Environmental Considerations in Product Mix Decisions Using ABC and TOC
Julie Lockhart, Audrey Taylor. Management Accounting Quarterly. Montvale: Fall 2007. Vol. 9, Iss. 1; pg. 13, 6 pgs
Abstract (Summary)
As environmental issues increasingly influence corporate performance, they need to be institutionalized in management accounting systems. Manufacturers need information from their management accounting systems for maximizing profit, given environmental spending. Two methods of evaluating product mix decisions given an environmental constraint include activity-based costing (ABC) and the Theory of Constraints (TOC). While ABC is important for understanding how environmental spending affects product cost, it does not necessarily help in making decisions to reduce the most environmentally damaging products from the mix. Under certain conditions, TOC may be the better choice for maximizing profit while minimizing the production of products causing the most environmental damage.
AS ENVIRONMENTAL ISSUES INCREASINGLY INFLUENCE CORPORATE PERFORMANCE, THEY NEED TO BE A STANDARD PART OF MANAGEMENT ACCOUNTING SYSTEMS.
One of the primary objections to the environmental movement is that it is too costly to businesses, which could place them at an economic disadvantage, especially when competing head-on with foreign companies unhampered by similar cumbersome and costly regulations. Increasingly, companies are faced with pressures from government, stockholders, and the public to improve their environmental records while achieving profitability goals to keep Wall Street happy. Some companies are finding, however, that going beyond regulatory compliance can create value for customers and shareholders alike. With so many pressures, how can management best make profitable choices between investing scarce resources to reduce environmental waste or to increase throughput and profit?
As environmental issues increasingly influence corporate performance, they need to be institutionalized in management accounting systems.1 Manufacturers need information from their management accounting systems for maximizing profit, given environmental spending. A 1994 article in Management Accounting by Jerry Kreuze and Gale Newell supports the use of activity-based costing (ABC) in conjunction with life-cycle costing for allocating environmental costs to products to get a handle on what those costs are.2 (Life-cycle costing tracks costs over the entire product life cycle "from cradle to grave.") Their article illustrates the implications on profitability analysis from using the theoretically more accurate ABC system to allocate environmental costs to products that generate those costs. The illustration, however, does not consider constraints in the production process, so the product mix decisions made from ABC information may not facilitate profit maximization goals.
Two methods of evaluating product mix decisions given an environmental constraint include ABC and the Theory of Constraints (TOC). While ABC is important for understanding how environmental spending affects product cost, it does not necessarily help in making decisions to reduce the most environmentally damaging products from the mix. Under certain conditions, TOC may be the better choice for maximizing profit while minimizing the production of products causing the most environmental damage.
ABC, TOC, AND DIFFERING ASSUMPTIONS
Both ABC and TOC appeared in literature during the decade of the 1980s. Robin Cooper and Robert S. Kaplan popularized ABC to trace costs to products based on the way each product uses resources.3 ABC recognizes that different products use resources based on complexity rather than volume. Cooper and Kaplan proposed using nonvolume drivers to allocate batch-and product-level costs to units produced. Around the same time, Eliyahu M. Goldratt promulgated TOC to prioritize scheduling of products over limited resources in order to maximize profit.4 Goldratt advocated eliminating all allocations of any nonvolume-based costs to units.5 The proponents of each method believed their method ensured that profit would increase more while costs were better controlled.
Because of the juxtaposed assumptions of each method, academics and practitioners have debated their usefulness with little agreement on common ground.6 ABC assumes that costs are predominantly variable over the long run and that variability should be recognized in all decision making. Cooper and Kaplan tracked the accelerated increase in "fixed costs" over the decades in specific companies, belying their "fixed cost nature."7 They said that such a dramatic increase in so-called fixed costs was overlooked because managers assumed these costs were fixed and did not need to be monitored carefully. Only by recognizing the "true" variability of these costs would managers be encouraged to monitor and limit their proliferation.
