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Management Accounting Systems
Execut ive Summary
The companys prof its are f alling and there is a build up of inventory within the production process. This
report considers three management systems which could rectif y the situation. Considering Theory of
Constraints, Just In Time and Programme Evaluation and Review Technique, the report recommends that
more inf ormation regarding the cause of the problems is undertaken, and a suitable programme of
revaluation of the business processes is undertaken.
Int roduct ion
The role of management accounting in the organisation has become so much more that the reporting of the
score to managers (Hansen, Mouritsen 2006). In the wake of the decline of Western Manuf acturing and the
relevance crisis of management accounting to modern business as outlined by Kaplan and Johnson in
Relevance Lost, the traditional cost accounting approach has been largely replaced by alternative
methodologies (Kee, Schmidt 2000). The role of the management accounting in the modern f irm is not only
to report the score, but to seek to inf luence the score by using techniques and theoretical approaches to
improve the business processes. As such it is important f or managers to understand the use and
usef ulness of a variety of alternatives to traditional accounting approaches, especially traditional cost
accounting and look to introduce other techniques which may have practical advantages f or the f irm
(DUGDALE, JONES 1998). There is no one size f its all approach which will work in any case and the
application of cost accounting can and will always provide key inf ormation about how the business is doing
in terms of its goals. Indeed many of the newer techniques f ocus on particular applications within industry
and each of them has something to of f er the f irm in terms of improving the business processes (Plenert
1993). This report considers three approaches in the context of practical application to a range of common
problems, problems which may be responsible f or the inventory build up of the f irm in question and its
declining prof its. The approaches are the Theory of Constraints (TOC) and the attendant logic of
Throughput Accounting (TA), Just in Tim Inventory Management (JIT) and wider implications to Lean
manuf acturing methodologies and the Program Evaluation and Review Technique f ramework (PERT). The
report outlines the main f eatures of these methodologies and the advantages and limitations of them with
specif ic ref erence to their usef ulness in a variety of practical situations. The report concludes that each of
the methodologies has something to of f er and that any management decision must be based on the goals
and objectives o the company and its strategic direction.
Theory of Const raint s and Throughput Account ing
Developed by E.M. Goldratt as a response to the criticisms of traditional cost accounting, the TOC states
that the traditional variable costs of Cost Accounting do not apply, or rather, they apply with less rigour in a
modern management situation (Bragg 2007). In the past Labour was seen as a totally variable cost, workers
would work to the managements discretion and short time and layof f s were dictated by the level of
production need. Goldratt argued that this was no longer the case as changes to society and legislation had
meant that the workf orce was more of a f ixed cost f or the organisation (Wei, Liu et al. 2002). The TOC
states that even though modern managers are still evaluated by labour use, such ef f iciencies can lead to
decisions which harm the organisation rather than help optimise production. This criticism led Goldratt to
develop the TOC as an alternative system, identif ying constraint as a decision relevant concept in the
service or production process (Watson, Blackstone et al. 2007).
The central idea to TOC and TA is that each organisation has a specif ic goal (or a set of specif ic goals)
which can be ef f ected by decision making, better decision making leads to better completion of the goals
(Linhares 2009). If one takes the normative assumption of a prof it orientated organisation as the
maximisation of the owners wealth, then the goal unit will be the throughput contribution (TC) which is
similar to the total contribution marginal costing (Hansen, Mouritsen 2006). The dif f erence in TA is that
throughput contribution is def ined in the TOC as Sales (S), less total variable cost (TVC) which is he cost
of raw materials (not labour). This is placed in the context of two f urther conceptual mechanisms,
Investment (I), which ref ers to money tied up in the system in terms of inventory and work in progress, as
well as with machinery and buildings and the like, the second is Operating Expense (OE) which is the money
spent by the system on generating goal units, but not the cost of raw materials, so items such as utilities
and wages (Davies, Mabin et al. 2005).
This delineation of the costs of production and services allows the processes to be viewed in terms of a
number of optimization questions. Typically f irms need to ask themselves how throughput (TC) can be
increased, how Investment (I) can be reduced and how Operating Expense (OE) can be reduced. These
questions in turn will af f ect the Net Prof it, Return on Investment, Productivity and Investment in the
f ollowing ways;
<Fig>
Theref ore it can be argued that the maximisation of throughput contribution is key to the maximisation of all
of the above key perf ormance indicators. The f irm can seek to maximise TC by optimising a number of
aspects of the production processes. There are f ive common steps associated with this process;
Identif y the system constraints
Exploit the system constraints
Subordinate everything else to the decisions made
Elevate the systems constraints
Restart the process if a constraint has been broken
The f ollowing example illustrates the process.
Company A has two workers and produces two products (Workers, A,B, Products X & Y). Product Y Requires
ten minutes of Worker As time, and product X requires f if teen minutes. Potential demand f or X is 100 units,
f or Y is 50 units. If the total time available to worker A is 2000 minutes per week Worker A is not a constraint
as the total time to manuf acture both products is equal to the total available time (15 minutes x 100, 10
minutes x 50 = 2000 minutes). Worker B also works on the two products but takes 15 minutes on both
products (15 minutes x 100, 15 minutes x 50 = 2250), assuming that Worker B has the same maximum time
available (2000 minutes) there is a constraint around Worker B. Thus the constraint has been identif ied.
