Proceedings of

The 4th Annual International Conference on

Industrial Engineering Theory, Applications and Practice
November 17-20, 1999, San Antonio, Texas, USA

Determine Product Mix using ABC and TOC

Poniman Tioanda, Larry Whitman, and Don Malzhan
Department of Industrial and Manufacturing Engineering
Wichita State University, Wichita. Kansas.

Abstract
Activity-Based Costing (ABC) and the Theory of Constraints (TOC) can be viewed as complementary philosophies.
This paper presents the use of ABC and TOC as tools to determine product combinations for better resource
utilization. Product combinations are vital to increase profit. The differences between ABC and TOC are defined. A
standard methodology that guides in determining product mix using ABC and TOC is presented.
Keywords: Activity-Based Costing, Theory of Constraint, Product Combinations

1. Introduction

Many enterprises have difficulty with product mix decisions. Each enterprise has its own capacity and
capability in producing various products but is unsure what products and the quantities of these products they should
produce in order to become more profitable. They need to determine their core business so that they can remain
competitive. Activity-Based Costing and the Theory of Constraints can be used together to find these product
combinations.

2. Activity Based-Costing and Theory of Constraints

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
[4]. Overhead costs are also traced to a particular product rather than spread arbitrarily across all product lines. An
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 [5].
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 non-
interacting components [1]. ABC and TOC are based on differing sets of assumptions that have an implicitly
different time horizon – ABC has primarily a long-run time horizon, while TOC has primarily a short-run time
horizon, so claims of superiority of one approach over the other should be abandoned. It is possible to use both
approached when they are used appropriately. The question becomes, “When does a TOC approach become invalid
and ABC become the ‘correct’ methodology?”[2].
Some researchers claim that TOC approach requires far less data and effort than ABC. Although TOC is easier
to implement and operate, it sometimes provides insufficient information to guide management decisions. A
frequent question is whether ABC is worth the cost or whether the TOC approach will be sufficient. This paper takes
the approach that ABC and TOC are not mutually exclusive and presents a methodology for the integration of the
two approaches.
3. IDEF0 – A Structured Analysis and Design Technique
IDEF0 is a modeling tool used to produce a model or structured representation of the functions of a system and
of the information and objects that tie those functions together. The boxes represent functions such as activities,
actions, processes or operations. Boxes are denoted by an active verb phrase inside the box, such as the "Determine
Product Mix using ABC and TOC" box A0 in Figure 1. Arrows indicate data. In IDEF0, data can be information
(like "Product Specifications and Operational Data") or physical objects (like "Resources and Analysts"). They
are named by noun phrases. The position of the arrow indicates the type of information being conveyed. The arrows
entering and leaving the boxes on the left and right represent "Inputs" and "Outputs", respectively. The function
transforms the inputs into the outputs. Arrows that enter from the top indicate "Controls", or things that constrain
or govern the function. Arrows entering the bottom of the boxes are "Mechanisms". Mechanisms can be thought
of as a person or resource required to perform the function.

Figure 1. A-0 Level Diagram of the Determine the right Product Combinations using ABC and
TOC Model
An IDEF0 model is made up of several diagrams. Each diagram describes in more detail from a more general
diagram. IDEF0 models are read in a "Top-Down" fashion. The top-level diagram, also called the Context or A-0 (A
minus zero) Diagram (Figure 1), summarizes the overall function of the system which is represented by a single box.
The A0 diagram represents the first decomposition of the system (Figure 2). The A0 and all subsequent diagrams
must contain 3 to 6 numbered boxes. The location of the boxes on a diagram does not necessarily imply sequence or
time. [10]
In ABC, IDEF0 activity modeling is also used as a structured approach to identify and analyze. Although ABC
can be attempted without the use of IDEF0 modeling, IDEF0 model creatively facilitates the complex task of
identifying discrete activities and then identifying the primary output measure for each activity.

2
Figure 2. A0 Level Diagram of the Determine the right Product Combinations using ABC and TOC Model

3
4. Method for Determining Product Combinations using ABC and TOC

Several preliminary activities must be completed prior to beginning the methodology. Management support
must be established prior to beginning as management frequently avoids change. Managers with the knowledge of
ABC cost accounting method and TOC management philosophy are also required. With this strong foundation laid
for implementation, five main activities are presented to find a good product combinations using ABC and TOC.

1. Understand issues/activities
First, the scope of the issues related to production must be identified. In ABC, documenting and understanding
issues and activities are necessary in order to improve the current processes. In this activity, a determination is made
whether an activity is value or non-value added; primary or secondary, and required or not needed. If the output of
the activity is directly related to customer requirements, it is a value-added activity. A major goal of this activity is
to reduce non-value-added activities and eliminate those that are not necessary. But we may not be able to eliminate
the non-value added activity because, for instance, if the output of an activity were an inventory report or update for
products (for which there are customers), the output would be non-value added, but necessary to the organization.
Primary activities directly support the enterprise’s mission while secondary activities support primary activities [9].
In this activity, alternatives and improvement of the current production methodologies is also performed.

2. Trace Costs to Activities

In ABC, this step is also used to gather costs from the activity producing the products or services provided by
the enterprise. These costs can be salaries, expenditures for research/development, machinery/equipment, and office
furniture. Then the costs are also traced by analyzing activities and the gathered organizational inputs. The costs are
brought together to get the total input cost for each activity. In this activity, we are not calculating the costs, just
finding where they come from [9]. This activity consumes most of the time depending upon the size of an enterprise,
product mix, and number of production activities.

