the Obsolescence of Cost Accounting Systems part 6
VI. Conclusion: The Required Shift in Focus
A. The Need for Separate, Focused Systems
Throughput Accounting as the Internal Solution
The basic theory in Throughput Accounting (TA) mirrors the direct costing and incremental costing taught in traditional management accounting [Smith (1999)].
TA, where typically only material is considered a variable cost, is preferred because it does not create incentives to build up inventories and is considered more useful in decisions [Noreen, Smith, and Mackey (1995)].
TA focuses on maximizing Throughput, decreasing Operating Expenses, and decreasing Investment[Noreen, Smith, and Mackey (1995)].
Throughput Accounting – A Simple, Focused Approach to Profit
Throughput Accounting (TA), the financial component of the Theory of Constraints (TOC), is a system designed to measure and guide a company’s performance based on its entire operating system, rather than measuring small parts in isolation [Noreen, Smith, and Mackey (1995), 438].
Mirroring Traditional Concepts
The first key point is that the underlying concepts of TA are not revolutionary new ideas, but rather a focused return to simple, logical rules taught in introductory business courses:
The basic theory in Throughput Accounting (TA) mirrors the direct costing and incremental costing taught in traditional management accounting [Smith (1999), 307, 366, 394].
Direct Costing and Relevant Costing: Throughput accounting is essentially the same as direct costing or variable costing, concepts commonly defined in managerial accounting textbooks [Smith (1999), 394]. This traditional method has been advocated for decades as a preferable internal reporting alternative to absorption costing (the method required for external financial statements) [Noreen, Smith, and Mackey (1995), 459].
Furthermore, TA’s method of determining which costs matter for a decision mirrors relevant cost analysis, a standard management accounting tool [Noreen, Smith, and Mackey (1995), 487]. Relevant costing aims to identify only the future costs and revenues that will actually change based on alternative actions [Smith (1999), 251]. In TA, this relevancy is centered squarely on the organization’s limiting factor or "scarce resource," which management textbooks agree should dictate profit maximization [Smith (1999), 250, 308].
The Three Core Building Blocks of TA
Throughput Accounting uses three key measurements to determine and evaluate the financial health of the business [Noreen, Smith, and Mackey (1995), 470, 454]:
TA focuses on maximizing Throughput, decreasing Operating Expenses, and decreasing Investment [Noreen, Smith, and Mackey (1995), 454, 470].
Throughput (T): This is the rate at which the system generates money through sales [Noreen, Smith, and Mackey (1995), 470]. It is calculated as Revenue less Truly Variable Costs [Noreen, Smith, and Mackey (1995), 471]. Throughput is conceptually indistinguishable from the traditional contribution margin [Noreen, Smith, and Mackey (1995), 474].
Operating Expenses (OE): This includes all the money the system spends in turning inventory into throughput [Noreen, Smith, and Mackey (1995), 471]. These are costs necessary to run the factory (like salaries, rent, and utilities) that do not change based on short-term production volume [Smith (1999), 337].
Investment (I) (or Assets): This is all the money the system invests in purchasing things it intends to sell, primarily inventory, equipment, and other assets [Noreen, Smith, and Mackey (1995), 470, 473].
The Strict Definition of Variable Cost
TA distinguishes itself in practice from conventional variable costing by defining "truly variable costs" very strictly:
TA, where typically only material is considered a variable cost... [Noreen, Smith, and Mackey (1995), 450, 471].
In TA, a truly variable cost is one that changes in a direct one-for-one ratio with a change in volume [Smith (1999), 255, 397].
Materials: Raw materials are almost always included as the primary variable cost [Noreen, Smith, and Mackey (1995), 471].
Direct Labor: Direct labor is generally excluded from variable costs and treated as a fixed Operating Expense [Noreen, Smith, and Mackey (1995), 475, 476; Smith (1999), 397]. This is because in modern companies, labor is fixed in the short term—workers are paid a salary or hourly wage regardless of minor production volume swings, and managers avoid layoffs [Noreen, Smith, and Mackey (1995), 476; Smith (1999), 399]. Exceptions are made only when labor is paid based on piece rate [Smith (1999), 255, 399].
Why TA is Preferred and How it Changes Behavior
The emphasis on these three measures (T, OE, I) is preferred because it solves a chronic strategic problem created by traditional cost accounting and focuses management effort on actions that are good for the whole company [Noreen, Smith, and Mackey (1995), 450].
