, which can, in principle, be increasedwithout limit. Product costing is seen as beingunnecessary and artificial.

ABC, on the other hand, advocates thecalculation of a more accurate product cost toimprove decision making. Cost control is amain theme of ABC. It is not limited toproduct costing, however. It has strategicrelevance because it allows a better

understanding of the activities and theirresource consumption in a business.

As we can see, TOC and ABC appearcontradictory. But both have been shown toimprove performance of businesses.

As we are always searching for ways toimprove a business’ operational and financialperformance, the possibility of combiningTOC and ABC to reap the benefits of each is attractive.

REVIEW OF RECONCILIATION ANDINTEGRATION STUDIES

Anumber of studies have been done on howABC and TOC can be reconciled and

integrated. These can be classified into twomain groups.

The first argues that the difference betweenABC and TOC lies in their respective timehorizons – ABC is a long-term tool while TOCshould be used in the short run.

The second group maintains that ABC andTOC can be integrated to make particulardecisions.

SHORT-TERM VERSUS LONG-TERMDECISION MAKING

T he first group of studies argues that TOCand ABC can be used in an organisation to

make decisions with different time horizons.

TOC is more appropriate as a short-term toolas it assumes that all costs apart from directmaterials are fixed. Therefore, it offers littlehelp in long-term strategic decision making.

As ABC is a resource consumption model, in theshort run changes in consumption do not translateto changes in spending, i.e. real cash savings arenot made in the short run. Therefore, ABC is moresuitable for long-term decision making.

These studies are summarised in Table 1.

ABC is a long-term tool while TOC should be used in the short run

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INTEGRATION OF ABC AND TOC TOMAKE PARTICULAR DECISIONS

This second group of studies argues that ABCand TOC can be combined for the purpose

of making particular types of decisions. Thesestudies are summarised in Table 2.

CAN WE GET THE BEST OF BOTHWORLDS?

Here we look at whether the studies outlinedabove are successful in fully integrating

TOC and ABC so we can reap the benefits ofboth approaches.

The first group of studies suggests that ABCand TOC are only different in terms of theirtime horizons.

ABC is a long-term tool because it assumes allcosts are variable and TOC is a short-term toolbecause it assumes everything except directmaterials is fixed.

This line of thinking has a number ofproblems. First, ABC and TOC are not differentonly in terms of their time horizons. To simplylabel TOC as a short-term tool and ABC a long-term measure is to neglect the full implicationsof these two approaches.

TOC is more a management philosophy than amarginal costing technique. It argues that productcosting is an unnatural way of breaking up totalcosts and only helps promote the local optima,not the overall goal of the business. It is importantto recognise TOC as a way of thinking, not analternative product costing method.

Similarly, ABC allows better understanding oforganisational processes and control of driversof costs and activities. ABC should also berecognised as a management philosophy, ratherthan just a product-costing technique. Theirdifference is more deep-rooted than theirdifferences in time horizons.

Second, the distinction between the short runand the long run is not clear cut in reality. It isdifficult to label any period as the short run orthe long run, or any kind of decision as a short-run decision or a long-run decision.

Study FindingsCampbell

(1992)❖ ABC can provide cost

information on activitiesand TOC can providemanagement with directionby focusing on constraints.

❖ Product mix decisionsshould be made on thebasis of throughput perbottleneck resource usage,adjusted for any ABC coststhat represent a change incashflow.

❖ In the short run, these ABCcost adjustments would beunlikely because productmix changes do notnecessarily impact on actualcosts in the short run.

MacArthur(1993)

MacArthur(1993)

❖ ABC is useful in estimatinglong-term product costs andTOC is more appropriate asa short-term measure.

❖ ABC can complement TOCin areas of long-run pricing,profit planning, capacitymanagement, etc, with itslong-run emphasis.

Holmen(1995)

❖ Examines the assumptionsbehind ABC and TOC andconcludes that ABC isintended primarily as along-term tool while TOC isuseful in the short run.

❖ Leaves open the question“when does a TOCapproach become invalidand ABC become thecorrect methodology?”

Fritzsch(1997)

❖ ABC and TOC are basedon opposing views of thenature of product cost –ABC assumes all costs tovary in proportion to costdrivers whereas TOCassumes all costs to besunk (or fixed) with respectto product choice andproduction level decisions.

❖ Therefore, ABCapproximates the long-runsituation and TOCcorresponds to a veryshort-run situation.

❖ Concludes that we shoulduse TOC for short-termdecisions, ABC for long-term decisions anddirect costing for decisionsthat are neither short-runnor long-run.

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THEORY OF CONSTRAINTS AND ACTIVITY-BASED COSTING

TABLE 1

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TABLE 2

Spoede et al (1994)

Product mix and pricing decisions

Cycle time reduction decisions

Process engineering

❖ Reports a steel service centre using a pricing model that combines elements of both ABC and TOC to trim cycle time.

❖ ABC is used to calculate costs associated with cycle time.❖ TOC will direct cycle time reduction efforts to constrained processes.