3. Identify the Constraints

Identify which activities in each product are constrained. Constraints are a factor that prevent/limit achieving a
certain desired goal. The constraint can be capacity. We can change/increase the level of the existing resources
supply of the constraining activity and hence the capacity limit. If the constraint can be increased, it will no longer
be a constraint. If there is a capacity limit, we must be sensitive to bottlenecks and undertake a special study to
optimize around them because a bottleneck occurs when the demand for a resource, in a given time period, outstrips
the firm’s ability to deliver it. To accommodate constraints, the best solution is to use the theory of constraints
(TOC) because in the short run, it is assumed that production capacity is fixed and cannot be changed readily and a
pure ABC system is unable to acknowledge constraints because ABC assumes that resource demand and usage
always match. However, In the long run, more and more costs become variable. Labor commitments become
changeable and thus are no longer a fixed cost. Other fixed costs also become changeable when the productive
capacity is adjusted [7]. The economic concept of short run (TOC) compare to long run (ABC) focuses on whether
the capacity of the production capacity can be increased or reduced [2]. In ABC, a product that consumes a large
quantity of the bottleneck resource is not penalized compared to a product that consumes only a small amount of that
resource [10]. If there are no constraints, the opportunity cost is zero [8]. In this activity, TOC improvement
concepts are also utilized in the following subactivities. Identify the system constraint. Decide how to exploit the
system constraint. If it is a physical constraint one would apply the rules of synchronized manufacturing and the
dynamic relationship between productive capacity, protective capacity and levels of inventory would have to be
considered. The idea is to get the absolute maximum out of the existing resources. Subordinate everything else to the
constraint. This step may be where some policy constraints are encountered. This step will normally require
behavior changes. Elevate the systems constraint, which means to increase capacity of the constraint. If in the above
steps the constraint is broken, go back to the first subactivity. Do not let inertia be the systems constraint. This is
very important as policies and procedures that are appropriate for the initial constraint may not be vital if the
constraint shifts [1].

4. Analyze Cost and Benefits

The calculated activity unit costs and bills of activity are used to identify candidates for improving the business
processes. The identification of non-value added activities occurs through this process with a clarity that allow us to
eliminate them, and at the same time permits the product or service to be provided to the customer with greater
efficiency [9]. In this activity, comparisons for the cost of increasing versus reducing the capacity thus eliminating
the production of certain products are performed. Opportunity costs and resource utilization are also considered in
this activity. The thing to keep in mind is to optimize the product combinations and utilizes the unused capacities as
much as possible.

5. Determine the Right Product Combination

From the analysis above, every cost and benefit are considered to determine and implement the result to the
current enterprise’s culture and the changes are documented so that those changes can be compared with the
previous one.
The next cycle of the above activities will be easier since most of the information is already obtained/recorded
and these activities should be performed repeatedly in order to be more profitable and also keep up with customer
requirements.

5. Summary
Many enterprises have difficulty with product mix questions. Each enterprise has its own capacity and
capability in producing various products but are unsure what products and quantities they should produce in order to
become more profitable. Activity-based costing (ABC) and the theory of constraints (TOC) shouldn’t be viewed as
competing against each other but can be used in a complementary manner. Currently there are many products that
are overpriced or underpriced. Neither situation is good because if a product is overpriced the company will likely
not be competitive and they will lose their business, and if the product is underpriced the enterprise will lose money
on the sales it makes. This could happen because they did not produce the right product combinations. Determining
product combinations using ABC and TOC is important to find the right product combinations. The right product
combinations are critical for an enterprise to excel today; enterprise resources must be utilized as efficiently as
possible. The enterprise that has analytically determined the right product combinations will have a decided
competitive advantage.

References

[1] Eliyahu M. Goldratt and Jeff Cox, The Goal, 2nd Revised Edition, North River Press, Croton-on-Hudson, N.Y.
[2] Jay S. Holmen, ABC vs. TOC: it’s a matter of time, Management Accounting (USA), Jan 1995 v76 n7 p37(4)
[3] John B. MacArthur, From activity-based costing to throughput accounting, Management Accounting (USA),
April 1996 v77 n10 p30(5)
[4] John H. Sheridan, Throughput with a Capital ‘T’, Industry Week, March 4, 1991
[5] Richard V. C., Eugene J. C., and Gerald E. C., Beware the New Accounting Myths, Management Accounting,
December 1989, pp.41-45.
[6] Robin Cooper, Regine Slagmulder, Integrating activity-based costing and the theory of constraints,
Management Accounting (USA), Feb 1999 v80 i8 p20(2)
[7] Robin Cooper, Robert Kaplan, Activity-Based Systems: Measuring the Costs of Resource Usage, Accounting
Horizons, September 1992, pp. 1-13.
[8] Steve Demmy, John Talbott, Improve internal reporting with ABC and TOC, Management Accounting (USA),
Nov 1998 v80 i5 p18(5)
[9] The Office of Information Technology ,Business Process Improvement (Reengineering), Handbook of
Standards and Guidelines, Integrated Product Team for Information Technology Services, November 30, 1995
[10] Waltman, W. D., & Presley, A. Reading & Critiquing an IDEF0 Model. Automation & Robotics Research
Institute, Texas. July 1993.