Eliminating the Inventory Trap
TA... is preferred because it does not create incentives to build up inventories and is considered more useful in decisions [Noreen, Smith, and Mackey (1995), 450].
Traditional absorption costing (required for external reporting) requires fixed overhead costs to be assigned to every unit produced, which means those costs are capitalized as an asset in inventory until the product is sold [Noreen, Smith, and Mackey (1995), 447; Smith (1999), 398, 404]. This perverse structure gives managers a strong incentive to overproduceinventory because the fixed costs are removed from the income statement, falsely boosting reported short-term profit [Noreen, Smith, and Mackey (1995), 447, 448].
TA removes this distortion entirely [Noreen, Smith, and Mackey (1995), 450].
Inventory is an Asset Drain: Under TA, inventory is valued only at the truly variable cost (materials) [Noreen, Smith, and Mackey (1995), 473, 477]. All fixed overhead costs are expensed immediately as Operating Expenses in the period they occur [Smith (1999), 398].
No Profit Manipulation: Since fixed costs cannot be hidden in inventory, TA prevents the manipulation of reported earnings [Smith (1999), 335, 340]. The reported profit is closer to a cash flow concept of income [Noreen, Smith, and Mackey (1995), 450, 480].
Better Decisions: Managers are not rewarded for building inventory; they are rewarded for selling it (increasing Throughput) [Smith (1999), 348]. The simple truth is that "Building inventory is not the goal; throughput is" [Smith (1999), 335].
Driving Strategic Focus
By focusing management attention on T, OE, and I, the Theory of Constraints ensures that local actions align with the global goal of maximizing profit and return on investment (ROI) [Smith (1999), 272, 428].
TOC practitioners prioritize increasing Throughput and decreasing Investment over cutting costs [Noreen, Smith, and Mackey (1995), 454].
Investment: Reducing inventory (Investment) is prioritized because excessive work-in-process inventories are considered major operating problems that increase cycle time and camouflage problems [Noreen, Smith, and Mackey (1995), 468, 449].
Throughput: Since operating expenses are largely fixed, maximizing profit is achieved by maximizing the rate at which money comes into the system (Throughput). This means management focuses on maximizing the contribution margin per unit of the scarce resource [Noreen, Smith, and Mackey (1995), 452, 458]. This focus ensures that the most profitable products (those that earn the most money per minute of bottleneck time) are prioritized, leading to optimal product emphasis and pricing decisions [Smith (1999), 409].
Example (Pricing Flexibility): When a company converts to Throughput Accounting, its reported margins are much larger than under absorption costing because less cost is assigned to the product [Noreen, Smith, and Mackey (1995), 482, 455]. This provides management with greater pricing flexibility [Noreen, Smith, and Mackey (1995), 455, 482]. Managers understand that anything above the truly variable materials cost (positive Throughput) is acceptable if there is idle capacity, allowing them to accept seemingly "low-price" orders that contribute cash flow without harming the system [Noreen, Smith, and Mackey (1995), 538]. This is considered more useful for decision-making than traditional methods that would incorrectly reject such profitable orders because the fully allocated cost was not covered [Noreen, Smith, and Mackey (1995), 488].
The entire goal of TA is to make the system simpler and more transparent, using concepts like direct costing to enable managers to focus and leverage their efforts where they will generate the highest return for the company as a whole [Smith (1999), 272, 323, 428].
The Principle of Separation
It is a widespread misconception that the same information used for Generally Accepted Accounting Principles (GAAP) must be used to make management decisions [Smith (1999)].
The organization must realize that GAAP compliance and throughput accounting are both necessary conditions for successful business operation [Smith (1999)].
A reconciliation bridge should be used: maintain systems on a Throughput Accounting basis for internal management, and convert using a simple month-end reconciliation to satisfy GAAP for external reporting [Smith (1999)].
Why Management Needs Different Numbers than the Auditors
The central issue in modern corporate accounting is a widespread and costly misunderstanding about what internal management reports should measure:
It is a widespread misconception that the same information used for Generally Accepted Accounting Principles (GAAP) must be used to make management decisions.
This belief, which assumes that "integrated" financial and management systems are necessary, is actually a recent historical development. Historically, management accounting systems were developed solely for internal use, separate from financial reporting. It was only in the past 60 to 70 years that external auditing and financial reporting demands took over the design of internal systems.
