A factory spends a year improving labour efficiency. Operators finish their work faster, standard hours are beaten, variances are favourable, and profit does not move. The reason is that the real limit on what the factory can sell is the capacity of one machine. The operators who got faster were not the ones feeding it. Throughput accounting starts from this fact.
Every system has a constraint, so management should find it, make the best use of it, and look for ways to remove it. Costs are not allocated to units, and the measure of success is the throughput earned from each hour of the scarce resource.
This topic explains throughput, inventory and operating expenses, how profit and inventory are measured, how throughput accounting differs from absorption and marginal costing, the theory of constraints, the throughput accounting ratio and how to improve it, and how to use the method to decide the product mix. It builds on the life cycle cost calculations topic. The next topic covers environmental management accounting and sustainability.
In 30 seconds
Throughput = sales − cost of raw materials and components. Operating expenses are all other costs, including labour, treated as fixed. Net profit = throughput − operating expenses. Investment (inventory) is money tied up in stock and assets, valued at material cost only. The theory of constraints says every system has a bottleneck that limits output: identify it, exploit it, ease or remove it, then find the next one.
Goldratt’s three routes to profit are increase throughput (the most effective), reduce operating expenses and reduce investment. The throughput accounting ratio (TAR) = throughput per bottleneck hour ÷ operating expenses per bottleneck hour; above 1 the product earns more than it costs. For several products, rank by throughput per bottleneck hour and make the best first, up to demand.
Full marks come from identifying the bottleneck, showing throughput per hour and stating what the TAR means.
The nature of throughput accounting
Throughput accounting is not really a costing system, because no costs are allocated to units of production except materials. Traditional costing focuses on controlling and reducing cost. Throughput accounting focuses on how to achieve the entity’s goals, which for a profit-making company is the maximisation of profit.
It is associated with the theory of constraints, which says that an entity always has a constraint limiting the achievement of its goals. Management should (a) identify the effective constraint, (b) maximise performance within its limit, and (c) look for ways to remove the constraint. It has similarities with marginal costing and limiting factor analysis, but different assumptions:
- In practice direct labour is a fixed cost: employees are paid fixed wages or salaries.
- The only variable cost is the purchase cost of materials and components from outside suppliers.
- A business makes real profit by adding value, and value is not added until the sale is made.
- Value added is the value of the sale less the variable cost of sales, which is the cost of the materials.
Throughput, investment and operating expenses
- Throughput is the rate at which the entity achieves its goals. For a profit-making entity, throughput = sales − cost of raw materials and components. It differs from contribution because only truly variable costs, mainly materials, are deducted. In a not-for-profit entity the goal may be non-financial.
- Inventory (investment) is all money tied up in the business: raw materials, work in progress, finished goods and also non-current assets. Until stock is sold it is capital earning nothing. Throughput is not created until finished goods are sold, so making goods for inventory damages the entity’s goals: it ties up finance that has a cost.
- Operating expenses are all the expenditure incurred to produce the throughput, meaning all costs that are not variable, so they include labour.
Profit = throughput − operating expenses. For example, sales ₦800,000 less materials ₦350,000 gives throughput ₦450,000; less operating expenses ₦340,000 leaves net profit ₦110,000.
Inventory valuation
In throughput accounting, all inventory, including work in progress and finished goods, is valued at the cost of raw materials and components only. No labour or overhead is added, because no value is added until the sale. It is impossible to make extra profit by producing more unless the extra output is sold.
This is why throughput accounting profit is less affected by changes in inventory than absorption costing profit, and why it discourages building stock.
Comparing the three profit measures
Absorption costing values inventory at materials, labour and fixed production overhead. Marginal costing values it at materials and labour (the variable costs). Throughput accounting values it at materials only. When inventory rises, profit is highest under absorption costing and lowest under throughput accounting, and the differences are entirely due to the inventory valuation.
Constraints, ratios and improving the TAR
A constraint is anything that limits the output of the system. Without a constraint, output would be zero or would rise without limit, so every working system has one. Constraints may be external (limited customer demand), weaknesses in the system (shortage of a key resource or capacity), or weaknesses in controls.
