Applying Strategic
Cost Analysis Concepts
to Capacity Decisions
B Y PA U L J U R A S , P H . D . , C M A , C PA , A N D
E I L E E N P E A C O C K , P H . D . , C M A , C PA
STRATEGIC
COST ANALYSIS HELPS COMPANIES IDENTIFY, ANALYZE, AND USE
STRATEGICALLY IMPORTANT RESOURCES FOR CONTINUING SUCCESS
AND GROWTH OF THE BUSINESS.
EXECUTIVE SUMMARY The product with the highest unit profit may not be the product with the highest profit per
unit of resource consumed. The Theory of Constraints (TOC), with its emphasis on throughput costing, offers one
possible approach to profitability analysis, but it is focused on the short term. The authors discuss why throughput
costing, in combination with ABC, is a better option to guide long-term, strategic decision making.
n the fall of 2005, Ford Motor Company announced
a nearly 50% reduction in the number of suppliers
it would use in the future. Soon after, Delphi Corp.,
the largest U.S. automotive parts manufacturer,
announced its move into Chapter 11 bankruptcy. In
the first quarter of 2006, Dana Corp., another large auto
parts manufacturer, also resorted to bankruptcy.
Why were such major players in the automotive
industry toppling like bowling pins? These events
resulted from the mounting costing pressures on companies in the automotive supply chain. In the auto
industry, as in any other highly competitive environment, cost management can be crucial. An organization’s cost information can turn out to be a strength or a
weakness, so the value of cost information depends on
how it is used. In this article, we discuss ways that companies can use their cost information strategically.
I
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
EFFECTIVE USE
OF
RESOURCES
An organization creates a competitive advantage through
the use of resources to provide features demanded by
customers. The resources consumed to create these
attributes are not free, and the effective use of the
resources is critical in any competitive environment.
The value of a cost management system comes from the
way management uses it to support decision making,
including decisions about long-term strategy.
Having reliable cost information on the various
aspects of their business allows management to make
decisions such as whether to charge different prices for
different attributes, how much demand various processes place on resources, and which products or services to
promote. In effect, the cost system becomes a strategic
support system. The primary benefit of a strategic cost
system is that it takes a long-term view of the organiza-
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FALL 2006, VOL.8, NO.1
Activity-based costing (ABC) analysis is a better
option to guide long-term decision making. We will
show how management can use the activity and cost
information obtained from the ABC process to make
decisions related to capacity. ABC is not without its own
limitations, however. We propose that management
combine TOC and ABC information to help make
capacity-utilization decisions regarding strategic
resources.
With the goal of helping management make
informed decisions regarding orders or types of bids
they should pursue, CPS assessed the financial profitability of its various product families (applications of a
series of paint coatings and finishes). CPS used ABC
analysis to identify the impact each product would have
on company profits. The conclusion of the analysis was
that an activity-based approach to costing provided a
better understanding of costs and, therefore, a possibility for improving company profitability.
While our 2005 article showed that product mix
drives costs, it did not define any customer strategy.
Essentially, CPS was taking a reactive, short-term
approach to pricing and cost management.
In an effort to show how companies can proactively
develop a customer strategy, we will revisit CPS to look
at costing the capacity of one of its strategic resources.
We will draw on strategic cost analysis concepts to help
companies identify, analyze, and use strategically
important resources optimally for continuing success
and growth of the business.
CPS is basically a job shop. Raw metal parts are
received from the customer, finished with the desired
application(s) of paint, and shipped back to the customer. The parts include bumpers, luggage racks, window sashes, tailgates, hoods, and body moldings.
tion. The system can provide valuable insights into the
firm’s operations, which can be used to formulate or
assess overall business strategies and plans.
The strategic plan should include a clear picture of
the organization’s current and future position and offer a
map for moving from the current to the future position.
Any move an organization makes toward a desired
future state requires the effective and efficient use of
strategically important resources. A properly designed
cost system can help identify and monitor the use of
strategic resources.