Why GAAP Numbers Fail Managers
GAAP, which dictates how costs are calculated for external reports (like inventory valuation for the balance sheet), requires cost information that is objective, verifiable, and consistent. It is designed to report historical events.
For internal managers, these historical numbers are insufficient and misleading for several reasons:
Too Slow and Aggregated: The internal accounting information is often driven by the monthly or quarterly financial reporting cycle. Operational actions that managers need to control (like utilization and quality) occur daily, but the cost reports arrive too late and at too high a level (aggregated) to help managers solve real-time problems.
Too Distorted and Inaccurate: The cost figures are required to be "fully absorbed," meaning fixed manufacturing expenses are spread across all products using simplistic and often arbitrary allocation methods (like direct labor). This systematically biases the reported cost of individual products. For financial auditors, it doesn't matter if the individual product costs are distorted, as long as the total inventory value is consistent with historical ledgers. For a manager, however, this information is inaccurate for product costing (e.g., pricing or deciding which products to emphasize).
Encourages Bad Behavior: GAAP's method of valuing inventory (absorption costing) actually creates incentives to build up inventory to artificially inflate reported profit, which compromises the long-term economic health of the firm.
Because GAAP information is too late, too aggregated, and too distorted, relying on it for internal planning and control means managers are "unwittingly courting trouble".
The Necessity of Two Systems
Despite the deep flaws of GAAP data for internal use, GAAP compliance is not optional. It is a necessary condition for companies to do business successfully in the U.S.. Therefore, organizations face a fundamental dilemma, known as the "accounting dilemma": they need external compliance, but they also need relevant internal information:
The organization must realize that GAAP compliance and throughput accounting are both necessary conditions for successful business operation.
The solution lies in acknowledging that the system used for external reporting (GAAP/absorption costing) and the system used for internal decisions (Throughput Accounting/direct costing) must coexist, but they do not have to be integrated into one flawed system.
The Solution—Building the Reconciliation Bridge
The goal is to provide managers with timely, relevant information that drives profitable behavior, while still meeting external compliance demands. This is achieved by separating the primary functions and using a simple conversion tool: the reconciliation bridge.
A reconciliation bridge should be used: maintain systems on a Throughput Accounting basis for internal management, and convert using a simple month-end reconciliation to satisfy GAAP for external reporting.
1. Maintain Internal Systems on Throughput Accounting (TA)
Throughput Accounting (TA), which mirrors widely accepted management accounting concepts like direct costing and relevant costing, is designed specifically to provide relevant information for decision-making.
Focus on Relevant Costs: TA is preferred because it strictly defines variable costs (typically only raw materials) and expenses all fixed overhead costs immediately as Operating Expenses. This removes the distortion caused by arbitrary fixed-cost allocations.
Aligns Behavior: TA avoids the "inventory trap" because fixed costs cannot be hidden in inventory. Managers are rewarded for maximizing Throughput (sales), not maximizing efficiency by building unwanted stock. This helps align measures with the global goal of the company.
Emphasizes the Constraint: TA's profit maximization philosophy is rooted in acknowledging the existence of a limiting factor or scarce resource. This constraint changes what information is considered relevant. By using TA, managers are forced to prioritize products that generate the highest profit per unit of constraint time.
2. The Simple Month-End Reconciliation Bridge
Instead of using a complicated, integrated system, the simpler solution is to use the direct costing information at month-end and convert it to absorption costing using a simple bridge calculation. This reconciliation process is already routine for small accounting firms.
Example: The Timing Difference
The difference between TA net profit and GAAP absorption costing net profit is simply a timing difference in recognizing fixed manufacturing overhead costs.
TA (Internal View): Fixed overhead is expensed right away, making the internal profit figure a close proxy for cash flow.
GAAP (External View): Fixed overhead is calculated, assigned to products, and capitalized as inventory. It is only expensed when the product is sold.
The reconciliation bridge uses a calculation to determine the change in the value of fixed costs (labor and overhead) embedded in the inventory between the beginning and end of the month. By adding this change in fixed cost value to the TA income statement, the financial statements for both methods arrive at the same final total profit figure, thereby satisfying GAAP requirements.
This approach allows the management team to use internal systems that are simple, effective, elegant, and inexpensiveto make real-time decisions, while the accounting department maintains compliance for external stakeholders with a routine calculation. It allows the company to focus and leverage its operations for profit, which is the only sound approach to management decisions.
