the Obsolescence of Cost Accounting Systems part 7
Additional Focus Discussion Topics to Achieve a Belief Turnaround
To address the CPA’s professional conviction, financial security, and philosophical defense, the presentation must introduce the superior logic of the Theory of Constraints (TOC) and Throughput Accounting (TA) across three new focus areas:
VII: The True Nature of Scarcity—Relevance and the Limiting Factor
This topic directly addresses the CPA’s philosophical defense: that accounting must reflect the economic reality of limited resources and trade-offs.
The Problem with Conventional Costing: Acknowledge the economic principle that resources are limited. However, explain that traditional costing violates its own core management accounting principle. Every introductory management accounting textbook recognizes that when one factor limits sales (a scarce resource exists), maximizing profit requires obtaining the greatest possible contribution margin per unit of the limiting factor [Smith (1999), 268, 269, 340, 341, 375].
The Irony of Ignoring Scarcity
The core issue discussed here is the deep and ironic contradiction within traditional management practices: while all businesses operate under the basic economic principle that resources are limited, the accounting systems managers use daily actively encourage them to ignore this fact, even though introductory textbooks teach otherwise.
The Economic Reality: Resources Are Limited
The fundamental economic reality for any profit-making system, such as a company, is that resources are limited[Smith (1999), 331]. If a system had unlimited resources, it would produce an infinite amount of product and, consequently, infinite profits [Smith (1999), 331]. Because this is not the case, every real system must have at least one constraint (a limiting factor) [Smith (1999), 331].
The constraint is the factor that limits the company from reaping more profits [Smith (1999), 331]. These constraints—whether they are a specific machine's capacity, a skilled labor pool, or market demand—ultimately determine the throughput (the rate at which money is generated through sales) and the return on investment (ROI) the company will experience [Smith (1999), 331]. Managers do not have a choice in the matter; they either manage the constraints or the constraints manage the company [Smith (1999), 331].
The Management Accounting Principle Violated
The most significant failure of traditional accounting is that it violates its own foundational, long-standing principles regarding resource scarcity:
Every introductory management accounting textbook recognizes that when one factor limits sales (a scarce resource exists), maximizing profit requires obtaining the greatest possible contribution margin per unit of the limiting factor [Smith (1999), 249, 268, 269, 312, 313, 340, 341, 375].
This principle is common core curriculum in management accounting and is covered in similar verbiage in all introductory texts [Smith (1999), 312, 383]. The principle states that when one factor limits sales, the criterion for maximizing profits is to obtain the greatest possible contribution to profit for each unit of the limiting or scarce factor [Smith (1999), 312, 383].
Contribution Margin (Throughput): This term is conceptually indistinguishable from the Throughput used in the Theory of Constraints (TOC), which is defined as sales revenue minus truly variable costs (usually just raw materials) [Noreen, Smith, and Mackey (1995), 474; Smith (1999), 255].
Limiting Factor: The existence of a limiting factor negates the validity of conventional contribution or gross margin analysis and conventional relevant costing [Smith (1999), 313, 340]. The simple truth is that the existence of a limiting factor changes what is considered relevant information for decision-making [Smith (1999), 250, 313].
Despite this core teaching, traditional management accounting systems typically ignore the scarcity of resources [Smith (1999), 316]. This is considered a fundamental flaw because the constraint is what determines the future benefit the entire company will experience [Smith (1999), 251].
The Practical Consequence of Irrelevant Costing
Traditional methods fail because they do not change their premise when a constraint is present [Smith (1999), 239, 314]. Instead of focusing on the resource limit, they concentrate on allocating all costs (including fixed overhead) to every product, regardless of whether those products use the scarce resource [Johnson and Kaplan, 7, 131, 137].
Example: The Wrong Product Mix Decision
The failure to incorporate the limiting factor leads to misguided strategic decisions, especially concerning which products a company should emphasize:
Conventional Focus: Without recognizing a constraint, a manager typically looks at the conventional financial reports and pushes the product with the highest gross margin or contribution margin per sales dollar [Smith (1999), 312].
The Flawed Result: The product that is most profitable when one particular factor limits sales may be the least profitable if a different factor restricts sales [Smith (1999), 312, 384]. Conventional gross margin analysis provides an insufficient clue to profitability when limitations exist [Smith (1999), 312, 384].
Example of the Limiting Factor (A Machine Constraint): Consider a factory with a specialized machine that is the constrained capacity resource (CCR), running at its maximum limit [Smith (1999), 376].
Product Alpha has a contribution margin of £100 per unit.
Product Beta has a contribution margin of £90 per unit.
A conventional manager would promote Product Alpha because of its higher margin. However, the CCR limits the total output. The relevant question is: Which product generates the most contribution margin per unit of constraint time?[Smith (1999), 328, 384].