In contrast, TOC assumes just the opposite-that most manufacturing costs are predominantly fixed, with materials being the only consistent variable cost. Researchers Eric Noreen, Debra Smith, and James T. Mackey documented the way managers controlled fixed costs in a TOC-based company.8 They theorized that TOC managers controlled fixed costs even in the face of increasing complexity because they believed these costs were truly fixed and should not increase. Therefore, the managers found ways to improve processes and decrease nonvalue-added activities so these fixed costs would stay constant. In addition, Noreen, Smith, and Mackey found that, in the face of increased complexity, ABC-based companies had increases in the nonvolume-based costs because the managers expected those costs to increase.
Several researchers also have argued that time is the primary difference between ABC and TOC.9 ABC views the company over a long time frame, whereas TOC looks at the short term. These researchers have proposed that TOC should be used for short-term production mix decisions where costs are predominantly fixed and that ABC should be used to determine any increases or decreases in capacity and products (as well as any other long-term decision) because, in the long term, all costs tend toward being variable.
A DIFFERENT FOCUS
Another important difference between TOC and ABC is focus. ABC's focus is predominantly on cost, and its primary goal is to increase profit by reducing cost via the reduction of complexity. In the case of Pitney Bowes, environmental operating and product costs were reduced through the use of ABC.10 TOC, on the other hand, focuses rigidly on profit and attempts to maximize profit given a certain stable level of capacity. To aid in the focus on profit, TOC removes complexity, not from the product but from the allocation process.11 It also attaches only volume-driven costs to each unit. The assumption is that nonmaterial costs are stable when used to produce several products with shared resources.
ABC, on the other hand, seeks to remove complexity from the system by focusing on higher-volume products using fewer resources for each unit produced. What the ABC advocates have tried to deal with was the quick rise in indirect costs for both production and nonproduction tasks. In effect, ABC has tried to become a method of doing incremental analysis by highlighting resources that will need to increase in order to increase the output of complex products. The product mix that results will not necessarily reduce the production and sale of the product that pollutes the most.
Focusing on the constraint. A unique attribute of the TOC method is the focus on the constraint of the system. In order to increase profit, TOC focuses on the use of limited resources and recognizes that neither unit cost nor unit-based profit is sufficient to determine which products should be produced. Instead, managers should realize that every system has a constraint that limits profit. A constraint can be external, such as the lack of demand in the market for the company's products, but often the constraint is internal to the company, such as limited resources for environmental compliance.
When the constraint is an internal resource, products using limited amounts of the constrained resource or products producing higher levels of profit for each unit of the constrained resource are preferred. In cases where the constrained resource is used to reduce pollutants, TOC helps to shift the product mix to the products that pollute the least. Products requiring more resources to reduce environmental pollutants will be given lower priority in the mix unless the prices charged to consumers are sufficient to cover the extra cost of eliminating those pollutants.
ENVIRONMENTAL COSTS AND RESOURCES
Clearly, all businesses have an impact on the natural environment from the use of electricity and fuel, to paper use and waste, to the more considerable impacts of chemical-related manufacturing. Both federal and state governments regulate hazardous material inputs and waste. Perhaps the most onerous of these are the Superfund regulations created to clean up toxic waste sites and the Resource Conservation and Recovery Act (RCRA) for facilities that treat, store, and/or dispose of hazardous waste. Beyond hazardous substances, many companies have chosen to adopt "eco-efficient" policies internally, which has the dual result of saving the companies money as well as improving their reputation with certain stakeholders.
Internal environmental costs when regulations are imposed may include record keeping, reporting, labeling, emissions and effluent management, waste management, compliance, training, research and development, certification, and permitting. Typically, costs may be different depending on whether a company is a generator/user, transporter, or disposal facility for hazardous materials. Table 1 includes four categories of costs that were derived under the assumption that the company uses and generates hazardous materials.
COMPARING ABC AND TOC
Clean Products, Inc. manufactures four products: R, S, T, and U. Four categories of environmental costs are included in the array of manufacturing costs in the company. Because hazardous chemicals are used in the manufacture of R, S, T, and U, we have included a hazardous waste disposal fee per pound, which is assumed to be variable. Clean Products invested in a scrubber to clean emissions at the end of the process, and the company incurs environmental reporting (by product) and regulatory costs (by facility). The sales prices, materials costs, direct labor usage, and resource usage of each of the four products are listed in Table 1.