Focus and Leverage
The ultimate goal is to provide managerial performance measures that appropriately reflect the technology, products, processes, and competitive environment [Johnson and Kaplan].
The Theory of Constraints provides the framework to align management with the global goal by ensuring that all actions focus and leverage the system's constrained resource [Smith (1999)].
The challenge of designing new management accounting systems is too important to be left to accountants alone, requiring the active involvement of engineers and operating managers [Johnson and Kaplan].
Designing Performance Measures for the Real World
For a company to succeed in the modern competitive environment, its internal measurement systems must accurately reflect the complex reality of its operations, products, and markets, a task that old accounting methods fail to achieve.
The Need for Relevant Performance Measures
The first statement emphasizes that management’s targets must match the company’s real operational context:
The ultimate goal is to provide managerial performance measures that appropriately reflect the technology, products, processes, and competitive environment [Johnson and Kaplan, 12, 121, 234].
In the past, accounting systems were designed to coordinate activities in simpler, vertically integrated firms [Johnson and Kaplan, 12, 19, 107]. However, today’s environment features vigorous global competition, rapid technological change, complex production processes, and highly diverse product lines [Johnson and Kaplan, 4, 13, 25, 257]. Traditional measures—often focusing narrowly on monthly profits or return on investment (ROI) derived from external reporting rules—are inadequate and misleading in this complexity [Johnson and Kaplan, 8, 12].
When management relies exclusively on outdated financial measures, they become isolated from the real, value-creating operations of the organization and fail to recognize when those numbers cease to provide relevant or appropriate measures of performance [Johnson and Kaplan, 12]. The management accounting system serves as a vital communication link, and when it fails to provide the relevant set of measures, managers receive misleading signals that undermine product development, process improvement, and marketing efforts [Johnson and Kaplan, 12, 15].
Example of Irrelevance: A typical cost system might focus narrowly on maximizing labor efficiency or machine utilization in every department [Smith (1999), 382]. This measure is inappropriate because direct labor is often an insignificant fraction of total costs in modern automated environments, and overhead allocation based on labor is arbitrary and distorting [Johnson and Kaplan, 9, 10]. A relevant measure, by contrast, would reflect the fact that the company’s success depends on the efficient use of its expensive, sophisticated equipment (technology) and its ability to rapidly satisfy diverse customer demands (competitive environment) [Johnson and Kaplan, 12, 13].
The Theory of Constraints: A Framework for Alignment
The Theory of Constraints (TOC) provides the necessary conceptual model to align management actions with the strategic success of the entire organization:
The Theory of Constraints provides the framework to align management with the global goal by ensuring that all actions focus and leverage the system's constrained resource [Smith (1999), 267, 270, 323, 347].
TOC is based on the idea that every interdependent system (such as a company) has at least one limiting factor or constraint that determines the overall performance and profit of the entire organization [Smith (1999), 270, 346]. Because the constraint determines the future benefit the entire company will experience, the existence of a constraint changes what is considered relevant information for decision-making [Smith (1999), 266, 267, 328].
TOC guides management on where and how they should focus resources to leverage return on investment (ROI)[Smith (1999), 291, 447]. This framework demands that management define a global goal for the company (usually maximizing throughput/profit) and ensures that all other local actions—such as a machine manager's decision or a purchasing department's policy—are subordinate to exploiting that single, most critical, constraining resource [Smith (1999), 270, 275, 323]. This focus on the constraint helps resolve chronic conflicts between departments caused by competing local measures [Smith (1999), 277].
Example of Leveraging the Constraint: If a specific machine (the constraint) is the only thing limiting the company from producing more salable product, then managerial measures must prioritize the uptime and efficiency of that machine above all others [Smith (1999), 318, 383]. A manager making a product mix decision would choose the product that generates the highest contribution margin (Throughput) per minute of time on the constraining resource—not the product that appears to have the lowest unit cost or the highest gross margin overall [Smith (1999), 328, 395]. This is how TOC ensures actions align with the global goal [Smith (1999), 277, 323].
The Critical Need for Cross-Functional Expertise
Given the complexity of modern technology and the systemic nature of performance issues, the sources conclude that designing effective performance measurement systems requires expertise that extends beyond the accounting department.
The challenge of designing new management accounting systems is too important to be left to accountants alone, requiring the active involvement of engineers and operating managers [Johnson and Kaplan, 239].