If Product Alpha requires 3 hours on the CCR, its return is $\text{\textsterling}100 / 3 \text{ hours} = \text{\textsterling}33.33$ per hour of constraint time.
If Product Beta requires 1 hour on the CCR, its return is $\text{\textsterling}90 / 1 \text{ hour} = \text{\textsterling}90.00$ per hour of constraint time.
In this scenario, maximizing profit requires the manager to focus all resources on Product Beta, even though its conventional margin is lower. Product Beta exploits the investment of the whole organization better [Smith (1999), 313, 384].
Failing to recognize the effect of this limited resource guarantees that companies will often choose alternatives that are less than optimal and perhaps even detrimental [Smith (1999), 418]. This is why systems like Throughput Accounting are preferred; they are designed to use this long-established management accounting principle of leveraging the scarce resource [Noreen, Smith, and Mackey (1995), 477; Smith (1999), 374].
Analogy: Traditional costing is like a traveler managing their trip using a map that shows every mile traveled (full-absorption cost), even though they are running low on fuel. The introductory textbook principle reminds them that when fuel is scarce, they should focus only on maximizing the miles per gallon (contribution margin per unit of scarce resource). By ignoring the fuel gauge (the constraint) and focusing only on total historical mileage, the traveler risks making a wrong turn that looks cheap on the map but leaves them stranded miles away from their destination.
How Cost Accounting Fails Scarcity: Conventional cost accounting (including ABC) is "insufficient" or irrelevant because it fails to consider the constraining resource when calculating relevant costs [Smith (1999), 213, 214, 269, 376]. Instead, it pretends all resources are equally scarce by allocating fixed overhead—which is usually a sunk, long-term strategic investment—to short-term unit production [Smith (1999), 309, 321, 322]. This process makes trade-offs based on arbitrary numbers rather than on the rate at which the product generates profit based on the limiting resource [Smith (1999), 375].
The Illusion of Equal Scarcity—Why Old Cost Systems Distort Reality
The statement explains that traditional accounting methods, even newer ones like Activity-Based Costing (ABC), rely on a flawed assumption: that all resources in a company are equally important and that all costs must be equally distributed among products. This fundamentally misleads managers about their company’s profitability.
The Fixed Cost Problem: Treating Long-Term Investment as Short-Term Expense
The first major flaw lies in how companies treat their large, unchanging expenses, known as fixed overhead costs:
Instead, it pretends all resources are equally scarce by allocating fixed overhead—which is usually a sunk, long-term strategic investment—to short-term unit production [Smith (1999), 309, 321, 322].
Fixed Overhead as Strategic Investment: Fixed overhead covers the massive, long-term costs required to run a business, such as rent, plant depreciation, property taxes, and salaries for support staff (like engineering, maintenance, and purchasing) [Smith (1999), 359]. These are sunk costs because they represent previous strategic investments that cannot be changed by short-term decisions about how much product to make today [Smith (1999), 289, 359, 376]. The investment was made for the long term to support the infrastructure of being in business [Smith (1999), 359].
Pretending Costs are Variable: Traditional systems, including most versions of ABC, treat these fixed costs as if they vary directly with the production of individual units [Noreen, Smith, and Mackey (1995), 558]. Cost accounting rules require these fixed costs to be applied, or allocated, to every short-term unit produced [Smith (1999), 374]. This practice pretends that all resource costs are equally scarce [Smith (1999), 321, 322, 384].
The Arbitrary Allocation: To attach these massive, aggregated fixed costs to individual products, the system uses simple, often arbitrary, allocation measures—such as direct labor hours or machine hours—that do not actually represent the true demand that a specific product makes on resources [Johnson and Kaplan, 10, 176, 188, 192]. In fact, the actual matching of expenses to products is often unknown and unknowable [Smith (1999), 376].
The Result: Arbitrary Numbers and Distorted Costs
This process, required to satisfy financial reporting rules, destroys the relevance of the numbers for managers:
This process makes trade-offs based on arbitrary numbers rather than on the rate at which the product generates profit based on the limiting resource [Smith (1999), 375].
Because fixed overhead is arbitrarily spread across products, the resulting reported "product cost" becomes distorted [Johnson and Kaplan, 10, 234]. Costs from complicated, low-volume products that require extensive support and specialized activities are often shifted onto simple, high-volume products [Johnson and Kaplan, 177, 232]. This introduces cross subsidies and distortions [Johnson and Kaplan, 220].
When managers try to make strategic decisions—like choosing which product to sell or whether to take a special order—they are forced to make trade-offs based on arbitrary numbers that do not reflect the true profitability of the product [Smith (1999), 375]. This is because the calculated cost includes irrelevant sunk costs and irrelevant allocations [Johnson and Kaplan, 13].