Campbell (1995)

Demmy and Talbott(1998)

❖ A combined approach helps discover products that are being mis-priced.❖ ABC is used to allocate only the indirect fixed costs to cost objects.❖ Suggests that this approach requires less effort than a traditional ABC

implementation and provides more information than the standard TOC approach.

Salafatinos (1995)

❖ Use of activity mapping to identify constraints by employing the techniques ofGantt chart and dependency grid.

❖ Suggests that a bottleneck occurs where demand on a set of activities exceedsthe capacity of that set of activities to support the demand.

❖ Argues that a constraint is more likely to occur because of a complex web ofconnecting activities rather than a single activity.

❖ Activity mapping also assists in finding out causes of constraints and ways toelevate them.

Buchwald (1996)

❖ Reports how a Fortune 150 company combines TOC and ABC to supportprocess re-engineering.

❖ “Activity Based Business Diagnostics”, combining activity management andconstraints management, enhances the understanding of inter-relationships ofthe activities and helps prioritise re-engineering efforts.

Gupta et al (1997)

❖ Uses the example of a healthcare company to illustrate how the use of ABCtogether with TOC creates an environment of continuous process improvement.

❖ Uses mixed-integer programming, a mathematical model, to integrate ABC and TOC to reach the optimal product mix.

❖ The model can explicitly recognise the capacity of production activities andidentify constraints and non-constraints.

❖ The result shows that the integrated model yields substantially higher incomethan the ABC-only model and a slightly higher income than the TOC-only model.

Kee (1995)

❖ The real potential of ABC is its ability to generate the data necessary tosupport the TOC management process.

❖ ABC provides details of capacities available and processing times required.❖ This data can be used to solve product mix decisions according to TOC by

recognising constraints as throughput per constraining factor.❖ Result shows the use of both ABC and TOC improves the quality of product

mix decisions.

❖ The decision to use ABC or TOC should be made on a department-by-department basis rather than a company-wide basis.

❖ ABC should be used in people-intensive departments and TOC in machine-intensive departments.

Campbell et al (1997)

❖ Proposes a tool called constraint-based profitability analysis (CBPA) whichcombines ABC and TOC to solve the optimal product mix.

❖ ABC profit per unit for various types of products is translated into profit perhour across a constraint process.

❖ The product with the highest profit per hour receives first priority for thebottleneck processes.

❖ A case study is reported with a company using CBPA experiencing a 20 percent improvement in operating income.

Hall et al (1997)

❖ ABC information on unused capacity can be used to identify constraints – an activity with zero unused capacity is a constraint.

❖ Uses a custom screen printing business to illustrate the application of the fivefocusing steps.

❖ TOC will then aid in the management of these constraints.

Baxendale and Gupta(1998)

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Arguably, any changes made in the short runwould have implications for the long run asthey contribute to the long-run survival andprofitability of a business.

Third, it is difficult to incorporate ABC andTOC in their entirety in one organisation tomake various decisions. This line of researchseldom operationalises the idea of integration.All of the studies in this area leave open thequestion of “when does a TOC approachbecome invalid and ABC become the ‘correctmethodology’?” (Holmen 1995).

There would be the problem with drawing aline between short-run and long-rundecisions. There would also be co-ordinationand communication problems, as departmentsnow have two sets of vocabularies, one of“throughput” and one of “costs”.

Fourth, there may be a conflict of goals andperformance measures, as measurements usedby ABC and TOC are different.

Many of the studies in the second groupchoose particular aspects of ABC and TOC toform a new system. A common combination isto use ABC information and TOC’s notion of constraints. This is a good suggestion as it is relatively easy to operationalise. Such integration also minimises co-ordinationand conflicts.

The main issue with such integration is thatit ignores important features of either ABC orTOC. For example, only incorporating thenotion of constraints into ABC ignores TOC’sunfavourable view of product costing. It alsoignores the fact that much of the power ofTOC lies in its ability to influence thinkingand behaviour.

TOC’s focus on the global optima is in directconflict with ABC’s use of separate cost pools.

Other studies in this group combine ABCand TOC differently. Campbell et al (1997)argues that ABC and TOC should be adoptedon a department-by-department basis. Adistinction is made between people-intensiveand machine-intensive departments.

This may create communication and co-ordination problems and it ignoresinteraction between departments. Also, it maynot ensure that global interests, instead ofdepartmental interests, are optimised.

Buchwald (1996) combines activitymanagement and constraints management.Activity management helps us understand theinter-relationships among activities, andconstraint management helps prioritise processre-engineering efforts.

This is different from the other studies as itdoes not incorporate activity costs in thesystem. This solves the difficulty TOC has withcalculating product costs. The strength of thissuggestion is the harmonious integrationbetween the components.

In summary, this second group of studiesoperationalises the integration of ABC andTOC by incorporating only particular elementsof each of the two approaches and for makingparticular types of decisions.

The main issue with this approach is thetrade-off between the extent to which the two approaches are incorporated and the easeof integration.

For example, using activity analysis withTOC is conceptually more harmonious thanapplying TOC with ABC product-costinformation.