With this focus in mind, we present a general strategic cost analysis (SCA) approach to managing capacity
and apply it to the specific situation faced by Custom
Paint Shop (CPS), a fictitious privately held custom
painter of automotive components for original equipment manufacturers (OEM) and Tier 1 and Tier 2 suppliers. We introduced our readers to CPS in our article
“Cost Management by Customer Choice,” which
appeared in the Spring 2005 issue of Management
Accounting Quarterly.1 That article contained a detailed
scenario explaining the job complexity caused by the
wide variety of coatings the company offered and the
company’s lack of a customer strategy. This lack of a
strategy led the company to bid on any job that came
their way, without regard for the demand that such jobs
would put on important resources.
In the 2005 article, CPS needed to develop a customer strategy. A critical element in any customerrelated competitive strategy is knowing which services
provide a competitive advantage and which provide the
most profit. Determining profitability may not be
straightforward because profit can be defined in a number of ways. The product with the highest unit profit
may not be the product with the highest profit per unit
of resource consumed.
Eliyahu M. Goldratt’s Theory of Constraints (TOC)
offers one possible approach to profitability analysis.
TOC directs management’s attention to the resources
that represent production constraints. These scarce
resources are known as “bottlenecks.” TOC promotes
focusing on the throughput per unit of scarce resource,
defined as revenue less material costs. This costing
method, known as throughput costing, is focused on the
short term.
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
H E A DA C H E R E L I E F
Most customers need their parts to be coated in accordance with OEM paint specifications but lack the
expertise, start-up capital, or desire to face the business
and financial risks associated with “tooling up” to perform the painting function. CPS, therefore, markets
itself as a “headache relief” option.
The immense number of combinations of coatings
and colors makes CPS’s jobs complex, however. In addi-
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FALL 2006, VOL. 8, NO. 1
Flow of the Paint Process
Figure 1:
tion to the different colors of the paint products,
the type of coating applied over the paint also
varies. Customers can choose enamel topcoat,
high gloss (HG) or low gloss (LG), base coat,
clear coat, and whether or not a primer is added
at the beginning of the paint process. The complexity is further increased by the variation in
the size and shape of the parts to be coated.
Thus, four variables—coating, color, shape, and
size—determine the mix of activities required
and the difficulty of each job.
Figure 1 illustrates the flow of parts through
the workplace. Notice that after pretreatment
and E-coating (a process by which negatively
charged paint in a large vat attaches to the positively charged parts that are dragged through
the vat), each part travels through four paint
booths—even though all four booths may not
be required for every type of part. For example,
when parts requiring a low-gloss coating are
being painted, the painters (employees) manning booths 3 and 4 are idle, and the spray guns
for those booths are turned off.
At the end of the process, the paint coating is
cured in an oven. Then, in the unload/load
area, each part is date-stamped, unracked onto
a monorail floor conveyor line, inspected,
unloaded, and packaged. The monorail conveyor line transports the parts through the whole
paint process. The conveyor moves at line
speeds of between 10 and 18 feet per minute,
depending on the complexity of the job. The
total paint cycle time is about 2.5 hours, and
setup between jobs take five minutes.
Pull paint racks
Booth 3
Clear coat
Hang paint racks
Booth 4
Clear coat
Pretreat/wash,
dry
Paint oven
cure/bake
E-coat tank
Inspection
Yes
E-coat oven
cure/bake
No
Adjust line speed
for painters
Can defect
be buffed
out?
Unload finished
parts
Booth 1
Primer
M A K E I T P E R F E C T, P L E A S E
The industry dictates the need for quality at
nearly a 100% perfection level. The nature of
the painting process, however, lends itself to a
certain level of defects. Dirt and dust in the
manual hand sprayers and CPS’s old equipment
add to the defect rate. Some defects can be corrected by finessing, which is a labor-intensive
process of buffing out the defects. The finessing process eliminates the need for complete
Good part?
