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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 fixed cost.

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.

Relevant Articles:

Variable Costing Versus Absorption Costing System
Income Comparison of Variable and Absorption Costing
Advantages, Disadvantages and Limitations of Variable Costing System
Advantages and Disadvantages of Absorption Costing
Variable Costing and Theory of Constraints
Impact of Just In Time (JIT) Inventory Methods on Variable and Absorption Costing System



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