In a factory a constraint is a bottleneck: a shortage of materials, of machine time or of skilled labour, or inefficiency such as stoppages, scrap and downtime.
- Focus. Effort to improve efficiency anywhere except the key constraint is wasted. Improving labour efficiency does nothing if machine capacity is the constraint.
- Goldratt’s steps. Identify the key constraint; consider ways to remove or ease it; when it is removed another constraint takes its place, so identify the new one and repeat. The output capacity grows with each step, but there is always a key constraint.
- Three routes to profit. Increase throughput, reduce operating expenses, or reduce investment such as inventory. Increasing throughput, by easing bottlenecks, is the most effective.
Performance measures
- Net profit = throughput − operating expenses.
- Return on investment = net profit ÷ investment.
- Throughput productivity = throughput ÷ operating expenses.
- Throughput per unit of the bottleneck resource and operating expenses per unit of the bottleneck.
- Throughput accounting ratio (TAR) = throughput per bottleneck hour ÷ operating expenses per bottleneck hour.
A TAR above 1 means the product earns more throughput per bottleneck hour than the cost of that hour, so it adds to profit. A TAR below 1 means operating expenses exceed throughput and improvement is needed. Because labour is a fixed cost and often small in automated plants, throughput accounting rejects the idea that better labour efficiency improves profit, and directs effort to the constraint.
Improving the TAR
- Increase throughput per hour: raise the selling price, reduce material cost, use the bottleneck more efficiently (make the product in less time), improve automation and resource allocation, and increase volume that can be sold.
- Reduce operating expenses: remove unnecessary spending, negotiate better contracts, streamline operations, which lowers the expense per bottleneck hour.
Benefits and limitations
Benefits: focuses on profit; identifies bottlenecks; improves decisions on product mix, pricing and resource allocation; discourages building inventory; simple, as only materials are variable. Limitations: a short-term focus, which may ignore long-term strategy; the assumption that all costs except materials are fixed may not be true; it depends on identifying one clear bottleneck, and the bottleneck can move.
Multi-product decisions
- Identify the bottleneck and its hours available.
- Throughput per unit of each product = price − materials.
- Throughput per bottleneck hour = throughput per unit ÷ bottleneck hours per unit.
- Rank the products by throughput per bottleneck hour.
- Plan production in rank order up to demand until the hours run out.
- Throughput of the plan less operating expenses = profit; then evaluate and improve.
Comparing the three costing methods
The same facts give three different profits, because the methods value inventory differently. Take a company that makes 1,000 units in June and sells 800 for ₦40,000. Materials cost ₦7,000, direct labour ₦9,000, fixed production overhead ₦12,000 and other non-production overhead ₦6,000. There was no opening inventory.
- Absorption costing.
Production cost 7,000 + 9,000 + 12,000 = ₦28,000.
Closing inventory of 200 units is ₦5,600.
Cost of sales ₦22,400, gross profit ₦17,600, less non-production overhead 6,000 = ₦11,600. - Marginal costing, with labour treated as variable.
Variable cost 7,000 + 9,000 = ₦16,000.
Closing inventory ₦3,200.
Cost of sales ₦12,800, contribution ₦27,200, less fixed costs 12,000 + 6,000 = 18,000 = ₦9,200. - Throughput accounting. Only materials are variable.
Closing inventory 200 × ₦7 = ₦1,400.
Cost of sales ₦5,600, throughput ₦34,400, less operating expenses (labour 9,000 + fixed 12,000 + other 6,000 = 27,000) = ₦7,400.
The differences are entirely inventory values: ₦5,600, ₦3,200 and ₦1,400. Absorption costing carries the most cost into the next period and so reports the highest profit; throughput accounting carries only the materials and reports the lowest. This is why throughput accounting discourages building inventory: producing more output that is not sold adds nothing to its profit, and only adds to investment.