The Irrelevance of Cost Systems When Scarcity Is Ignored
The second, and most critical, conceptual flaw is that conventional cost systems ignore the one factor that truly limits a company’s ability to make money: the constraining resource.
Conventional cost accounting (including ABC) is "insufficient" or irrelevant because it fails to consider the constraining resource when calculating relevant costs [Smith (1999), 213, 214, 269, 376].
The Flaw of Ignoring the Constraint
The Theory of Constraints (TOC) asserts that every dependent system is limited by a constraining resource (or limiting factor)—a machine, employee, or market condition that sets the maximum pace for the entire organization's ability to generate sales (throughput) [Smith (1999), 331].
The simple truth is that the existence of this limiting factor changes what is considered relevant information for decision-making [Smith (1999), 250, 282, 283, 313, 337, 340, 375]. Because the constraint determines the future benefit the entire company will experience, information about that resource is relevant [Smith (1999), 283].
ABC’s Failure: Even Activity-Based Costing (ABC)—developed to provide more accurate cost tracing by focusing on activities—fails to overcome this fundamental limitation [Smith (1999), 284]. As typically implemented, ABC ignores the impact of the scarce resource [Smith (1999), 284].
The Contradiction: Conventional costing pretends that all resources are equally important by arbitrarily allocating fixed costs, rather than treating the constraint as the only scarce and vital resource that determines the company’s potential income [Smith (1999), 322, 384].
Maximizing Profitability vs. Minimizing Arbitrary Cost
This conceptual failure means that conventional systems systematically violate their own core management principle:
The criterion for maximizing profits when one factor limits sales is to obtain the greatest possible contribution to profit for each unit of the limiting or scarce factor [Smith (1999), 281, 335, 395].
This concept, found in every introductory management accounting textbook, dictates that the goal is not to produce the lowest-cost unit, but to maximize the rate at which the product generates profit based on how much time it consumes on the limiting resource [Smith (1999), 375, 395, 427].
Example of Suboptimal Trade-offs: Imagine a company has two products, A and B, and only one bottleneck machine that can run 10 hours a day.
A conventional cost system (using arbitrary allocations) might report that Product A has a slightly higher overall gross margin than Product B, leading management to push Product A [Smith (1999), 312].
A relevant costing approach focused on the constraint would ignore the allocated cost figures and calculate Throughput (or contribution margin) per minute of bottleneck time [Smith (1999), 335, 427].
If Product A takes 30 minutes on the bottleneck to generate £100 in Throughput, and Product B takes 10 minutes to generate £50 in Throughput, Product B is the correct choice (£5 per minute vs. £3.33 per minute).
By continuing to use arbitrary allocated cost figures, the company makes trade-offs that are less than optimal and perhaps even detrimental to the company's profitability because they fail to recognize the predictable effect of the limiting resource [Smith (1999), 418, 435]. The result is that the company operates based on irrelevant, delayed, and aggregated cost information [Johnson and Kaplan, 10, 13, 194, 218].
The TOC Solution: Focus and Leverage: The Theory of Constraints (TOC) is the practical application of the basic profit maximization principle of management accounting [Smith (1999), 333]. TOC provides the framework to identify the true constraint (which may be a policy, not a machine) and ensures that all trade-offs focus on maximizing Throughput (revenue minus totally variable costs, usually just materials) generated by that constraint [Smith (1999), 216, 235; Noreen, Smith, and Mackey (1995), 462]. This focuses the CPA's analytical skills precisely on the most critical limited resource, fulfilling the highest economic requirement.
Connecting Academic Theory to Real-World Profit
The Theory of Constraints (TOC) is a management philosophy built on one core idea: every business, regardless of its size or complexity, is limited by at least one thing—a constraint [Smith (1999), 252; Noreen, Smith, and Mackey (1995), 428].
The statements provided highlight that TOC is not a radical new theory but rather a system that finally puts into practical application a fundamental truth that has been taught in business school textbooks for decades:
The Theory of Constraints (TOC) is the practical application of the basic profit maximization principle of management accounting [Smith (1999), 298, 333].
The Core Principle of Profit Maximization
Every introductory management accounting textbook recognizes a critical truth that applies when a company cannot sell an infinite amount of product because one resource or factor limits its sales (i.e., a scarce resource exists) [Smith (1999), 235, 312, 375]:
The principle is that maximizing profit requires obtaining the greatest possible contribution margin (profit contribution) for each unit of that limiting factor [Smith (1999), 235, 312, 340, 383].
This principle teaches managers that the focus of their actions must shift away from merely lowering the average cost of a product and instead focus on how efficiently they are exploiting the single resource that controls the rate at which the entire company makes money [Smith (1999), 275, 313, 340].
