Theory of Constraints



The objective of this paper is to analyze both the Activity-Based Costing (ABC) and Theory of Constraints (TOC) approach together and also individually. One of the aims of manufacturing companies is to determine the right product mix and volume and indentify the critical restrictive bottlenecks of an organization. So, determining the bottlenecks and the amount of idle capacity of each non-bottleneck activity in the system is a powerful tool and gives firms a huge advantage over their competitors.

Making a product mix decisions, product price calculation, and consumers' profitability analysis are some harsh decisions that a manufacturing company should make to maximize its profit. In order to achieve this goal, a reasonable approach would be to focus on the most profitable product mix and volume for the company by using its resources to manufacture this product line. So, while following this way, company will be able to increase its profit by using its resources in most profitable way. In this way, the company may be faced with some obstacles. One of them could be to make a decision on the optimum quantity of product mix and volume to produce.

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So, in order to make the right decisions, decision making would need more precise information about the best product mix and volume, and the restrictive bottlenecks of an organization. Management can get the correct information by using the ABC method with/or TOC approach, depends on other circumstances.

Activity-Based costing can provide the desired information about the product mix, as Theory of Constraints Approach (TOC) can help the decision making to analyze the system successfully by identifying the bottlenecks that need to be removed from the system to streamline the operation.

Activity-based costing is an accounting technique that allows an organization to assign costs to products based on the resources they consume and services produced by the organization. It recognizes the causal relationship of cost drivers to cost activities by measuring the cost and performance of process-related activities and cost objects [1].

The Theory of Constraints is a management philosophy that looks at an organization as a complete and complex system that consists of any number of components that interact with one another. It aims to refine the performance of the system by looking at it as an entire system rather than treating the organization as a collection of noninteracting components [3].

Traditional costing systems, also called volume based cost systems (VBC systems), allocate costs based on actual departments or cost center which does not allow the company to receive the accurate information to make the right decision.

The real power of activity-based costing arises from its ability to support managerial decisions. Specifically, ABC generates the data necessary to support the theory of constraints [2].Therefore, according the provided information; manager should take the action on the basis of ABC approach to improve the efficiency of activities and the profitability of the product line. Moreover, another action should be taken to transfer the resources that are used for unprofitable product line to more profitable one.

On the other hand, the basic main aim of the TOC approach is to lead firm to improve its financial and operational performance without the use of product cost information. And also, another goal is to "make more money now as well as in the future" (Goldratt 1990) [4].

What is the Activity-Based Costing?

The traditional method allocates the company's indirect costs to the items that are manufactured on the basis of volume such as the number of units produced, the direct labor hours, or the production machine hours. However as the percentages of indirect had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products.

On the other hand, ABC establishes cost pools for each indentified activity and costs are allocated to those products that pass through the activity. Indirect costs which cannot be traced to each unit of product as easy as the direct cost. These indirect costs are allocated on the basis of cost drivers and those are accounted for the variability of the activity. The underlying concept in ABC method is to rest on the premise that product use activities and activities use resources.

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The cost of a product = the cost of the raw materials + the sum of the cost of all the activities required to produce that product.

So, ABC systems is able to trace costs to activities and then to products by using the multiple driver and cost hierarchies. Hence, it enables ABC approach to be more accurate relative to the traditional method. Therefore, assigning operating expenses to output on the basis of activities performed is a really good benefit for a company. Basically, it is important to point out that ABC method is a not only a strategic decision making tool; it can also be used as an operating decision technique in process improvement and product design processes. 

The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing [8]. Moreover, Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. [9]

Robin Cooper and Robert S. Kaplan also stated that ABC is a system to solve the problems of traditional cost management systems. As it was mentioned before, these traditional systems are not able to allocate the costs precisely of the production and of the cost of the related services.

In 2004, Kaplan and Anderson improved the first version of ABC method and create the second version of ABC, called time-driven activity-based costing (TDABC), in order to point out some of the practical problems faced by companies using conventional ABC. In contrast with traditional ABC systems, TDABC has at least five significant differences that will be discussed later in this paper.

ABC claims that the more accurate product cost provides the more improvement on decision making. It basically implies that cost control is the most important subject for a company. Thus, it has a better understanding in the organizations activities and their resource consumption in a business.

ABC is a two stage-stage approach similar but not as same as the traditional cost system.




