Theory of Constraints Handbook - James Cox Iii [254]
In the example, a normal year (Year 1) income is $200,000 and return on sales is 10 percent. The 50 percent WIP and FG inventory reductions occur in the second year (Year 2) and GAAP income drops to $66,667 and return on sales drops to 3.33 percent. (See the “GAAP Accounting” spreadsheet, cells A48:Y80.) The third year of the example, GAAP return on sales recovers to 6.67 percent (cells A83:Y113) with income of $133,333, but is not back to the full 10 percent (income of $200,000) until Year 4 (A116:Y147). The reduced income occurs because, with traditional (GAAP) accounting, WIP contains a portion of fixed manufacturing costs, depending on the percent complete, and FG contains its fair portion (100%) of full fixed manufacturing costs. In the environment established in this example, the only way to reduce inventory is to cease entry of raw materials into the system.39 The decrease in production activity required to lower inventories means that all fixed costs of the current period, plus the fixed costs in units in beginning FG and WIP, are charged to cost of sales in the inventory reduction year.
The TA approach, shown on the second spreadsheet of the “InventoryReductionExample” shows that income and return on sales for the entire 4-year period remain constant at $200,000 and 10 percent, respectively. The third spreadsheet in the example file reconciles GAAP and Throughput income for the year of the inventory reduction and suggests general journal entries to adjust from internal Throughput reporting to external GAAP statements. Table 13-4 shows the reconciliation followed by the general journal entries.
Because the inventory reduction is permanent, other things remaining equal, reported GAAP income would remain $200,000 less than that reported under TA.40 Given that this inventory reduction permits the opportunity to increase future earnings (lower WIP means faster processing that permits additional production with no increase in fixed costs), the potential “sacrifice” in reported earnings is necessary and must be undertaken. Careful planning and communication with relevant stakeholders, especially employees, creditors, and owners, can minimize potential negative effects.
Table 13-4 illustrates how the difference between GAAP income of $66,667 and Throughput income of $200,000 in Year 2 (a difference of negative $133,333) may be explained totally by the change (reduction) in fixed costs in beginning and ending WIP of $53,333 plus the change (reduction) in fixed costs in beginning and ending FG of $80,000.
Following Table 13-4 are all the year-end adjusting general journal entries to convert all income and balance sheet accounts from Throughput to GAAP. This example clearly indicates that keeping accounting records using Throughput concepts during a period quite easily can be converted to GAAP accounts at the end of a period.
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Difference explained by change in fixed costs in inventories:
TABLE 13-4 Reconciliation of Traditional (GAAP) Costing Operating Income and Throughput (Variable) Costing Operating Income for Year of Inventory Reduction
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End of period adjusting entries to convert from Throughput to GAAP accounting:
Value Metric Used to Track Performance
To provide timely feedback to managers and operations personnel, TOC has some unique metrics that reveal both what should be done and what should not be done. These metrics support standard TOC policies and are designed to encourage appropriate behavior. Many use a TOC concept called value days