No
Yes
Reject part
Unload
paint racks
Booth 2
Base coat/
enamel, topcoat
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
Finesse part
("save")
Transfer to
finished goods
storage, ship
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Table 1:
A Comparison of Profit Margins: ABC and Absorption
Costing Systems
Product Family
Percent of Sales
Profit under ABC
Profit under Absorption Costing
XY Hitchplate - G
0%
-282%
XY QM150 - G
0%
1%
NA
XYZ Metal GMT600, 2 pass - A
0%
14%
NA
Data - A
0%
0%
NA
Deli - G
0%
-34%
-29%
Other
0%
-24%
NA
NAO - G
0%
51%
Samples
0%
NA
NA
XY UN150 - G
1%
8%
-14%
XY Service, Var
1%
38%
NA
XYZ PN150 - A
1%
4%
23%
Horne - A/G
1%
8%
19%
Dango - G
1%
40%
NA
Darama XJ - G
2%
55%
-19%
Window Sash - G
2%
16%
34%
MT Xrail - A
2%
29%
-11%
MT Srail - A
2%
29%
-11%
TMG 425 - A
4%
-29%
-53%
Q3 - A/G
4%
32%
-7%
Data - G
4%
11%
9%
Dango - A
5%
17%
22%
XY QM 96, P131, UN93 - G
7%
10%
16%
-1%
33%
XY QM150 - A
8%
5%
12%
Darama XJ - A
17%
25%
-2%
XY QM 96 - A
17%
9%
29%
XY UN150 - A
20%
32%
46%
Total
100%
0% indicates less than 1%
many different kinds of parts, implying that a change in
how CPS determines the cost of the paint jobs may
alter the bidding strategy and overall profitability. The
profit for each part under the old absorption-costing
method was compared to the profit under the new ABC
system. The parts with the largest change in profit margin were the low-production-volume parts, meaning
that these parts had been assigned a disproportionate
level of production costs.
For example, the reported profit of the Darama XJ-G
part changed from a 19% loss under the absorption cost-
reprocessing. Approximately 5% of all bumpers come
out with a defective paint job, but most are saved by
finessing.
Historically, CPS accepted most of the work assignments it was offered, but, at one point, demand started
to increase significantly, especially for the higher-grade
coatings. Such paint jobs were thought to be profitable,
but after doing an ABC analysis, management found
that some of those jobs were not as profitable as originally thought.
Table 1 shows a dramatic change in profit margins for
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FALL 2006, VOL. 8, NO. 1
conveyor line. Because there is a limit on the number of
rails that can move the parts through the paint process
in a given time, the rails and conveyor are a limiting factor, also known as a scarce resource.
Pursuing high-margin products may not be a practical
course of action, therefore, because the ABC profit levels do not explicitly consider the demand that the products put on the strategic resources. Through proper
analysis and strategic decision making, management can
proactively manage the demands on a constraint and
help improve their organization’s chances of financial
success.
An effective costing system will help identify the
products or processes that provide the greatest return
within the given production environment. It can also
identify the specific areas that the firm should progressively shift resources toward or away from through capital investment and restructuring of the production
process. We will focus on exploiting the existing
resources within the current operating structure as CPS
moves in the intended direction. This is accomplished
through the use of strategic cost analysis.
ing method of accounting to 55% profit under the ABC
method, and the MT Xrail part went from an 11% loss
to a 29% profit. Given this data, management’s logical
conclusion was to seek out jobs coating parts with high
profit margins.
U S E W H AT Y O U L E A R N
As competitive pressures mount, companies must
become more customer focused. This means finding
out what the customer wants and is willing to pay, as
well as understanding what it costs to provide the product or service. To help understand costs, CPS has
devoted significant resources to developing an effective
ABC system. The key is to use the costing system to
generate information that will not only help management better understand the costs of different finishes
but will also help with strategic decision making.
An ABC analysis draws attention to the cost of production. While this analysis indicates the cost and related profitability of products, the results of the analysis
may cause management to move in the wrong direction
by trying to attract paint jobs that are profitable at the
per unit level but place a high demand on production
capacity. The result is that a profitable job that requires
a large amount of conveyor time and space can severely
limit the potential total profit that can be earned by
reducing the available capacity for other paint jobs.