Using ABC to determine product mix. Using the demand levels in Table 1, the first step is to determine the load on each resource to see if the current demand can be filled. To test this, the capacity used by each resource needs to be calculated and compared to the capacity available for each resource. The calculations to determine the demands on each resource are listed in Table 2.
As you can see from the calculation of machine hours needed on each resource, only the environmental scrubber needs more time than it has available; therefore, not all of the products can be produced. Management must determine which products to emphasize and which to defer to last.
Prioritizing production using ABC. ABC is highly valued because of its ability to trace the cost of activities to products. In Table 1, a list of activities and cost drivers is presented, using the cost-driver rates to attach the cost of the activity to each product. The annual amount of each driver listed in the table is its practical capacity, or the amount of the cost driver possible if 100% of the resource is used, given real-world efficiencies. For many companies, practical capacity is considered to be 85% of its theoretical or ideal capacity.
By using practical capacity as the cost-driver level, several benefits occur:
* Allocated unit costs are consistent for decision making as long as costs for the resources are unchanged.
* Available capacity is highlighted on each resource.
* Unavailable capacity is highlighted on constrained resources.
Using ABC to determine the product mix choice, we calculated contributions for each product. For each product-level cost, the amount of the cost driver consumed by the product was multiplied by the rate for that particular cost driver. The resulting overhead was then traced to each product line (see Table 3).
Using ABC to trace the costs to each unit, the ranking for each product by profitability from highest to lowest would be S, R, T, and U. With this order of production, and given the limited time on the environmental scrubber, S, R, and T are produced to their demand levels, and the remaining time is used to make 1,000 units of U. Because of the decrease in production of U from 8,000 units to 1,000 units, fewer of the unconstrained resources are needed. Inventories in this example are assumed to be zero, so any unused capacity costs for any activity are expensed as a period cost. Based on this level of production and sales, the profit for the company is $1,020,000 (see Table 4).
Prioritizing production using TOC. The Theory of Constraints prioritizes production based on throughput over the constrained resource. Throughput in TOC is defined as sales less the truly variable costs (usually just materials). Calculation of throughput per hour of time on the environmental scrubber is presented in Table 4. Using the throughput per scrubber hour to determine the order of production, Product R is the most profitable, followed by S, U, and T, respectively. When production follows this order, all of the units of demand for R, S, and U are produced and sold; in the remaining time, 10,500 units of T's demand can be satisfied (see Table 5).
Following this plan, the profit is $1,695,000. This TOC-based profit is $675,500 greater than the ABCbased profit. Again, the profit difference is due solely to the focus of TOC vs. ABC on profit maximization vs. cost control. The profit calculations and the differences in the product rankings and in the profit generated by ABC and TOC are presented in Tables 6 and 7.
TOC is always the best choice given the following conditions:
1. Products use shared resources.
2. Demand for all of the products sharing those resources is greater than the capacity of at least one resource.
3. There is a commitment to maintain capacity at the current level for the immediate future.
4. There is a desire to maximize profit over the current level of resources.
5. When capacity increases are made, the constrained resource is the first resource purchased.
6. The market dictates the price of the competing products, and those prices or price and volume choices are known before production plans are solidified.
7. The creation of certain toxins is of concern to the company, and there is a desire to determine the product mix that generates the fewest toxins.
POSSIBLE RAMIFICATIONS FOR "GREEN" COMPANIES
By using TOC to identify the constraint and to use it so that the environmental scrubber was used most profitably, the company simultaneously chose products that used the least amount of scrubber time per unit. In effect, the TOC method fostered the selection of a theoretically cleaner product than the previous mix because it emitted fewer toxins requiring scrubber time. Product T needed two hours of scrubber time, while Product U used only one hour. In addition, the company improved its own profitability.
It is also important to note that when the TOC mix is chosen, there is unmet demand (3,500 units) for Product T in the market. This means that the company has some leeway for potentially increasing the price of T to better reflect its environmental impact. This in turn could increase profits even more. If companies can reduce emissions while maximizing profit, resistance to making environmental improvements should be more tenable.
CONCERN IS OBLIGATORY
Investments in environmental assets can be very expensive, but, given the current regulatory environment regarding toxic substances as well as public demand for clean products, concern over the environment is obligatory. Regardless of the motivation, companies find that they must be proactive about reducing the environmental impact of the products they produce. By adopting the TOC methodology, companies investing in environmentally sound resources can maximize their profits, given environment investments, while producing a better mix of Earth-friendly products.
