Summary by Lorrie Ramirez
Master of Accountancy Program
University of South Florida, Summer 2002
ABC Main Page | TOC Main Page
The purpose of this article is to explain the differences between the underlying assumptions of activity-based costing and the theory of constraints. In addition, Holmen points out that one method isn’t necessarily superior over the other and that both tools can be used when they are used appropriately.
The Six Assumptions of Activity-Based Costing (ABC)
Activity-based costing is a method that recognizes the causal relationship of cost drivers to cost activities by measuring the cost and performance of process-related activities and cost objects. Costs are assigned to activities based on resource consumption and then assigned to cost objects based on activity consumption.
ABC is different than traditional costing in the way that costs are accumulated. Traditionally, cost accumulation is a two-stage process:
1. Costs are accumulated by function or department.
2. Costs are assigned or traced to products through a single activity measure.
Activity-based costing looks at resources and activities as cost generating while the traditional system sees the products as cost generating. Based on this definition of ABC, two assumptions become apparent:
1. Activities consume resources (and acquiring resources creates costs) and
2. Products or customers consume activities.
The third assumption states that ABC models consumption rather than spending. The implication of this assumption is the greatest. In order for costs to decrease, the level of spending has to change. ABC, however, does not recognize spending, but consumption. Thinking in the short-term, a change in activity will have little, if any, impact on resource consumption. In the long-term, however, spending can be adjusted to align with consumption.
The fourth assumption is that there are numerous causes for the consumption of resources. Another assumption embedded in the forth assumption is, that a wide array of activities can be identified and measured. These activities are the link between the resource costs and the cost objects. These links reflect a cause-and-effect relationship because they enable multiple cost pools rather than just one.
Traditional systems use few activity measures when tracing costs to products - often direct labor hours. A major advance of activity-based costing was the recognition of a hierarchy of activity measures. This hierarchy is presented below:
1. Unit-level activities - performed each time a unit is produced.
2. Batch-level activities - performed each time a batch is produced.
3. Product-level activities - performed as needed to support the production of each different type of product.
4. Facility-level activities - sustain the facility’s general manufacturing process.
The fifth assumption is that cost pools are homogeneous. This means that each cost pool has only one activity. An ABC model would have numerous cost pools in comparison to the traditional system.
The last assumption states that all costs in each cost pool are variable (strictly proportional to activity). Coupled with the fifth assumption, this assumption recognizes that the only "fixed" costs in a traditional cost system would be "facility-level" activities. All other costs would be associated with a fluctuating activity.
These assumptions represent one major implication: ABC is intended primarily as a long-term tool. Spending is relatively unchangeable in the short-run and it is only in the long run that spending and consumption are brought into alignment. Using ABC to predict short-run costs overlooks the fact that costs are the result of spending decisions.
Assumptions of Activity-Based Costing
Activities consume resources.
Products or customers consume activities.
ABC Models consumption rather than spending.
Resources consumed have numerous causes.
Activities of wide array can be identified and measured.
Cost pools are homogeneous.
Costs in each pool are variable (strictly proportional to activity).
Theory of Constraints (TOC)
The theory of constraints was developed by Goldratt and Fox in the 1980’s and has since evolved. Goldratt developed a scheduling approach known as optimized production technology (OPT) that used TOC principles. This method was coined "synchronous manufacturing" in 1984 and became the theory of constraints in 1987.
TOC is usually explained using the Five Focusing Steps. The purpose of these steps is to center a manager’s attention on the constraining resources - those inhibiting profit growth.
The Five Focusing Steps of the Theory of Constraints
1. Identify the system’s constraints.
2. Decide how to exploit the system’s constraints.
3. Subordinate everything else to the decision made in Step 2.
4. Elevate the system’s constraints.
5. Go back to Step 1 if the constraint is broken in Step 4. Watch for inertia.
There are a number of assumptions underlying the theory of constraints. The first is that the goal is to make money now and in the future. Making money is the primary reason for a company to exist - otherwise it wouldn’t be in business. The second assumption states that throughput is used as a way to measure money. Throughput is defined as revenue minus the variable cost of materials and energy. It is important to understand that with this assumption direct labor is not a variable cost, it is a commitment made to the workers for the planning horizon. It is also assumed that overhead costs won’t vary in the short-run. However, a short-run planning horizon doesn’t allow for costs that can change in the long run.
The third assumption is that there is always at least one constraint on each product that limits the company’s revenue. This constraint could be internal or external to the organization. The fourth assumption builds on this constraint - there are three types of resources: scarce bottleneck resources, non-bottleneck resources, and capacity constraint resources (CCR). A capacity constraint resource is one that is not a bottleneck but possesses the ability to become a constraint if not properly managed. The fifth assumption is that most manufacturing operations have only a few CCRs, and thus it is easy to control them.
The theory of constraints also assumes two characteristics about the production process:
Dependent events exist that result in interactions between resources and products.
Within every manufacturing environment statistical fluctuations and random events occur.
These assumptions create a need for scheduling and prioritizing the product flow. The OPT method of scheduling implies a rather short time horizon.
The eight assumption states that the OPT system is implicitly stable - at any given time bottlenecks are identified, and the order mix is stable with respect to given resources. For the short time period, capacity is fixed and bottlenecks are inevitable.
Assumptions of the Theory of Constraints
The goal is to make money now and in the future.