The problems that plague corporate measurement systems are more behavioral and systemic than they are strictly technical [Smith (1999), 264]. Even though technological barriers to creating complex, accurate systems have been removed by modern computing capabilities, the underlying conceptual flaws and misaligned incentives remain [Johnson and Kaplan, 16, 17].
Historically, cost accounting systems were designed by managers and engineers to facilitate the management of processes and the efficiency of labor and material consumption [Johnson and Kaplan, 10, 21, 39, 41]. Cost accounts were created to aid management decisions, such as pricing, and were separate from the financial statements [Johnson and Kaplan, 22]. However, over the last half-century, the design of internal cost systems was yielded to financial accountants and auditors, prioritizing external reporting over internal relevance [Johnson and Kaplan, 26, 27].
Why Collaboration is Essential
The challenge of redesigning management accounting systems is immense, requiring collaboration between those who understand financial objectives and those who understand operational reality [Johnson and Kaplan, 238].
Engineers and Operating Managers: These professionals understand the technology, products, and processes—the true economic and technical realities of production [Johnson and Kaplan, 9, 13]. They know the actual demands products place on resources (the cost drivers) and the operational consequences of local decisions [Johnson and Kaplan, 9, 238]. Engineers, in particular, were responsible for early innovations in standards and efficiency measurements that formed the basis of early cost management systems [Johnson and Kaplan, 22, 46].
Accountants: Accountants understand the financial constraints, the requirements for external reporting (GAAP), and the methods for compiling and reporting financial results [Smith (1999), 279, 369]. However, they often lack the training or methodology to design systems that emphasize relevant management information [Smith (1999), 284]. Furthermore, many accountants who provide cost information often do not understand the consequences to global operations of focusing on local optimization measures [Smith (1999), 283].
To design a system that truly reflects the company's technology and processes, management accountants must work closely with design and process engineers, operations managers, and product and business managers [Johnson and Kaplan, 238]. Without the active involvement of engineers and operating managers, the new system will likely repeat the errors of the past, failing to provide useful signals for measuring the efficiency of processes and the profitability of products, thereby compromising the strategic success of the organization [Johnson and Kaplan, 236, 239].
The ultimate necessity is to align measures, work practices, and reporting to reinforce the profitable behavior the company is seeking [Smith (1999), 280]. This goal is only achievable when all functions contribute to creating a set of performance measures that are coherent, timely, and strategically relevant to the organization’s overall goals, as defined by the leverage points (constraints) identified through TOC [Smith (1999), 277, 323].
Beyond the Intellect, here is the emotion
Given the deep institutional, professional, and financial investment a CPA has in the existing accounting paradigm, simply presenting a critique of historical methodology is likely insufficient to effect a "turnaround" in belief.
We indicate that management accounting systems have been co-opted by financial reporting rules (GAAP), leading to a system that is mandatory for external reports but dysfunctional for internal decisions [Johnson and Kaplan, 6, 7; Smith (1999), 212, 368]. The CPA's success is rooted in the very system you seek to dismantle.
Therefore, to persuade a successful CPA, the discussion must pivot from merely identifying faults to demonstrating an equally rigorous, practical, and defensible alternative that directly addresses the CPA's core professional and philosophical assumptions.
Evaluation of the Six Focus Topics
The above six focus discussion topics provide the necessary intellectual foundation by documenting the historical loss of relevance and the technical faults of cost accounting [Johnson and Kaplan, 3, 7, 131, 144]. They are critical because they:
Challenge the Authority: They establish that the obsolescence of current systems is not a revolutionary idea but a regression from the highly relevant management accounting practices that existed before 1925 [Johnson and Kaplan, 3, 14, 12].
Expose the Technical Flaw: They prove that cost accounting systems systematically bias and distort costs of individual products due to arbitrary, simplistic allocation measures (like direct labor) [Johnson and Kaplan, 7, 145].
However, these points alone are unlikely to convince the CPA because:
Institutional Inertia: Cost accounting is firmly entrenched, used for training all accounting personnel, and is mandated by government organizations (SEC, IRS) [Smith (1999), 226, 307, 368]. The CPA's compliance and clean audits are necessary for the firm's survival [Smith (1999), 281].
Perceived Lack of Alternatives: The CPA likely believes that traditional cost accounting, though flawed, is the only methodology available to control costs, especially in complex environments, or that alternative methods are too costly or technically difficult to implement [Smith (1999), 228, 318].
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