In the first step, ABC assigns all costs of resources to the activities in the activity based on the resource driver. Cost of a resource or input consumed by an activity is called a cost element. And, in the second step, cost assigned to the cost pools are then assigned to the products on the basis of product's consumption of each activity and the level of activity in the ABC hierarchy.  So, the cost is directly associated with the product is called a cost object. In Activity-Based Costing (ABC) any factor which causes any change in cost is called cost driver.  An activity can have at least one cost driver or if it have more than one, it would increase the accuracy of the information. Production runs number of machine setups, number of products, and number of purchased order can be used as a cost driver.

Especially, the second step distinguishes the Activity-Based Costing from the traditional approach. As it is also seen in the Figure A, costs are allocated to products based on one cost driver in the traditional system.

In today's manufacturing environment, as it was also mentioned before, the proportion of the material cost accounts for higher percentage of the costs relative to direct labor. Hence, the product cost distortion became the problem for the traditional system. To skirt this problem, ABC is a great tool to provide accurate information to determine the components of overhead.

Concerns about adopting Activity-Based Costing;

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First, implementation of ABC is time consuming and costly. And so, it becomes a major obstacle as a result of interviewing and surveying employees to get their time allocation. Moreover, infrequently updating the system just because of the high cost causes another problem which leads inaccurate estimation of process, product, and service costs. In addition, finding additional new activities to an existing activity is difficult task to accomplish for company. Finally, while determining the cost driver rate, including the cost of unused capacity would be not relevant.

What is the Theory of Constraints?

Dr. Eliyahu M. Goldratt in his 1984 book titled, The Goal, first introduced TOC as an overall management philosophy. The TOC approach primarily seeks to focus on identify the constraint and restructure the rest of the organization around it, to improve throughput by identifying the bottlenecks in the system. A bottleneck is any condition that constrains the performance of a system relative to its goal. Moreover, managers can use the TOC method through using the five focusing steps for managing constraints and improve the system.

1. Identify the constraint (the resource or policy that prevents the organization from obtaining more of the goal)

2. Decide how to exploit the constraint (make sure the constraint's time is not wasted doing things that it should not do)

3. Subordinate all other processes to above decision (align the whole system or organization to support the decision made above)

4. Elevate the constraint (if required or possible, permanently increase capacity of the constraint; "buy more")

5. If, as a result of these steps, the constraint has moved, return to Step 1. Don't let inertia become the constraint. [6]  

The Theory of Constraints approach focuses on three measurements stated below to understand that a company is achieving the goal;

1) Throughput contribution is the difference between sales revenue less direct material. First, all bottlenecks should be determined to increase the throughput. Next step would be to enhance the system based on improving the bottlenecks in order to increase the overall process efficiency. While applying this approach, management is able to get some benefits not to put its effort trying to improve the non-bottleneck activities. ("The rate at which the system generates money through sales").

2) Inventory is defined as the material costs contained in raw materials, work-in process, and finished goods inventories. ("All the money that the system invests in purchasing things which it intends to sell"). And Goldratt also claims that excessive amount of inventory will decrease the performance of the company because it will force company to tie up its investment in the inventory, rather investing other profitable projects. Moreover, Goldratt maintains that decreasing inventory will help to decrease problems of the system to improve the overall organization.

3) Operating Expenses consist of all costs of conversion, except for direct material cost because it overlaps with throughput contribution, such as administrative expenses, depreciation, machines, and material-handling activities. ('all the money spends in order to turn inventory into throughput")[7].

Finally, TOC basically focuses on maximizing throughput, which can be raised without limit. It advocates that product costing is difficult and artificial.

ABC (Activity-Based Costing) versus TOC (Theory of Constraints)

Proponents of activity-based costing (ABC) and the theory of constraints (TOC) have been engaging in a somewhat heated debate for a long time. Even if the proponents on each side have some thoughts about superiority of one another, TOC and ABC have complementary features. TOC seeks to optimize production by managing the constraints and thus obtain higher throughput. ABC aims to increase the accuracy of product costs by a systematic allocation of costs to activities consumed by the products (Jones and Dugdale, 2002). [11]

ABC system gives visibility to how effectively resources are being used and how all activities contribute to the cost of a product. But the additional data collection resources needed to obtain cost drivers and detailed activity costs may be difficult to justify, at least for many small- to medium-sized business.

