Understanding Throughput Accounting

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The following article is relevant to all the subjects related to Cost Accounting especially with Throughput accounting as part of their syllabus. For example, ACCA F5. Though this article is written keeping ACCA F5 syllabus in consideration, it can be used by the students of other professional qualifications as well.

ACCA F5 students, especially, can make this article as part of their notes as author attempted to touch every possible requirement of the syllabus regarding Throughput Accounting. This article also includes summary steps that are perfect for revision of this topic during the preparation of ACCA F5 exams.

1 | Why Throughput accounting?

Well its an obvious question that when we already have Absorption and Marginal cost accounting techniques and are helping managers in decision making process why we need yet another? And if we do need then we must first of all know the deficiencies of the older techniques as compared to the new one.

1.1 | Traditional techniques Basic flaw

Here when I will be saying traditional costing techniques then I will mean both absorption and marginal costing. Also to my mind marginal costing is not a modern technique any more as we cannot call it modern just because it came after absorption costing.

In traditional costing methodologies, the emphasis was on maximizing profit WITHOUT considering generation of profit.

1.2 | Why it was a flaw?How this problem got in the seed of traditional techniques

Few hundred years back when manufacturers were far less and a large group of consumer used to depend on these manufacturers. Now small number of manufacturers mean almost no competition at all and this also implies not so many choices to customers as they will have to buy goods from the same manufacturer i.e. Monopoly.

Now, as customers are depending on the manufacturer (instead of manufacturers depending on customers which is a present day situation), manufacturer would have never thought about losing the customers to another manufacturer. Therefore, it was really easy for manufacturer to decide about prices himself without even considering its affect on demand and customers as customers will have to buy from this very person.

Because of this monopolistic economy, manufacturers were not even worried about the cost that they are incurring as they knew that what ever cost they are going to incur they just have to add their desired profit in the total cost and there you have a selling price. This technique of setting prices is called cost plus pricing.

In such economic system, manufacturers had no problems regarding cash flows and they would have never thought their sales are going to decrease due to any reason at all as their sales are promised and they knew their goods will be sold irrespective of price charged.

So, problems of cash generation remained out of the scene until the end of this monopolistic system and the only challenge for the manufacturers was maximization of profit and the most simplest solution they had to maximize the profit was: Produce more unit to earn more profit!

Or if we make it more precise then it can be summed up as: Produce more and earn more profit by charging higher prices!

1.3 | End of monopolistic system Beginning of new problems

The day manufacturers start getting competitors in the market, the dependency of consumers on just one manufacturer starts getting diluted and slowly and gradually, consumers became aware (market knowledge) that as they have the alternative goods (substitutes) in the market then they can choose between the manufacturer and can buy items from such manufacturer who is offering lesser prices.

Thus a new era of markets started and the system of monopoly starts fading. With every additional manufacturer in the market offering similar items, the market became more and more competitive or in other words consumers started getting more and more choices and ultimately manufacturers were unable to control and decided about the prices on their own

2 | Throughput AccountingA new dimension

After the managers recognized the weaknesses in the traditional techniques, as it was not coping up with the emerging perfectly competitive market i.e. environment of perfect competition, they found old techniques are not helping much in pricing decisions as they were  unable to add up the affect of customer’s will to buy products.

This is where a new technique which also considers the affect of customers’ will to buy products. As now we can understand that by merely producing items and having them in the store in the finished goods form does not promise profits. We earn profits ONLY when goods change hands i.e. actual sales take place.

And that is also the meaning of the word throughput. Under this technique we do not emphasize on increasing profit, instead we emphasize on generation of cash inflows by increasing sales which will automatically push profits to increase.

For some this shift might not be of much importance as increasing sales means increasing profit. But it is certainly not the same as when we want to increase the sales we have to deal with lot of other things also which we never even consider while increasing profit.

One possible example is as follows to understand this shift from increasing profit to increasing throughput (sales).

We all can understand that total revenue can be calculated using the equation:

Revenue = Quantity Demanded × Per unit Price

Keeping above equation in mind, if we consider only to increase profit (which was the case in old days) then total Profits can be increased by either increasing the number of units sold OR by increasing per unit profit i.e. by increasing per unit price but that is easily possible only if there is just one manufacturer in the market as customers has no other option.

But in the market where more then one manufacturer are selling the same and then you cannot do either of these easily. Why? Because if you are going to increase the per unit price then customers will switch to other manufacturers as they will be able to buy the same thing at cheaper rates. Therefore, increasing price will not give you more profits as units will decrease. And also, quantity sold cannot be increased if you are not decreasing price as customers need reason to buy things from you.

Thus, we understood that without increasing sales we cannot increase profits. And this is what we did. We changed our preference from increasing profits to increasing sales.

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