Throughput is defined as revenue minus the variable cost of materials and energy.
There is always at least one constraint on each product that limits the firm’s revenue.
There are three types of resources: scarce bottleneck resources, non-bottleneck resources, and capacity constraint resources (CCR).
Most manufacturing operations have only a few CCRs, and thus it is easy to control them.
Dependent events exist that result in interactions between resources and products. Within every manufacturing environment, statistical fluctuations and random events occur.
The optimized production technology system is implicitly stable - at any given time bottlenecks are identified, and the order mix is stable with respect to given resources.
It’s a Matter of Time
When comparing ABC with the TOC it becomes clear that the cost paradigms are based on different time horizons - ABC has a long run horizon, while the TOC has a short-run horizon. The concept of short-run versus long run looks at whether the capacity of the production facility can be expanded or contracted.
It is assumed that in the short-run production capacity is fixed and cannot be readily changed. This creates bottlenecks or constraints. This context brings the assumptions of the TOC to life. In the long run, however, more costs become variable, especially when spending and consumption are brought into alignment. This reinforces the assumptions underlying ABC.
These methods are based on different sets of assumptions with separate time horizons; thus, claims that one approach is superior over the other should be abandoned. There is room for both approaches when they are used appropriately. Accountants need to understand each tool and how they work in order to know when one is appropriate and the other is not.
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Related summaries:
Baxendale, S. J. and P. S. Raju. 2004. Using ABC to enhance throughput accounting: A strategic perspective. Cost Management (January/February): 31-38. (Summary).
Campbell, R. J. 1995. Steeling time with ABC or TOC. Management
Accounting (January): 31-36. (Summary).
Campbell, R., P. Brewer and T. Mills. 1997. Designing an information system
using activity-based costing and the theory of constraints. Journal of
Cost Management (January/February): 16-25. (Summary).
Coate, C. J. and K. J. Frey. 1999. Integrating ABC, TOC, and financial reporting. Journal of Cost Management (July/August): 22-27. (Summary).
Corbett, T. 2000. Throughput accounting and activity-based costing: The driving factors behind each methodology. Journal of Cost Management (January/February): 37-45. (Summary). (According to Corbett, the underlying assumptions of ABC and TOC are the exact opposites and accountants cannot agree with both).
Demmy, S. and J. Talbott. 1998. Improve internal reporting with ABC and TOC. Management Accounting (November): 18-20, 22 and 24. (Summary).
Goldratt, E. M. 1990. What is this thing called Theory of Constraints. New York: North River Press. (Summary). (In Chapter 4 Goldratt says that the word "cost" is a dangerous and confusing multi-meaning word and that the word "product cost" is "an artificial, mathematical phantom" p. 49).
Goldratt, E. M. 1990. The Haystack Syndrome: Sifting Information Out of the Data Ocean. New York: North River Press. (Summary). (In Chapter 7 Goldratt tells us that the business world today has changed and cost accounting has been slow to react. They have not reexamined the fundamentals, the financial statement logic, to create new solutions. Instead, they have formulated ineffective answers like “cost drivers” and “activity-based costing.” We can no longer allocate based on direct labor. So allocating expenses at the unit level, batch level, group level, and company level is meaningless. These cannot be aggregated at their respective levels nor at the top. So why do it?).
Goldratt, E. M. and J. Cox. 1986. The Goal: A Process of Ongoing Improvement. New York: North River Press. (Summary).
Huang, L. 1999. The integration of activity-based costing and the theory of constraints. Journal of Cost Management (November/December): 21-27. (Summary).
MacArthur, J. B. 1993. Theory of constraints and activity-based costing: Friends or foes? Journal of Cost Management (Summer): 50-56. (Summary).
MacArthur, J. B. 1996. From activity-based costing to throughput accounting. Management Accounting (April): 30, 34, 36-38. (Summary).
Martin, J. R. Not dated. Chapter 7: Activity Based Product Costing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter7.htm
Martin, J. R. Not dated. Chapter 8: Just-In-Time, Theory of Constraints, and Activity Based Management Concepts and Techniques. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter 8
Martin, J. R. Not dated. Comparing Dupont's ROI with Goldratt's ROI. Management And Accounting Web. Comparing Dupont Goldratt ROI
Martin, J. R. Not dated. Comparing Traditional Costing, ABC, JIT, and TOC. Management And Accounting Web. Trad ABC JIT TOC
Martin, J. R. Not dated. Drum-Buffer-Rope System. Management And Accounting Web. Drum Buffer Rope
Martin, J. R. Not dated. Global measurements of the theory of constraints. Management And Accounting Web. TOC Measurements
Martin, J. R. Not dated. Goldratt's dice game or match bowl experiment. Management And Accounting Web. Match Bowl Experiment
Martin, J. R. Not dated. TOC problems and introduction to linear programming. Management And Accounting Web. TOC Problems Intro To LP
Rezaee, Z. and R. C. Elmore. 1997. Synchronous manufacturing: Putting the goal to work. Journal of Cost Management (March/April): 6-15. (Summary).
Ruhl, J. M. 1996. An introduction to the theory of constraints. Journal of Cost Management (Summer): 43-48. (Summary).
Westra, D., M. L. Srikanth and M. Kane. 1996. Measuring operational performance in a throughput world. Management Accounting (April): 41-47. (Summary).