ABC attempts to measure the consumption of the
activities known as “cost drivers,” which are part of
each paint job’s production process. The capacity of
every resource to perform activities is limited, and the
demands on the most constrained resource can have
strategic implications for an organization. ABC analysis
does not explicitly consider that the quantity of
resources demanded may not equal the capacity of
resources supplied. Management should consider the
potential profit from each product’s use of a resource to
help promote effectiveness and efficiency to maximize
value.
Take the product mix decision as an example. The
ABC costing process indicates that bumpers are one of
the most profitable parts to coat, so CPS’s management
will try to gain more business coating bumpers. The
problem is that the size of the bumpers limits the number that can be put on the rails that hold them on the
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
M A N AG I N G CO ST S
AND
PROFITS
WITH
S CA
Strategic cost analysis is a process of developing cost
information that helps managers make strategic choices
with an emphasis on maximizing the use of strategic
resources in the future. The SCA process examines the
relationships between the cost of providing a product or
service and the value delivered. SCA relies on a good
understanding of the underlying causes of costs. Undertaking an ABC analysis, as CPS has already done, provides an understanding of causal factors and
relationships.
SCA looks at two types of cost drivers—structural
and executional. Structural cost drivers relate to the
scale, scope, and technology of the production environment. Decisions that create the structural cost drivers
pertain to capital equipment investment, hiring of
employees of certain skill levels, and pay rates.
Given that CPS has been in business for more than
a decade, management has already made decisions on
what the production environment (structural cost
drivers) looks like. Structural cost drivers can be
changed, but only with a fundamental modification in
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FALL 2006, VOL. 8, NO. 1
Connecting Customer
Requests with Firm
Capabilities
Figure 2:
the way the organization chooses to compete. For our
discussion, we take the structural drivers as a given for
CPS and focus on the second component of a company’s
total cost structure—the executional cost drivers. Executional cost drivers relate to the way management utilizes
the operating and production resources to provide the
attributes customers demand. These cost drivers include
such factors as product and process design, quality control, and capacity management (see Figure 2).
T H E P AT H
TO
Customer wants:
● Defect-free finish
I M P R OV E D P R O F I T S
Our 2005 article focused on understanding the cost of
providing the service by looking at past results. The lack
of customer strategy identified in that article meant that
CPS may not have been properly matching the customers’ perceived added value of the paint process to
the cost of providing the service.
No organization, CPS included, wants to have its
resources committed to a path with limited profit potential by simply accepting whatever work comes along and
not considering the limits an order may put on potential
profits. Some jobs may require the use of a strategic
resource that restricts the ability to accept more profitable work requiring the same resource. This is an issue
only if there is a resource that lacks sufficient capacity to
keep up with demand—also known as a “bottleneck” or
“production constraint.” For CPS, the paint line does
not sit idle due to a lack of jobs. In fact, the conveyor
line is the bottleneck.
The conveyor line is the key strategic resource, so
good communication with the customer is needed to
manage the products produced on the line. For example,
what kinds of concessions are you and the customer willing to make regarding lead times and delivery schedules,
which have an impact on managing the resources consumed to make the product? One strategy would be to
attract jobs that do not use the bottleneck resource (conveyor), but there are no paint jobs that CPS could perform without using the conveyor.
The value desired by the
customer: Transform
uncoated parts of various
sizes and shapes into parts
coated with specified,
defect-free finish.
Do we try to fill these wants, and,
if so, how?
Develop a customer strategy given
existing capabilities, cost
structure, and company
performance targets.
The cost of meeting
customer wants using available resources (executional
drivers), such as:
● Batch sizes
● Setup times
● Quality levels
Company capabilities
and cost structure
(structural drivers):
● Capital investments (e.g.,
conveyor line)
● Personnel
policies (e.g.,
staffing levels
I N C R E A S I N G C A PA C I T Y
Drawing on concepts from TOC, efforts should focus on
increasing the capacity of a constrained resource, such as
reducing the already short setup time (five minutes) or
reducing the number of setups needed. Another possi-
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lization that must be covered over the long term. The
use of throughput costing to make all bidding and
customer-related decisions would result in a continuous
series of decisions made with a strictly short-term, dayto-day emphasis. No organization can survive in the
long run if it continually ignores the costs of production
other than material costs.