As environmental issues increasingly influence corporate performance, they need to be institutionalized in management accounting systems. Manufacturers need information from their management accounting systems for maximizing profit, given environmental spending. Two methods of evaluating product mix decisions given an environmental constraint include activity-based costing (ABC) and the Theory of Constraints (TOC). While ABC is important for understanding how environmental spending affects product cost, it does not necessarily help in making decisions to reduce the most environmentally damaging products from the mix. Under certain conditions, TOC may be the better choice for maximizing profit while minimizing the production of products causing the most environmental damage.
AS ENVIRONMENTAL ISSUES INCREASINGLY INFLUENCE CORPORATE PERFORMANCE, THEY NEED TO BE A STANDARD PART OF MANAGEMENT ACCOUNTING SYSTEMS.
One of the primary objections to the environmental movement is that it is too costly to businesses, which could place them at an economic disadvantage, especially when competing head-on with foreign companies unhampered by similar cumbersome and costly regulations. Increasingly, companies are faced with pressures from government, stockholders, and the public to improve their environmental records while achieving profitability goals to keep Wall Street happy. Some companies are finding, however, that going beyond regulatory compliance can create value for customers and shareholders alike. With so many pressures, how can management best make profitable choices between investing scarce resources to reduce environmental waste or to increase throughput and profit?
As environmental issues increasingly influence corporate performance, they need to be institutionalized in management accounting systems.1 Manufacturers need information from their management accounting systems for maximizing profit, given environmental spending. A 1994 article in Management Accounting by Jerry Kreuze and Gale Newell supports the use of activity-based costing (ABC) in conjunction with life-cycle costing for allocating environmental costs to products to get a handle on what those costs are.2 (Life-cycle costing tracks costs over the entire product life cycle "from cradle to grave.") Their article illustrates the implications on profitability analysis from using the theoretically more accurate ABC system to allocate environmental costs to products that generate those costs. The illustration, however, does not consider constraints in the production process, so the product mix decisions made from ABC information may not facilitate profit maximization goals.
Two methods of evaluating product mix decisions given an environmental constraint include ABC and the Theory of Constraints (TOC). While ABC is important for understanding how environmental spending affects product cost, it does not necessarily help in making decisions to reduce the most environmentally damaging products from the mix. Under certain conditions, TOC may be the better choice for maximizing profit while minimizing the production of products causing the most environmental damage.
ABC, TOC, AND DIFFERING ASSUMPTIONS
Both ABC and TOC appeared in literature during the decade of the 1980s. Robin Cooper and Robert S. Kaplan popularized ABC to trace costs to products based on the way each product uses resources.3 ABC recognizes that different products use resources based on complexity rather than volume. Cooper and Kaplan proposed using nonvolume drivers to allocate batch-and product-level costs to units produced. Around the same time, Eliyahu M. Goldratt promulgated TOC to prioritize scheduling of products over limited resources in order to maximize profit.4 Goldratt advocated eliminating all allocations of any nonvolume-based costs to units.5 The proponents of each method believed their method ensured that profit would increase more while costs were better controlled.
Because of the juxtaposed assumptions of each method, academics and practitioners have debated their usefulness with little agreement on common ground.6 ABC assumes that costs are predominantly variable over the long run and that variability should be recognized in all decision making. Cooper and Kaplan tracked the accelerated increase in "fixed costs" over the decades in specific companies, belying their "fixed cost nature."7 They said that such a dramatic increase in so-called fixed costs was overlooked because managers assumed these costs were fixed and did not need to be monitored carefully. Only by recognizing the "true" variability of these costs would managers be encouraged to monitor and limit their proliferation.
In contrast, TOC assumes just the opposite-that most manufacturing costs are predominantly fixed, with materials being the only consistent variable cost. Researchers Eric Noreen, Debra Smith, and James T. Mackey documented the way managers controlled fixed costs in a TOC-based company.8 They theorized that TOC managers controlled fixed costs even in the face of increasing complexity because they believed these costs were truly fixed and should not increase. Therefore, the managers found ways to improve processes and decrease nonvalue-added activities so these fixed costs would stay constant. In addition, Noreen, Smith, and Mackey found that, in the face of increased complexity, ABC-based companies had increases in the nonvolume-based costs because the managers expected those costs to increase.