A multi-product plan ranked by throughput per bottleneck hour
When several products compete for the bottleneck, the plan is built in six steps:
- identify the bottleneck
- find the throughput per unit (price less materials)
- divide by the bottleneck hours each unit uses
- rank the products by throughput per bottleneck hour
- allocate the hours in rank order up to the demand limit for each product
- then deduct operating expenses
Consider three products with a bottleneck of 2,000 machine hours a week, operating expenses of ₦700,000 a week, and weekly demand of 2,000 units of P, 2,500 of Q and 3,000 of R.
- Throughput per unit.
P 300 − 120 = ₦180
Q 260 − 100 = ₦160
R 220 − 90 = ₦130. - Machine hours per unit. P 0.5; Q 0.4; R 0.2. Throughput per hour: P ₦360; Q ₦400; R ₦650. Rank: R first, Q second, P third.
- Allocation.
R: 3,000 units × 0.2 = 600 hours, throughput ₦390,000.
Q: 2,500 × 0.4 = 1,000 hours, throughput ₦400,000.
P: the 400 hours left allow 800 units, throughput 800 × 180 = ₦144,000.
Total throughput ₦934,000; less operating expenses 700,000; profit ₦234,000. - Throughput accounting ratio.
Operating expenses per hour 700,000 ÷ 2,000 = ₦350.
P 360 ÷ 350 = 1.03
Q 400 ÷ 350 = 1.14
R 650 ÷ 350 = 1.86.
All exceed 1, so each product earns more than the cost of the bottleneck hour it uses, and R is by far the most profitable use of the scarce hours.
If the bottleneck could be eased, for example by adding machine time, the extra hours would first go to the next product in the ranking (P, up to its demand), which shows that a new constraint will appear once P’s demand is met, in line with Goldratt’s idea that removing one constraint reveals the next.
Layouts
- Throughput per unit = price − materials per unit.
- Throughput per bottleneck hour = throughput per unit ÷ hours per unit (or × units per hour).
- Operating expenses per bottleneck hour = total operating expenses ÷ bottleneck hours available.
- TAR = (2) ÷ (3).
- Profit = total throughput − operating expenses.
Money is in naira, ratios to two decimal places, and each answer is rounded once at the end.
Worked examples
Example 1: three profit figures. A company makes 2,000 units in a month and sells 1,600 at ₦60 each (₦96,000). Materials cost ₦12,000, direct labour ₦20,000, fixed production overhead ₦24,000 and other overheads ₦8,000. There was no opening stock. Required: profit under absorption, marginal and throughput accounting.
- Absorption.
Production cost 12,000 + 20,000 + 24,000 = ₦56,000, or ₦28 a unit.
Cost of sales 1,600 × 28 = ₦44,800.
Gross profit 96,000 − 44,800 = ₦51,200.
Less other overheads 8,000 = profit ₦43,200. - Marginal.
Variable cost 12,000 + 20,000 = 32,000, or ₦16 a unit
cost of sales 1,600 × 16 = ₦25,600.
Contribution ₦70,400.
Less fixed costs 24,000 + 8,000 = 32,000 = profit ₦38,400. - Throughput.
Materials sold 1,600 × 6 = 9,600.
Throughput 96,000 − 9,600 = ₦86,400.
Operating expenses 20,000 + 24,000 + 8,000 = ₦52,000.
Profit ₦34,400. - Reconciliation. Closing stock 400 units: absorption ₦11,200 (400 × 28), marginal ₦6,400 (400 × 16), throughput ₦2,400 (400 × 6).
Absorption minus marginal 43,200 − 38,400 = ₦4,800, which is the fixed overhead in stock (400 × 12).
Marginal minus throughput 38,400 − 34,400 = ₦4,000, the labour in stock (400 × 10).
Example 2: the TAR and how to raise it. Product Y sells for ₦45 and uses materials of ₦17. Each unit needs 6 minutes on the bottleneck machine, which has 800 hours a month. Operating expenses are ₦100,000 a month. Required: the TAR, and the effect of a 5% price rise.
- Throughput per unit.
45 − 17 = ₦28.