ABC is an alternative costing approach that does factor in the cost of all resources consumed during production. Although it offers a rational assignment of costs,
ABC mixes fixed and variable costs in the assignment,
which can lead to decisions that are not optimal. Figure
3 helps illustrate this point.
In the figure, a particular cost actually behaves in a
step function, meaning that additional costs are
incurred in lump sum amounts as certain driver activity
levels are reached. Each step represents an additional
investment in capacity to handle the added demand for
activity. The main issue is the selection of the denominator in the formula (total cost/unit activity) used to calculate the fixed cost per unit. Some argue that practical
capacity of the resources rather than actual demand on
the resources should be used in the denominator.
The advantage of using practical capacity is that the
ABC cost per cost driver unit remains constant irrespective of the actual or estimated demand placed on a
resource by other products. Keep in mind, however, that
operating at practical capacity may mean some qualitative factors of production or customer service may suffer,
as described by Gilbert Y. Yang, former CFO of UFO
Group, Ltd., and Roger C. Wu, former controller of
Diamond Entertainment.2 In their article, Yang and Wu
note that a customer’s wait time before a call center
operator answers a phone is an element of customer service that is strategically important. Although, from a
practical capacity point of view, a phone can be constantly in use 24 hours a day, they recommend planning to
have more phones in use in order to reduce the amount
of time a customer must spend on hold.
We condone following this recommendation and
suggest using strategic capacity, which is usually less
than practical capacity, in the denominator. As Figure 3
shows, the use of strategic capacity in the denominator
raises the cost per driver unit because strategic capacity
is less than practical capacity. The use of strategic
bility is to hire temporary workers, but there is already
idle labor when some paint jobs are run, so temporary
workers will not help solve the problem.
Outsourcing some of the work is not an option
because the physical painting is CPS’s value proposition. Outsourcing to another paint vendor would simply
support a direct competitor. If we accept that CPS has
reached its capacity limit, the objective is to optimize
the use of the constrained conveyor resource by maximizing the profit generated by the paint jobs that
demand some of the resource’s capacity.
As mentioned earlier, four factors—shape, size, coatings, and color—determine job complexity, and job
complexity drives up the demand for line capacity.
Large parts, for example, take up more space on racks,
meaning that more racks are needed and that fewer
parts can be painted simultaneously. The shape of a
part determines loading and unloading times.
The size of the parts on a rack affects the number of
parts that can fit on the rack and on the conveyor belt.
A bumper, for example, is easier to paint than a luggage
rack because there is more uniform surface area and
because the bumper takes up less square footage on the
conveyor line. Some colors are easier to work with than
others, which impacts line speed, which impacts capacity demanded. Also, the parts with the LG finish have
fewer defects than the parts with the HG finish, meaning that LG parts have a higher first-pass yield rate. A
company can optimize profits by marketing certain finishes more proactively or by only accepting customers
that request coating for a limited number of parts—but
profitability must still be determined in advance.
COSTING METHODS
As mentioned previously, TOC promotes focusing on
the throughput per unit of scarce resource. This approach to managing a constrained resource uses a shortterm, day-to-day view to develop a long-term customer
strategy. As noted earlier, the production environment
(structural cost drivers) of CPS is not expected to change
in the short term, and the goal is to create a customer
strategy to satisfy customer needs given the production
environment that management has put into place.
While throughput costing may seem to be the obvious approach to use, it ignores the cost of capacity uti-
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Figure 3:
ABC Cost Estimate Using Practical Versus
Strategic Capacity Levels
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
method used, the information must be utilized in order
to make strategic decisions.
capacity also reduces the cost assigned to excess capacity, which is the distance between the sloped cost-perunit line and the step representing the cost of capacity
acquired.