Several researchers also have argued that time is the primary difference between ABC and TOC.9 ABC views the company over a long time frame, whereas TOC looks at the short term. These researchers have proposed that TOC should be used for short-term production mix decisions where costs are predominantly fixed and that ABC should be used to determine any increases or decreases in capacity and products (as well as any other long-term decision) because, in the long term, all costs tend toward being variable.
A DIFFERENT FOCUS
Another important difference between TOC and ABC is focus. ABC's focus is predominantly on cost, and its primary goal is to increase profit by reducing cost via the reduction of complexity. In the case of Pitney Bowes, environmental operating and product costs were reduced through the use of ABC.10 TOC, on the other hand, focuses rigidly on profit and attempts to maximize profit given a certain stable level of capacity. To aid in the focus on profit, TOC removes complexity, not from the product but from the allocation process.11 It also attaches only volume-driven costs to each unit. The assumption is that nonmaterial costs are stable when used to produce several products with shared resources.
ABC, on the other hand, seeks to remove complexity from the system by focusing on higher-volume products using fewer resources for each unit produced. What the ABC advocates have tried to deal with was the quick rise in indirect costs for both production and nonproduction tasks. In effect, ABC has tried to become a method of doing incremental analysis by highlighting resources that will need to increase in order to increase the output of complex products. The product mix that results will not necessarily reduce the production and sale of the product that pollutes the most.
Focusing on the constraint. A unique attribute of the TOC method is the focus on the constraint of the system. In order to increase profit, TOC focuses on the use of limited resources and recognizes that neither unit cost nor unit-based profit is sufficient to determine which products should be produced. Instead, managers should realize that every system has a constraint that limits profit. A constraint can be external, such as the lack of demand in the market for the company's products, but often the constraint is internal to the company, such as limited resources for environmental compliance.
When the constraint is an internal resource, products using limited amounts of the constrained resource or products producing higher levels of profit for each unit of the constrained resource are preferred. In cases where the constrained resource is used to reduce pollutants, TOC helps to shift the product mix to the products that pollute the least. Products requiring more resources to reduce environmental pollutants will be given lower priority in the mix unless the prices charged to consumers are sufficient to cover the extra cost of eliminating those pollutants.
ENVIRONMENTAL COSTS AND RESOURCES
Clearly, all businesses have an impact on the natural environment from the use of electricity and fuel, to paper use and waste, to the more considerable impacts of chemical-related manufacturing. Both federal and state governments regulate hazardous material inputs and waste. Perhaps the most onerous of these are the Superfund regulations created to clean up toxic waste sites and the Resource Conservation and Recovery Act (RCRA) for facilities that treat, store, and/or dispose of hazardous waste. Beyond hazardous substances, many companies have chosen to adopt "eco-efficient" policies internally, which has the dual result of saving the companies money as well as improving their reputation with certain stakeholders.
Internal environmental costs when regulations are imposed may include record keeping, reporting, labeling, emissions and effluent management, waste management, compliance, training, research and development, certification, and permitting. Typically, costs may be different depending on whether a company is a generator/user, transporter, or disposal facility for hazardous materials. Table 1 includes four categories of costs that were derived under the assumption that the company uses and generates hazardous materials.
COMPARING ABC AND TOC
Clean Products, Inc. manufactures four products: R, S, T, and U. Four categories of environmental costs are included in the array of manufacturing costs in the company. Because hazardous chemicals are used in the manufacture of R, S, T, and U, we have included a hazardous waste disposal fee per pound, which is assumed to be variable. Clean Products invested in a scrubber to clean emissions at the end of the process, and the company incurs environmental reporting (by product) and regulatory costs (by facility). The sales prices, materials costs, direct labor usage, and resource usage of each of the four products are listed in Table 1.
Using ABC to determine product mix. Using the demand levels in Table 1, the first step is to determine the load on each resource to see if the current demand can be filled. To test this, the capacity used by each resource needs to be calculated and compared to the capacity available for each resource. The calculations to determine the demands on each resource are listed in Table 2.