TOC Provides the Practical Framework
If this concept is so well established, why do companies struggle? The issue is that traditional accounting systems, focused on reporting historical costs for external audiences (GAAP), make the practical application of this principle nearly impossible for internal managers [Smith (1999), 169, 245].
TOC provides the practical framework and methodology—the "how-to steps"—to apply this principle daily [Smith (1999), 174, 298]. The TOC framework begins with understanding the true financial measure that should be maximized when managing a constraint: Throughput.
Throughput (T): This is the rate at which the company generates money through sales [Noreen, Smith, and Mackey (1995), 470]. It is calculated as Revenue minus Totally Variable Costs [Smith (1999), 235].
Variable Cost Definition: TOC uses a very strict definition of variable costs: costs that change in a direct one-for-one ratio with volume [Smith (1999), 175, 343]. In most modern companies, the only truly variable cost is raw materials [Noreen, Smith, and Mackey (1995), 450, 471; Smith (1999), 345]. Costs like direct labor are typically considered fixed (Operating Expenses) in the short term, as workers are rarely laid off or hired for minor production swings [Smith (1999), 345; Noreen, Smith, and Mackey (1995), 476].
By focusing on Throughput, TOC provides a clearer picture of profitability than older methods like absorption costing, which inflate product costs by adding irrelevant fixed overhead [Smith (1999), 242; Noreen, Smith, and Mackey (1995), 449].
Identifying the Critical Constraint and Focusing Analytical Skills
TOC's framework is successful because it forces the organization to look past misleading measures and pinpoint the true limited factor that must be leveraged for profit.
TOC provides the framework to identify the true constraint (which may be a policy, not a machine) and ensures that all trade-offs focus on maximizing Throughput (revenue minus totally variable costs, usually just materials) generated by that constraint [Smith (1999), 216, 235; Noreen, Smith, and Mackey (1995), 462].
Beyond the Physical Constraint
The constraint is the factor that limits the company from reaping more profits [Smith (1999), 252, 428]. While this constraint may be physical (like a slow machine or limited testing capacity), TOC recognizes that the constraint is often non-physical:
Policy Constraints: Most constraints are not physical limitations but are limitations created because of beliefs or policies about how resources must be managed [Smith (1999), 177, 216]. For instance, a policy dictating that a machine must maximize its local efficiency might lead to overproduction, which clogs the system and harms total output—the policy itself is the constraint [Smith (1999), 222, 224].
TOC uses tools to expose erroneous policies and measures that limit a company’s ability to maximize output [Smith (1999), 270].
Focusing on the Highest Economic Requirement
Once the constraint is identified, whether it is a policy or a machine, all management effort and decision-making must be subordinated to maximizing the benefit derived from that constraint [Smith (1999), 174, 179]. This is the crux of the highest economic requirement:
This focuses the CPA's analytical skills precisely on the most critical limited resource, fulfilling the highest economic requirement [Smith (1999), 216].
When a scarce resource exists, maximizing profit means obtaining the greatest Throughput per unit of that scarce resource [Smith (1999), 175, 235, 451]. This measurement is paramount for making sound business decisions:
Product Emphasis: Management must evaluate product profitability not by its raw sales margin, but by the ratio of Throughput dollars generated per minute of time consumed on the constraint [Smith (1999), 328, 375, 395]. This prevents managers from pushing a product that looks profitable on paper but actually ties up the system’s most valuable resource for too little return [Smith (1999), 312, 384].
Investment Decisions: The opportunity cost of using the constrained resource provides the measure of the value of elevating the constraint [Noreen, Smith, and Mackey (1995), 443]. Analytical skills are focused on determining if the benefit of buying more capacity (elevating the constraint) exceeds the cost, thereby ensuring capital investment decisions are aligned with maximizing ROI [Noreen, Smith, and Mackey (1995), 444; Smith (1999), 195].
TOC simplifies the complex environment so that management can focus its resources where they will yield the greatest impact on total company profits, leading to predictable financial results that can be communicated quickly and easily throughout the organization [Smith (1999), 253, 360; Noreen, Smith, and Mackey (1995), 471]. This strategic focus ensures that local actions taken by managers leverage the organization’s overall Return on Investment (ROI) [Smith (1999), 195].
Analogy: If running a marathon, the fundamental rule is that your overall speed is determined by the slowest runner in your group (the constraint). Traditional accounting is like measuring the average cost of every pair of shoes worn by the runners. TOC, however, applies the true management principle: it identifies the slowest runner (the constraint, whether that runner is physically limited or being held back by a flawed belief about their pace) and ensures that all resources are dedicated to maximizing the speed of that specific runner. All decisions—like whether to carry water for that runner (Throughput) or if a strong runner should slow down (subordination)—are evaluated based only on how they impact the total time of the slowest runner, fulfilling the goal of finishing the race as quickly as possible.
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