Step two seeks to exploit the constraint. Concentrating on Worker B as this is where the constraint occur,
the exploitation of the constraint means the company (according to its goal of maximising wealth) needs to
make a decision based on how to allocate production. To do this the managers need to know what the
Throughput Contribution is f or each unit. Assume that TC f or product X is 75 per unit and f or product Y it
is 120 per unit. The constraint here is time, measured in units of a minute, theref ore the TC per unit of
constraint is f ound by dividing the TC by the time taken with each worker, at the point of constraint this is as
f ollows (X, 75/15 = 5, Y, 120/15 = 8.33), as there are only 2000 minutes available the TOC suggests that
all 50 units of product Y should be produced with a total time taken of (50 x 15 = 750, TC = 8.33 x 750 =
6247.5) leaving 1250 minutes to produce product X (TC 1250 x 5 = 6250). Net prof it will theref ore be
(6247.5 + 6250 = 12497.5). In this example this is how the TOC makes all other considerations subordinate
to this decision.
TOC does have its problems, it makes many of the normative assumptions about the behaviour of costs
that traditional cost accounting does, and largely ignores costs of changing the activities of many of the
business processes to suit a particular set of circumstances (Rand 2000). Yet it is a powerf ul decision
making tool and one which, if used properly can alter the success of a manuf acturing process in terms of
the goal of maximising the wealth of the company .
Just In Time (JIT)
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JIT Inventory Management is one of a set of Lean manuf acturing methodologies which has grown out of
the Japanese Approach to management accounting (Abdul-Nour, Lambert et al. 1998). In particular much of
modern JIT management is based on the Kanban system of Inventory management which is a part of the
Toyota Production System (TPS) which is f amous the world over f or its ef f iciency and speed to market with
new products (Houghton, Portougal 1997). JIT as a part of a Lean system relies upon the pull of the market
rather than the push of production targets and generally states that investment in inventory, both in terms
of raw materials and work in progress, also f inished goods, represents a waste to the company (White,
Prybutok 2001). JIT requires the accurate organisation of the production process in terms of both
processes and components of production and f inds a minimum level of stock holding at every level of the
process. The original Kanban system was based around a set of two cards which accompanied an individual
component through the production process. At each point where a component was removed f rom stock to
be used in a process of manuf acturing one of the cards would be returned to the previous process to alert
that process that another was required. This meant that without the aid of sophisticated computers the TPS
managed to cut its value of stock in the f actory to a f raction of what it had been, requiring less investment
of working capital, lower overheads in terms of storage and warehousing, and less risk of over production
of any components or of f inished goods (Abdul-Nour, Lambert et al. 1998).
JIT is a system which has largely been adopted in many of the larger production f acilities which have
adopted Lean technology. These range f rom most car manuf acturers to manuf acturers of high technology.
But there is growing evidence that it may be very usef ul in terms of the smaller manuf acturer, and even the
service industry, especially as the cost of raw materials is rising in the f ace of increased demand f or core
materials (Abdul-Nour, Lambert et al. 1998, Khan, Sarker 2002).
JIT is dif f icult to implement and requires considerable investment in the production processes (Hansen,
Mouritsen 2006, Houghton, Portougal 1997). It is impossible to implement JIT unless there has been a
programme of business process redesign to allow such minimum stock levels to be held, and this can
present a large investment cost in the f irm which may or may not ultimately benef it f rom such an inventory
management programme. JIT requires the f irm to invest heavily in partnerships with suppliers as well and to
evaluate the supply chain f rom almost every angle to prevent a total collapse of the production system
(David, Eben-Chaime 2003). This is because there is little room f or error in the process, if demand is poorly
predicted and is higher than expected then the f irm will run out of the raw materials of production and may
lose custom (Kelle, Al-khateeb et al. 2003). If lower than predicted the f irm will not have the capacity to store
inventory (die to process redesign). Further if suppliers f ail to deliver f or any reason the process will come
to an abrupt halt. JIT theref ore requires a signif icant amount of managerial inf ormation f rom both the
external market and the internal processes to get right and there have been many cases of dif f icult
implementation, especially in smaller companies (Abdul-Nour, Lambert et al. 1998).
Notwithstanding this there is a lot of evidence that with more and sophisticated modelling techniques f rom
increasingly advanced technology, JIT systems are getting easier to implement (White, Prybutok 2001, Yasin,
Small et al. 1997). Theref ore as long as the systems are set up correctly there are major advantages in
reducing the waste of inventory throughout the process of manuf acturing. Because of its requirements, and
making everything subordinate to the level of inventory, it is not applicable f or JIT systems to be used in
conjunction with the Theory of Constraints, as managers are unable to subordinate all decisions within the
production process to a bottleneck. Theref ore some would argue that JIT systems are less f lexible, or
certainly allow less f lexibility that TOC does (Yasin, Small et al. 1997).
