In an earlier column, I explained why traditional budgeted hourly cost rates (BHR’s) often cause managers to make bad short-term pricing decisions. BHR-based estimating systems lead to bad pricing because they treat all operating expenses as variable manufacturing costs when the vast majority of operating expenses in a modern printing company are actually fixed costs. Because of their approach to costing, BHR systems do not accurately reflect how a company actually incurs operating expenses or how those expenses change (or don’t change) as a result of producing jobs. Therefore, a traditional BHR estimating system cannot enable managers to predict the bottom-line profit impact of their pricing decisions. This column briefly discusses an alternative approach to pricing that I call throughput pricing. Throughput pricing uses a cost estimating methodology that enables managers to accurately calculate the effect that a prospective job will have on company cost levels and profitability.

The most widely used alternative to absorption costing systems like BHR’s is direct costing. With direct costing, the only costs that are assigned to a prospective job are those that are variable with respect to that job. The principal advantage of direct costing is that it accurately portrays how a prospective job will cause company cost levels and profitability to change. However, direct costing it does have one significant disadvantage from a pricing perspective. Because it omits all fixed costs when calculating the cost of a prospective job, a direct costing system will not disclose whether a job’s target selling price is high enough to recover both the variable costs related to the job and a “fair share” of the company’s fixed operating costs.

Throughput pricing avoids the cost distortions created by traditional BHR systems and enables managers to determine when the selling price of a prospective job will recover an appropriate portion of the company’s fixed operating expenses. Throughput pricing is based on the accounting concepts that lie at the heart of Eliyahu M. Goldratt’s Theory of Constraints (TOC). Goldratt raised a lot of eyebrows in the business world in the 1980s when he questioned the usefulness of several long-standing management accounting procedures. For example, one of Goldratt’s major themes in TOC is that absorption costing leads to bad management decisions and improper management actions. TOC replaces absorption costing with a management accounting system that is composed of three core elements—throughput, inventory, and operating expenses. Goldratt and other TOC practitioners forcefully argue that the best way to boost a company’s profits is to increase the company’s throughput while holding inventory and operating expenses in check.