TOC systems can be much easier to implement and more appropriate tool in the short run than ABC method because TOC assumes that all costs apart from direct material are to be sunk (or fixed) with respect to product choice and production decision. So, it provides little help in the long run decision making relative to ABC approach. To improve the process with TOC approach, managers need to focus on increasing the through put by eliminating the bottlenecks and decreasing cycle time of products. Last but not least, managers haven't so much impact over adjusting operating expenses after capacity has been set.

In contrast, ABC method does not consider the short run changes such as spending or real cash saving. And so, ABC is long- term oriented and assumes that final decision will be made about less profitable products, channels, and customers. Also, ABC assumes that capacity resources can be changed by managers. On the other hand, the hardest work in ABC is to be gathered all information to record all material, labor and overhead expenses and track all these allocated costs to individual products. In other words, the ABC approach indentifies specifically all fixed and variable costs for each product. Therefore, it is complex and difficult process relative to the TOC system. ABC means redesigning a company's general accounts into activities. In sum, ABC and TOC has different time horizon for product mix and volumes. ABC is based on a long-term horizon, while TOC is based on a short-term horizon. So, while deciding the superiority of one of these, we will have to abandon one of them based on in the same time horizon, but if it is appropriate, TOC and ABC can be used as parallel systems that do not pose a choice problem. In some cases, manufacturing companies can face difficulty in making and maintaining two different product mixes, one for short and one for long term. This problem can be huge in case of contradiction of product mixes with each other.

According to proponents of ABC, TOC has some positive aspects relative to ABC approach, for example, it is less costly and easier to implement and operate. It sometimes, however, gives managers insufficient information to make decisions. So, in this paper, I would like to seek whether ABC approach is worth the cost or whether the TOC will be satisfactory to company for decision makers.

In this manufacturing environment, companies have been experiencing and trying to deal with several problems. Companies are changing with technology and becoming more information intensive. Being flexible and responding promptly to the consumer expectation is becoming more important thing which is getting hard to achieve today's environment. And so, gathering the right information about the true cost of products, services, processes, activities, distribution channels, customer segments, contracts, and projects is getting more important and harsh. Although ABC method has some concerns, using the right cost information to assign the correct product mix and volume is to be key factor for company. And, it is most likely to lead the company to make the right decisions and help to maximize its profit as well.  On the other hand, in the short time horizon, TOC is more appropriate tool, because it assumes that all costs are to be fixed except direct material.

First, we can describe that TOC is more a management thinking, instead of marginal cost calculating. But, ABC provides more accurate information on cost and gives better understanding of control of cost drivers and activities. Second, the time horizon issue between these two approaches is not clear cut in real life. It is really hard to address any period as short run or long run. And, it is not that hard to observe that any short run decision would have some implications on the long run. So, drawing the line between short run and long run decision would be another problem.


1.              John H. Sheridan, Throughput with a Capital 'T', Industry Week, March 4, 1991

2.              Spoede C., E. O. Henke and M. Umble, "Using Activity Analysis to Locate Profitability Drivers" Management Accounting, May 1994, p.43-48.

3.              Eliyahu M. Goldratt and Jeff Cox, The Goal, 2nd Revised Edition, North River Press, Croton-on-Hudson, N.Y.

4.              Goldratt, E. M. (1990). The haystack syndrome. New York: North River Press.

5.              Cox, Jeff; Goldratt, Eliyahu M. (1986). The goal: a process of ongoing improvement. [Croton-on-Hudson, NY]: North River Press

6.              Goldratt, E. M. (1992). From cost world to throughput world. Advances in Management Accounting 1,35-53.

7.              Consortium for Advanced Manufacturing-International,

8.              Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987)

9.              Sheu,H.,&Pan,C..(2009). Cost-system choice in a multidimensional knowledge space: traditional versus activity-based costing.International Journal of Technology Management,48(3),358. Retrieved March 31, 2010, from ABI/INFORM Research. (Document ID:1720790531).

10.              Namazi,M..(2009,September). PERFORMANCE-FOCUSED ABC: A THIRD GENERATION OF ACTIVITY-BASED COSTING SYSTEM.Cost Management,23(5),34-46. Retrieved March 31, 2010, from ABI/INFORM Research. (Document ID:1869942831).