Management should attempt to price a product as if
the company were operating at the strategic capacity
level. It is then up to the management team to find
ways to actually operate at that capacity level through
various strategic decisions. Management also must
remember that a reduction in fixed resource demand
does not translate into more profit for the organization
unless the now idle capacity is either eliminated or
redeployed.
As noted previously, the simple profit information
that the ABC process generates is not enough, but it is
still relevant. The ABC information has already served
two purposes: directing management’s attention to the
varying demand that products place on various
resources and providing a refined calculation of the
profit that each paint job generates.
We propose combining the TOC and ABC information into a format similar to the template in Figure 4.
The calculation contained in the figure shows that the
costs of capacity used to produce or support a product
can be explicitly considered. Regardless of the costing
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
CAPTURING
THE
COSTS
We will now focus on the profit analysis of a single type
of paint job and use the ABC and capacity demand
information to help direct management’s attention
toward appropriate long-term actions. The emphasis
will be on dealing with a part of a certain size and how
A Template for
Combining TOC and ABC
Costing Information
Figure 4:
Product A
Price
– Materials
= Throughput
x Volume
= Total throughput
– ABC costs
= Product margin
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Product B
Table 2:
The Effect of High-Gloss and Low-Gloss Finishes
on Certain Variables
Rejection
Rate
Number
of Colors
High Gloss
Increases
More required
Low Gloss
Decreases
Fewer required
Batch
Size
Inspections
Line
Speed
Smaller required More required
More required
Slower
Larger required
Fewer required
Faster
Using Capacity Demand to Rank Profitability
Profit Per
Square
Demand
Unit of
Feet Per Per Square
Finished
Unit of
Foot
Product
Product = (DF / Sq. Ft.) (In dollars) PTU*
Speed
Complexity
Factor
Demand
Factor
= (RF ✕ CF)
1.000
15
1.20
1.20
10
0.120
10.00
8.33
5%
1.031
12
1.50
1.55
10
0.155
12.00
7.76
92%
5%
1.031
12
1.50
1.55
10
0.150
12.00
7.76
93%
5%
1.020
12
1.50
1.53
10
0.150
12.00
7.84
92%
6%
1.020
12
1.50
1.53
10
0.150
12.00
7.84
Yield
Rate
Recovery
Rate
Run Factor
= 1 / (YR + RR)
Bumper—LG
95%
5%
Bumper—HG
92%
Bumper—HG
Increase YR
Increase RR
Product
Fewer required
maintenance costs, and slower line speed. Also, the HG
products are treated as they pass through stations 3 and
4, but products requiring LG finishes simply pass
through those booths untreated. As some of the costs
related to the resource capacity of booths 3 and 4 are
fixed costs, throughput costing does not capture the
additional cost of capacity demanded.
Table 3 presents a method for factoring the various
elements into the demand for conveyor capacity. Con-
to best manage operations and pricing decisions for that
type of part.
To illustrate, we will now present information for two
hypothetical bumpers, one requiring a low-gloss coating
and the other a high-gloss coating. As Table 2 shows,
high-gloss and low-gloss finishes have different
requirements.
The HG finishes have higher reject rates and require
additional painters, more colors, more inspections and
Table 3:
Number
of Painters
INITIAL
COMPARISON
SCENARIO 1
SCENARIO 2
Bumper—HG
92%
5%
1.031
12
1.50
1.55
10
0.150
12.00
7.76
Increase speed
92%
5%
1.031
13
1.38
1.43
10
0.140
12.00
8.41
Bumper—HG
92%
5%
1.031
12
1.50
1.55
10
0.150
12.00
7.76
Increase profit
92%
5%
1.031
12
1.50
1.55
10
0.150
12.60
8.15
SCENARIO 3
SCENARIO 4
Bumper—HG
92%
5%
1.031
12
1.50
1.55
10
0.150
12.00
7.76
Change speed
and YR
88%
5%
1.075
13
1.38
1.49
10
0.150
12.00
8.06
*Adjusted Product Profit Per Throughput Unit Profit Per Sq. Ft./BDF)
Bottleneck Demand Per Square Foot (BDF), Complexity Factor (CF), Demand Factor (DF), Profit Per Throughput Unit (PTU), Recovery Rate (RR), Run Factor (RF),
Square Feet (Sq. Ft.), Yield Rate (YR).
