The Opportunity Cost of Operations

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The Opportunity Cost of Operations

A major concept of throughput accounting is to determine the true cost to a company of its capacity constraint. The capacity constraint is the drum (bottleneck) operation. If the use of the drum is not maximized, what is the opportunity cost to the company?

The Opportunity Cost in Traditional Accounting

In a traditional cost accounting system, the cost would be the foregone gross margin on any products that could not be produced by the operation. For example, a work center experiences down time of one hour, because the machine operator is on a scheduled break. During that one hour, the work center could have created 20 products having a gross margin of $4.00 each. Traditional cost accounting tells us that this represents a loss of $80. Given this information, a manager might very well not back-fill the machine operator, and allow the machine to stay idle for the one hour break period.

The Opportunity Cost in Throughput Accounting

Throughput accounting uses a different calculation of the cost of the capacity constraint. Since the performance of the constraint drives the total throughput of the entire system, the opportunity cost of not running that operation is actually the total operating expense of running the entire facility, divided by the number of hours during which the capacity constraint is being operated. This is because it is not possible to speed up the constrained operation, resulting in the permanent loss of any units that are not produced. For example, if the monthly operating expenses of a facility are $1.2 million and the constrained resource is run for every hour of that month, or 720 hours (30 days x 24 hours/day), then the cost per hour of the operation is $1,667 ($1,200,000 divided by 720 hours). Given this much higher cost of not running the operation, a manager will be much more likely to find a replacement operator for break periods.

What about the cost of not running a non-constrained resource operation? As long as its downtime does not impact the operation of the constrained resource, it has no opportunity cost at all. In fact, the situation is reversed, for it is actually better to only run non-constraint resources at the pace of the drum operation, since any excess inventory produced will only increase the amount of inventory in the production system – and this represents an additional investment in the system for which there is no offsetting increase in throughput.

Thus, there are substantial differences in the opportunity cost of running various operations, which can be interpreted differently with different accounting systems. Throughput accounting focuses attention on the high cost of not running a constrained resource, while showing that there is a negative opportunity cost associated with running a non-constrained resource more than it is needed.

Podcast

A discussion of throughput concepts is available on Episodes 43 through 47 of the Accounting Best Practices podcast.