Units per hour 10, so throughput per hour = ₦280. - Operating expense per hour.
100,000 ÷ 800 = ₦125. - TAR.
280 ÷ 125 = 2.24.
Each hour earns more than twice its cost. - With a 5% price rise.
Price 47.25; throughput 30.25 a unit; per hour ₦302.50; TAR 302.50 ÷ 125 = 2.42.
Example 3: the product mix. A company makes P, Q and R. Prices ₦600, ₦450, ₦380; materials ₦220, ₦200, ₦150; bottleneck hours per unit 0.8, 0.5, 0.4; weekly demand 3,000, 4,000, 5,000. The bottleneck has 4,200 hours a week. Operating expenses are ₦1,900,000 a week. Required: the best plan, the profit and the TAR of each product.
- Throughput per unit. P ₦380; Q ₦250; R ₦230.
- Per bottleneck hour.
P 380 ÷ 0.8 = ₦475
Q 250 ÷ 0.5 = ₦500
R 230 ÷ 0.4 = ₦575.
Rank R, Q, P. - Plan.
R 5,000 × 0.4 = 2,000 hours
Q 4,000 × 0.5 = 2,000 hours
200 hours remain for P: 200 ÷ 0.8 = 250 units. - Throughput.
R 5,000 × 230 = ₦1,150,000
Q 4,000 × 250 = ₦1,000,000
P 250 × 380 = ₦95,000.
Total ₦2,245,000.
Less operating expenses 1,900,000 = profit ₦345,000. - TAR.
Expense per hour 1,900,000 ÷ 4,200 = ₦452.38.
P 475 ÷ 452.38 = 1.05
Q 500 ÷ 452.38 = 1.11
R 575 ÷ 452.38 = 1.27.
All are above 1, and R is the most profitable use of an hour.
Expect variants: a process with several resources and the bottleneck to be found, a price or time change, and a question that asks for the effect of easing the bottleneck.
The profit-maximising output
The profit-maximising output is found by ranking the products by throughput per bottleneck hour (the same order as the throughput accounting ratio, TAR = throughput per bottleneck hour ÷ conversion cost per bottleneck hour) and making them in that order until the bottleneck hours run out, subject to the maximum demand for each. Example. The bottleneck has 1,000 hours a period and conversion cost is ₦60m (₦60,000 an hour).
Product P gives throughput of ₦90,000 a unit and uses 1.0 bottleneck hour: ₦90,000 an hour, TAR 1.5. Product Q gives ₦96,000 a unit and uses 2.0 hours: ₦48,000 an hour, TAR 0.8. Demand for P is 700 units, so P takes 700 hours; the remaining 300 hours make 150 units of Q. Throughput = 700 × 90,000 + 150 × 96,000 = ₦77.4m; less conversion cost ₦60m gives profit of ₦17.4m.
A TAR below 1 (product Q) warns that the product earns less per bottleneck hour than the hour costs, so the company should look for a higher price, a lower material cost or a shorter bottleneck time, or relieve the bottleneck.
Throughput accounting compared with marginal costing
The main difference is the treatment of labour and variable overhead. Marginal costing treats materials, labour and variable overhead as variable, so contribution = sales − all variable costs. Throughput accounting treats only materials (and bought-in components) as variable and regards labour and other costs as a fixed factory cost in the short term: throughput = sales − material cost.
The factory cost per bottleneck hour = (labour + variable overhead + fixed costs) ÷ bottleneck hours, and TAR = throughput per bottleneck hour ÷ factory cost per bottleneck hour. Because labour and overhead are left out of the ranking, the order of products can change. Illustration. L: price ₦120, material ₦55, labour and variable overhead ₦25, 2 hours; M: price ₦150, material ₦50, labour and overhead ₦60, 3 hours. Contribution per hour: L ₦20, M ₦13.33, so marginal costing makes L first. Throughput per hour: L ₦32.50, M ₦33.33, so throughput accounting makes M first.