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FALL 2006, VOL. 8, NO. 1
result is a total demand factor (DF). This demand factor helps managers recognize the relative demand that
each paint job puts on the capacity of the paint conveyor. In the initial comparison shown in Table 3, the line
speeds for the LG and HG bumpers differ. The line
speed of 12 feet per minute for the HG bumper is slower than the 15 feet per minute for the LG bumper
because of the complexity of applying an HG finish.
tinuing to use bumpers as an example, consider the
quality issue. The greater the percentage of defects in a
finish, the lower the yield rate (YR) for a production
run. The yield rate refers to the number of parts that
have gone through the coating process without any
defects. More complex shapes and finishes have lower
yield rates than less complex shapes and finishes. In the
following example, the LG bumper will have a higher
YR than the HG bumper.
As noted earlier, defective products can be recovered
through in-house finessing. The recovery rate (RR)
runs at about 5% for bumpers, which means that about
5% of all bumpers painted are recovered through the
finesse process, which, when added to the first pass
yield rate (YR) yields a value less than or equal to
100%. Because the recovered bumpers are brought up
to an acceptable quality level, they contribute toward
meeting customer demand and put no further demand
on the conveyor capacity.
The YR and RR can be combined to determine how
many parts must be processed on the conveyor to generate one unit of acceptable quality. We call this concept the “run factor” (RF). The computation to
determine the run factor is 1/(YR+RR). If the yield rate
plus the recovery rate equals an RF of 1, then only one
unit must be put on the conveyor to yield one unit of
acceptable quality. The RF for an LG bumper is lower
than the RF for an HG bumper.
The next production factor relates to line speed.
Line speed can vary from 10 to 18 feet per minute,
depending upon the size, shape, and required coating
of the product, all of which are elements affecting the
complexity of the painting process. As these three elements can be combined in a number of ways, we
attempt to capture the various combinations in the form
of a complexity factor (CF). We consider 18 minutes to
be the standard time unit for the conveyor line. A complexity factor ranging between 1 (for fastest line speed)
and 1.8 (for slowest speed) can be determined for each
group of parts and included in the calculation of
demand.
The CF is computed by dividing the standard line
speed of 18 feet per minute by the line speed required
for the specific product, so a faster line speed results in
a lower CF. When the CF is multiplied by the RF, the
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
WHICH PRODUCTS
TO
P R O M OT E ?
Parts can vary in shape and size, so we needed a standard unit of measure to compare the total demand that
each part places on the conveyor. Because it is the surface area of each part that is coated, square footage of
each part is a logical measurement unit. As a result, the
DF described above is actually a demand placed on the
conveyor per unit of finished good of a particular part
type, such as bumpers or luggage racks.
When the DF is divided by the total square footage
of a particular part (e.g., a bumper), the end result is a
demand factor per square foot of a particular size,
shape, and finish, which we call the bottleneck demand
factor (BDF). The ABC profit level per square foot can
now be divided by the BDF to yield the profit per
throughput unit (PTU) on the conveyor line.
The initial product comparison in Table 3 shows that
while the profit per throughput unit of finished good is
higher for the HG bumper, the PTU on the LG
bumper is higher, so these bumpers should be targeted
for increased sales. Keeping in mind that demand for
certain types of coatings varies and that there is insufficient demand for any one product to fully utilize the
line, planning profitability now depends on the mix of
products and their respective PTUs. The approach we
suggest gives management valuable information to help
them decide which coatings to promote.
