Variable Costing and Theory of Constraints:
The Theory of Constraints
(TOC) focuses on managing constraints in a company as the key to
improving profits. Companies involved in Theory of Constraints (TOC) use a form
of variable costing. One difference is that in Theory of Constraints (TOC)
approach, direct labor is generally considered to be a fixed cost.
In many companies direct labor is
not really a variable cost. Even though direct labor may not be paid on an
hourly basis, many companies have a commitment--sometimes enforced in labor
contracts or by law--to guarantee workers a minimum number of paid hours. In TOC
companies, there are two additional reasons to consider direct labor to be a
First, direct labor is not usually
a constraint. In simplest case constraint is a machine. In more complex cases,
the constraint is a policy (such as a poorly designed compensation scheme for
sales persons) that prevents the company from using its resources more
effectively. If direct labor is not the constraint, there is no reason to
increase it. Hiring more direct labor would increase costs without increasing
the output of salable products and services.
Second, TOC emphasizes continuous
improvement to maintain competitiveness. Without committed and enthusiastic
employees, sustained continuous improvement virtually impossible. Since layoffs
often have devastating effects on employee morale, managers involved in TOC are
extremely reluctant to lay off employees.
For these reasons, most managers
in TOC companies regard direct labor as a committed fixed cost rather than as a
variable cost. Hence, in the modified form of variable costing used in TOC
companies, direct labor is not usually included as a part of product costs.