Advantages of throughput accounting over marginal costing
Throughput accounting (i) identifies the bottleneck that limits output and focuses effort on relieving it; (ii) treats labour as a fixed cost in the short run, which reflects reality where employees are paid whatever is made; (iii) discourages building stock, because only materials are charged and so producing for stock adds no profit, which supports just-in-time; (iv) gives the throughput accounting ratio, which ranks products and shows whether each earns more per bottleneck hour than the hour costs; and (v) supports continuous improvement in throughput.
Common mistakes
- Deducting labour in throughput. Only materials and components come off sales.
- Valuing stock with labour or overhead. Throughput accounting stock is at material cost.
- Using hours per unit instead of per hour. Convert minutes to a rate per hour.
- Ranking by throughput per unit. Rank by throughput per bottleneck hour.
- Improving a non-bottleneck. It will not raise profit.
- Misreading the TAR. Above 1 is acceptable; the higher, the better.
Quick revision
- Throughput = sales − materials. Operating expenses include labour. Profit = throughput − operating expenses.
- Stock valued at material cost; no profit from output that is not sold.
- Theory of constraints: find, exploit, ease; the next constraint appears.
- TAR = throughput per bottleneck hour ÷ expenses per bottleneck hour. Above 1 acceptable.
- Improve TAR: price, materials, bottleneck time, expenses.
- Multi-product: rank by throughput per bottleneck hour; plan to demand and hours.
How the marks are earned
- Explain: throughput, investment and operating expenses, and the constraint idea.
- Calculate: throughput per unit, per hour, the ranking, the plan, profit and TAR, each a mark.
- Evaluate: what the TAR means and how to improve it.
Practice questions
These are original questions, written in the style of the Skills examination. Work each one before you open the answer.
Recall check: multiple choice
Question 1. Throughput is:
- Sales minus all costs
- Sales minus labour
- Profit before tax
- Sales minus the cost of raw materials and components
Show the answer
D. Only materials are variable.
Question 2. In throughput accounting, inventory is valued at:
- Raw materials cost only
- Full absorption cost
- Marginal cost
- Selling price
Show the answer
A. No value is added until the sale.
Question 3. Operating expenses include:
- Only materials
- Only tax
- Labour and all other costs that are not variable materials
- Only interest
Show the answer
C. Labour is treated as fixed.
Question 4. The theory of constraints states that:
- No system has limits
- Every system has a constraint that limits output
- Constraints cannot be removed
- Only demand limits output
Show the answer
B. Identify it, exploit it, and ease it.
Question 5. The TAR is:
- Throughput per bottleneck hour ÷ operating expenses per bottleneck hour
- Profit ÷ sales
- Sales ÷ materials
- Operating expenses ÷ throughput
Show the answer
A. It compares the earning of an hour with its cost.
Question 6. A TAR greater than 1 means:
- A loss
- No throughput
- The bottleneck has moved
- Throughput per hour exceeds the cost of the hour, so the product is profitable
Show the answer
D. Below 1 the product needs improvement.
Question 7. The most effective way to increase profit, according to Goldratt, is to:
- Cut labour
- Cut materials only
- Increase throughput
- Raise inventory
Show the answer
C. By easing bottlenecks.
Question 8. Improving labour efficiency when the constraint is machine capacity will:
- Greatly raise profit
- Do little to raise profit
- Remove the bottleneck
- Double throughput
Show the answer
B. Effort must go to the constraint.
Question 9. In a multi-product plan, products are ranked by:
- Selling price
- Throughput per unit
- Throughput per bottleneck hour
- Materials cost
Show the answer
C. The scarce resource is the hour.
Question 10. Producing goods for inventory in throughput accounting is:
- Harmful, as it ties up finance and creates no throughput until sold
- Always profitable
- Required
- Tax efficient
Show the answer
A. Investment finance has a cost.
Section B style: written questions
Question 11 (10 marks). (a) Explain throughput, investment and operating expenses. (6 marks) (b) State FOUR ways of improving the throughput accounting ratio. (4 marks)
Question 12 (15 marks). A product sells for ₦80 with materials of ₦30. Each unit needs 12 minutes on the bottleneck machine, which has 500 hours a month. Operating expenses are ₦90,000 a month.