Programme Evaluat ion and Review Technique (PERT)
Put simply a PERT map is a model of complex processes which occur to f acilitate an outcome (Castro,
Gmez et al. 2008). The PERT f ramework is very similar and of ten used in conjunction with a critical pathway
diagram which shows the key processes involved in such an outcome (Mummolo 1997). PERT modelling
makes a number of assumptions and has many conventions. In draf ting a PERT chart the processes will be
numbered in tens, to allow f or f urther additions as the model grows. Further the model assumes that there
is a linear relationship between the processes and theref ore a number of key relationships (critical
pathways) are determined (Cox 1995). These are of ten termed predecessor events and successor events.
The PERT model deals with time in a number of ways giving an optimistic time and a pessimistic time f or the
completion of a process. It allows managers to view a project, task or process in a way which will help to
maximise the ef f iciency of such a task in terms of a number of variables (Shipley, de Korvin et al. 1997).
Implementation of PERT requires a signif icant investment of time and expertise and so can have an impact
on the costs of an activity, which must be weighed with the advantages or benef its such analysis brings to
the process redesign (Azaron, Katagiri et al. 2006). Of ten PERT is a usef ul way to implement Lean
techniques of production as it allows the mapping of existing processes to look f or slack in the system. But
its complexity can also be a disadvantage in terms of the time it takes to complete and the risk of errors in
the model having unintended consequences to any new or redesigned process (Azaron, Katagiri et al. 2006).
PERT is most usef ul at outlining the dependencies of a process and the identif ication of the critical
pathways which af f ect the outcomes of a process. Further the methodology allows f or the identif ication of
the benef its of early, late and slack starts or a process (Cox 1995). It is also a way of organising a large and
complex amount of inf ormation I a way which is relatively easy to understand by non specialist managers,
and as such allows the input of many areas of speciality in the redesign process, some of which may not be
heard in terms of purely operations or accounting systems such as JIT and TOC.
Yet PERT can have a number of signif icant disadvantages when used. First and f oremost is the possibility
of thousands of critical and interrelated aspect of a singly process (Mummolo 1997). The time taken to map
out all of them can be considerable and even if they are all mapped out the subtle interrelationships are
of ten dif f icult to place into such a restrictive f ramework. It is a given that in real lif e the process will not
always work inn the way in which it is modelled, and small changes across a f ew key aspects can vastly
change the outcomes and behaviours of many of the assumptions behind PERT analysis. PERT is very
usef ul in terms of initial investigation of a process or event, but it takes both art and science to appreciate
how something will work in the real world situations of manuf acturing or service industries. In this respect
PERT should be seen only as an aid to understanding and not a right answer (Castro, Gmez et al. 2008).
Conclusions
The three managerial tools which have been outlined in this report are all powerf ul providers of decision
relevant inf ormation. Further all three allow the management to view not only the outcomes at the current
time, but also to make signif icant changes to the processes of production or provision of services which
can dramatically improve perf ormance. The case given points to both poor prof its and returns on investment
and poor inventory management as problems f or the company, as such it is important bef ore any decisions
are made about the implementation of new management practices, as to why these are occurring. If the drop
in prof its are due to a slackening of demand, a change to JIT and the attendant redesign of the business
along Lean philosophy may be signif icantly advantageous, as it will allow tight control over inventory and
allow the company to respond to the needs of the market more ef f ectively. By removing overproduction and
inventory as wastes to the business, prof its would be expected to recover, as long as the business is still a
going concern (Hansen, Mouritsen 2006).
If , however, the company still has similar levels of demand f or its products then the company will need to
investigate where the problems in the existing processes are. TOC would be one way of looking at this
problem, so too would JIT. It is f elt if the levels of demand are broadly similar it may well be worth the
management of the company undertaking some analysis of the business processes with a view to coming to
a decision about the suitability of either TOC or JIT, but it must be appreciated that each of these
approaches carry some signif icant costs and risk if the analysis is not well thought out. PERT analysis will
map out the internal process and identif y the various problems with slack and time, but it does not look in
much detail at costs. Other methodologies the company may like to consider as a part of any process
redesign are the Activity Based approaches to costing, management and budgeting, these f it well with JIT
management, but not so well with TOC. TOC has signif icant limitations because it subordinates everything
to the constraint, and as new constraints appear the process has to be restarted f rom scratch. This
criticism also gives it the f lexibility that the other systems mentioned herein do not possess. This report
recommends that managers identif y the reason f or the f alling prof its, and look to f ind out why inventory is
building up (are these a symptom of slack demand, or of inef f iciencies within the business). Based on these
f indings a decision as to what f urther systems are needed can be made.
Ref erences
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allocation problem in PERT networks. European Journal of Operational Research, 172(3), pp. 838-854.
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comparison with selected OR/MS methodologies. Omega, 33(6), pp. 506-524.
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