Also, by narrowing the scope of integrationto particular types of decisions, it is difficult to ascertain whether ABC and TOC can beintegrated as a general management controlsystem.

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Departments now have two sets ofvocabularies, one of “throughput”and one of “costs”

REFERENCES

Anderson, S. W. (1995). A framework for assessing cost management systemchanges: the case of activity based costing implementation at General Motors,1986-1993. Journal of Management Accounting Research 7 Fall, 1-51.

Baxendale, S., and Gupta, M. (1998). Aligning TOC and ABC for silkscreen printing.Management Accounting (US) 79(10), 39-44.

Buchwald, S. (1996). How can the theory of constraints and activity-basedmanagement co-exist to support process engineering? A Case Study. APICS(Australasia) 8th Conference Proceedings, 19-21.

Campbell, R. J. (1992). Competitive cost-based pricing systems for modernmanufacturing. Quorum Books.

Campbell, R. J. (1995). Steeling time with ABC or TOC. Management Accounting(US) 76(7), 31-36.

Campbell, R., Brewer, P., and Mills, T. (1997). Designing an information systemusing activity-based costing and the theory of constraints. Journal of CostManagement 11(1), 16-26.

Cooper, R. (1992). How activity-based cost systems help managers implement newstrategic directions. Advances in Management Accounting 1, 81-95.

Cooper, R., and Kaplan, R.S. (1992). Activity-based systems: measuring the costsof resource usage. Accounting Horizons September, 1-13.

Demmy, S., and Talbott, J. (1998). Improve internal reporting with ABC and TOC. Management Accounting (US) 80, 18-24.

Fritzsch, R. B. (1997). Activity-based costing and the theory of constraints: usingtime horizons to resolve two alternative concepts of product costs. Journal ofApplied Business Research 14(1), 83-89.

Goldratt, E. M. (1997). Critical chain. Great Barrington, MA The North River Press.

Goldratt, E. M. (1994). It’s not luck. Great Barrington, MA: North River Press.

Goldratt, E. M. (1992). From cost world to throughput world. Advances inManagement Accounting 1,35-53.

Goldratt, E. M. (1990). The haystack syndrome. New York: North River Press.

Goldratt, E. M., and Cox, J. (1986). The goal: a process of ongoing improvement.New York: North River Press.

Gupta, M., Baxendale, S., and McNamara, K. (1997). Integrating TOC and ABCMin a health care company. Journal of Cost Management 11(7), 23-33.

Hall, R., Galambos, N.P., and Karlsson, M. (1997). Constraint-based profitabilityanalysis: stepping beyond the theory of constraints.Journal of Cost Management 11(7), 6-10.

Holmen, J. S. (1995). ABC vs TOC: it’s a matter of time. Management Accounting(US) January, 37-40.

Kaplan, R. (1989a). John Deere Component Works. 9-187-107/8. Boston: HarvardBusiness School.

Kaplan, R. (1989b). Kanthal. 9-190-002/3. Boston: Harvard Business School.

Kee, R. (1995). Integrating activity-based costing with the theory of constraints toenhance production-related decision-making. Accounting Horizons 9(4) December, 48-61.

Mabin, V., and Balderstone, S. (1998). A review of Goldratt’s theory of constraints(TOC) – lessons from the international literature. Presentation at the University ofAuckland 16 October 1998.

MacArthur, J. B. (1993). Theory of constraints and activity-based costing: friends orfoes? Journal of Cost Management Summer, 50-56.

Noreen, E., Smith, D., and J.T. Mackey. (1995). The theory of constraints and itsimplications for management accounting. The North River Press Publishing Corp.

Raffish, N., and Turney, P.B.B. eds. (1991). The CAM-I glossary of activity-based management. Arlington, Texas: Consortium for Advanced Manufacturing-International.

Salafatinos, C. (1995). Integrating the theory of constraints and activity-basedcosting. Journal of Cost Management 9(3), 58-67.

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CONCLUSION

T his paper begins by explaining ABC andTOC and highlighting their main areas of

contention. We see that TOC, with its focus onconstraints, denies the need for product costinformation. Studies have shown someremarkable improvements in performance afterimplementation of TOC.

At the same time, numerous ABCimplementation studies (e.g. Kaplan 1989a and1989b) have shown a growing, and successful,use of ABC.

Given these success stories, one would betempted by claims that ABC and TOC can beintegrated into one system, containing thestrengths of each of ABC and TOC.

Studies on integration suggest somepromising results, showing that a combinedsystem is superior to using only ABC or TOC.As we have seen, however, there may beimplementation difficulties to overcome.

With careful and proper design, thesedifficulties may be overcome to ensure that ABCand TOC are integrated in a synergetic way.

FURTHER READINGGoldratt and Cox’s (1986) book is an excellent

introduction to the basic ideas of the theory of

constraints. Goldratt’s other books are also highly

readable and illuminating. Cooper and Kaplan’s

(1992) article is a useful source of information on

activity-based costing.

Annabella FuPOSTGRADUATE STUDENT

Department of Accounting and Finance

University of Auckland Business School

Email: bella@ihug.co.nz