As you can see from the calculation of machine hours needed on each resource, only the environmental scrubber needs more time than it has available; therefore, not all of the products can be produced. Management must determine which products to emphasize and which to defer to last.
Prioritizing production using ABC. ABC is highly valued because of its ability to trace the cost of activities to products. In Table 1, a list of activities and cost drivers is presented, using the cost-driver rates to attach the cost of the activity to each product. The annual amount of each driver listed in the table is its practical capacity, or the amount of the cost driver possible if 100% of the resource is used, given real-world efficiencies. For many companies, practical capacity is considered to be 85% of its theoretical or ideal capacity.
By using practical capacity as the cost-driver level, several benefits occur:
* Allocated unit costs are consistent for decision making as long as costs for the resources are unchanged.
* Available capacity is highlighted on each resource.
* Unavailable capacity is highlighted on constrained resources.
Using ABC to determine the product mix choice, we calculated contributions for each product. For each product-level cost, the amount of the cost driver consumed by the product was multiplied by the rate for that particular cost driver. The resulting overhead was then traced to each product line (see Table 3).
Using ABC to trace the costs to each unit, the ranking for each product by profitability from highest to lowest would be S, R, T, and U. With this order of production, and given the limited time on the environmental scrubber, S, R, and T are produced to their demand levels, and the remaining time is used to make 1,000 units of U. Because of the decrease in production of U from 8,000 units to 1,000 units, fewer of the unconstrained resources are needed. Inventories in this example are assumed to be zero, so any unused capacity costs for any activity are expensed as a period cost. Based on this level of production and sales, the profit for the company is $1,020,000 (see Table 4).
Prioritizing production using TOC. The Theory of Constraints prioritizes production based on throughput over the constrained resource. Throughput in TOC is defined as sales less the truly variable costs (usually just materials). Calculation of throughput per hour of time on the environmental scrubber is presented in Table 4. Using the throughput per scrubber hour to determine the order of production, Product R is the most profitable, followed by S, U, and T, respectively. When production follows this order, all of the units of demand for R, S, and U are produced and sold; in the remaining time, 10,500 units of T's demand can be satisfied (see Table 5).
Following this plan, the profit is $1,695,000. This TOC-based profit is $675,500 greater than the ABCbased profit. Again, the profit difference is due solely to the focus of TOC vs. ABC on profit maximization vs. cost control. The profit calculations and the differences in the product rankings and in the profit generated by ABC and TOC are presented in Tables 6 and 7.
TOC is always the best choice given the following conditions:
1. Products use shared resources.
2. Demand for all of the products sharing those resources is greater than the capacity of at least one resource.
3. There is a commitment to maintain capacity at the current level for the immediate future.
4. There is a desire to maximize profit over the current level of resources.
5. When capacity increases are made, the constrained resource is the first resource purchased.
6. The market dictates the price of the competing products, and those prices or price and volume choices are known before production plans are solidified.
7. The creation of certain toxins is of concern to the company, and there is a desire to determine the product mix that generates the fewest toxins.
POSSIBLE RAMIFICATIONS FOR "GREEN" COMPANIES
By using TOC to identify the constraint and to use it so that the environmental scrubber was used most profitably, the company simultaneously chose products that used the least amount of scrubber time per unit. In effect, the TOC method fostered the selection of a theoretically cleaner product than the previous mix because it emitted fewer toxins requiring scrubber time. Product T needed two hours of scrubber time, while Product U used only one hour. In addition, the company improved its own profitability.
It is also important to note that when the TOC mix is chosen, there is unmet demand (3,500 units) for Product T in the market. This means that the company has some leeway for potentially increasing the price of T to better reflect its environmental impact. This in turn could increase profits even more. If companies can reduce emissions while maximizing profit, resistance to making environmental improvements should be more tenable.
CONCERN IS OBLIGATORY
Investments in environmental assets can be very expensive, but, given the current regulatory environment regarding toxic substances as well as public demand for clean products, concern over the environment is obligatory. Regardless of the motivation, companies find that they must be proactive about reducing the environmental impact of the products they produce. By adopting the TOC methodology, companies investing in environmentally sound resources can maximize their profits, given environment investments, while producing a better mix of Earth-friendly products.
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