(a) Calculate the throughput per unit. (2 marks) (b) Calculate the throughput per bottleneck hour. (3 marks) (c) Calculate the operating expenses per bottleneck hour. (2 marks) (d) Calculate the TAR. (3 marks) (e) Interpret the TAR. (2 marks) (f) Advise on THREE ways to improve it. (3 marks)
Question 13 (20 marks). A company makes A, B and C. Prices ₦500, ₦420, ₦360; materials ₦180, ₦200, ₦140; bottleneck hours per unit 0.6, 0.4, 0.3; weekly demand 2,000, 3,000, 4,000 units. Bottleneck hours available 2,400 a week. Operating expenses ₦1,200,000 a week.
(a) Calculate the throughput per unit and per bottleneck hour of each. (4 marks) (b) Rank the products and prepare the production plan. (6 marks) (c) Calculate the profit. (3 marks) (d) Calculate the TAR of each product. (4 marks) (e) State TWO limitations of throughput accounting. (3 marks)
Model answers
Show the model answer to Question 11
(a) Throughput is sales less the cost of raw materials and components, the rate at which the entity earns its goal (2). Investment is all the money tied up in stock and assets, which earns nothing until goods are sold (2). Operating expenses are all the costs of producing the throughput that are not variable materials, including labour (2).
(b) Any four: raise the selling price; reduce material cost; make the product in less bottleneck time; improve automation and resource allocation; sell more volume; reduce operating expenses (1 each).
Show the model answer to Question 12
(a) 80 − 30 = ₦50 (2).
(b) 12 minutes gives 5 units an hour; 50 × 5 = ₦250 (3).
(c) 90,000 ÷ 500 = ₦180 (2).
(d) 250 ÷ 180 = 1.39 (3).
(e) Above 1: each bottleneck hour earns more than it costs, so the product adds to profit (2).
(f) Any three: raise price; cut material cost; shorten machine time; cut operating expenses; ease the bottleneck (1 each).
Show the model answer to Question 13
(a)
- A 500 − 180 = 320
- ÷ 0.6 = 533.33 an hour.
- B 420 − 200 = 220
- ÷ 0.4 = 550.
- C 360 − 140 = 220
- ÷ 0.3 = 733.33 (4).
(b)
- Rank C, B, A (2).
- C: 4,000 × 0.3 = 1,200 hours; B: 3,000 × 0.4 = 1,200 hours; total 2,400, so no A is made (4).
(c) Throughput C 4,000 × 220 = 880,000; B 3,000 × 220 = 660,000; total ₦1,540,000; less 1,200,000 = profit ₦340,000 (3).
(d)
- Expense per hour 1,200,000 ÷ 2,400 = 500.
- A 533.33 ÷ 500 = 1.07
- B 550 ÷ 500 = 1.10
- C 733.33 ÷ 500 = 1.47 (4).
(e) Short-term focus; the assumption that all costs except materials are fixed may be wrong; relies on one clear bottleneck that may move (any two, with explanation) (3).
Pathfinder on Throughput accounting, TOC and the throughput accounting ratio
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Marginal mix for one plant, throughput accounting profitability, new plant marginal statement, break-even units and value, combined statement, RI viability.
Revise first: Layouts
Throughput accounting ratio with bottleneck, optimum mix with contract minimum, ways to raise bottleneck capacity.
Revise first: Layouts
Machine utilisation and bottleneck; marginal analysis; throughput accounting mix; TA inventory valuation; scarce resources in budgets and LP.
Revise first: Layouts
Marginal costing mix, throughput accounting ratio and mix, TA v marginal contribution.
Revise first: Layouts
TAR and profit-maximising output, advantages over marginal costing.
Revise first: Layouts
Marginal costing v throughput accounting, TAR, profit-maximising output.
Revise first: Layouts
Source: ICAN Pathfinder, Performance Management. Diets covered: March/July Diet, 2020 to May Diet, 2026. All 13 diets in the Pathfinder are mapped.
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