In our examples, we have focused only on demand
for the conveyor line capacity. TOC tells us that it is
possible to expand the capacity of a bottleneck to the
point where the limiting constraint moves to a different
resource. The ABC information can be combined with
the capacity information for various resources to obtain
a company-wide analysis of the cost of resources
demanded. Given that there may be more than one
capacity constraint, a linear programming model could
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Table 4:
Summary of Effects of Production Changes on PTU
Change in YR
Change in RR
Change in Line Speed
ABC Profit
Increase to 76%
Up .01
Increase to 6%
Up .01
Increase to 13
Up .10
Increase to $24
Decrease to 70%
Increase to 13
THE
PTU
Turning back to the hypothetical HG bumper, the current PTU is $7.76. If management sees or promotes a
shift in customer demand toward this type of part, they
should turn their attention to trying to improve the
PTU. Table 3 provides the results of several types of
actions management may take. We now consider each
in turn.
In the first scenario, we look at increasing the yield
and then at increasing the recovery rate. If changes can
be made to the processes on the conveyor line to
increase the YR from 92% to 93%, the RF and DF
decrease. The decrease translates into an increase in
the PTU of $0.08. If, instead, the recovery process is
modified to increase the RR from the current 5% level
to 6% and the conveyor line speed is unchanged, the
end result is the same $0.08 increase in the PTU. Given these results, management would be advised to pursue the option that is least costly to implement.
It should be noted that the finesse process is labor
intensive but requires very little in the way of materials.
The Finesse department has excess capacity and is not
a bottleneck resource. Throughput costing would only
consider the minor incremental cost of materials used in
the finesse process and would show little difference in
the total profitability of the two options described in
the previous paragraph. ABC, on the other hand, would
show a much bigger difference between these options.
In the second scenario, the focus is on increasing line
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
Up .05
Up .02
speed while holding the other factors constant. Again,
changes would have to be made to the painting process
to increase the line speed, but increasing the line speed
to 13 feet per minute results in about an 8% increase in
the PTU. Management then would have to decide if
the necessary changes to attain the increase in the conveyor line speed are cost effective.
In the third scenario, the speed, YR, and RR are held
constant, and the profit per unit of finished product is
changed. Such a change may come from using the ABC
information to identify ways to decrease resource consumption costs for the process and/or to look at increasing the price of the coating.
Management does not have to consider one change
at a time, and trade-offs could be factored into an analysis. For example, increased speed may increase the
defect rate (lower the YR), but there could be a coordinated effort to simultaneously increase the RR of defective units.
The fourth scenario shows that an increase in conveyor line speed to 13 feet per minute with a corresponding decrease in the YR to 88% actually increases
the PTU. Management could prepare a matrix like the
one in Table 4 to summarize the impact of various
options and compare the benefits to the costs that
would need to be incurred to bring about the change.
The resources of all organizations have limited productive capacity. An organization’s cost management
systems should help guide management in making
decisions on how to best use these limited resources
strategically. In this article, we have attempted to illustrate the advantage of combining the constraint-focused
view of throughput costing with the ABC approach of
assigning resource costs to give management a more
possibly be developed to help identify ways to maximize the total profit.
The Solver function in Excel is a tool that can handle
the computations of a linear programming model.3
I M P R OV I N G
Change to PTU
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FALL 2006, VOL. 8, NO. 1
effective cost management tool.
■
Paul Juras, Ph.D., CMA, CPA, is an associate professor at
Wake Forest University. He can be reached at (336) 7584836 or [email protected].
Eileen Peacock, Ph.D., CMA, CPA, is a professor and dean
at University of Massachusetts, Dartmouth. She can be
reached at [email protected].
E N D N OT E S
1 Eileen Peacock, “Cost Management by Customer Choice,”
Management Accounting Quarterly, Spring 2005, pp. 28-36.
2 Gilbert Y. Yang and Roger C. Wu, “Strategic Costing & ABC,”
Management Accounting, May 1993, pp. 33-37.
3 For more information on using Sover, see Sidney J. Baxendale,
Mahesh Gupta, and P.S. Raju, “Profit Enhancement Using an
ABC Model,” Management Accounting Quarterly, Winter 2005,
pp. 11-21.
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