Theory of Constraints

Short-term Capacity Optimization

1
Theory of Constraints

Significance of bottlenecks
Maximum speed of the process is the speed of
the slowest operation
Any improvements will be wasted unless the
bottleneck is relieved
Bottlenecks must be identified and improved if the
process is to be improved

2
Theory of Constraints

Purpose is to identify bottlenecks or other

constraints and exploit them to the extent
possible
Identification of constraints allows management to
take action to alleviate the constraint in the future
Reduce cycle time
Time from receipt of customer order to shipment
Improve manufacturing cycle efficiency (MCE)
Processing time / total cycle time

3
Theory of Constraints

Assumes current constraints cannot be

changed in the short-run
What should be produced now, with current
resources, to maximize profits?
Question cannot be answered by traditional accounting
methods

4
Theory of Constraints

Management tool, not an accounting tool

Not used to determine inventory values
Not used to allocate overhead to inventory
Does not comply with GAAP
Does indicate how to use available resources
most effectively

5
The Need for TOC

Standard costing
Can promote undesirable behavior
Work to keep people busy
Local optimization
Inventory is produced regardless of need

Does indicate what it should cost to produce a

product

6
The Need for TOC
Does not indicate which products will maximize
profits given the constraints
Doesnt take constraints into account
Does not consider the demands each item places on
limited resources

7
The Need for TOC

Absorption costing
Can promotes undesirable behavior
Production costs are assets until sold
Accumulation of inventory keeps costs off the income
statement
Illusion of profitability

Does indicate what it costs to produce a product

8
The Need for TOC
Does not indicate which products will maximize
profits given the constraints
Doesnt take constraints into account
Absorption cost does not consider the demands each
item places on limited resources

9
The Need for TOC

Variable (direct) costing

Identifies the incremental costs of producing a
product
Identifies product that provides the greatest
contribution margin, or contribution margin per unit of
constrained resource
Cannot deal with more than one constraining
resource at a time

10
The Need for TOC
Traditional definition of variable cost doesnt hold
in the short-run
Labor, variable overhead arent really variable
on a day-to-day basis
Some costs are truly variable in the short-run
Material, commissions, delivery costs, out-of-
pocket selling costs, etc.
Each additional unit produced or sold causes
more of the cost to be incurred
11
The Need for TOC

Theory of Constraints
Uses linear programming to determine best use of
limited resources
Indicates what should be produced and in what
quantities

12
Theory of Constraints

Constraining resource must be maximized

All other operations must be geared toward this
goal
May require suboptimization in other areas
Upstream operations must provide only what the
constraint can handle
Downstream operations will only receive what the
constraint can put out

13
Theory of Constraints
Constraint must be kept operating at its full
capacity
If not, the entire process slows further

Focus is on maximizing throughput

Sales totally variable costs
All other costs treated as fixed operational
expenses
Cannot vary much in the short-run

14
Theory of Constraints

Based on the concepts of drum, buffer and

ropes
Drum
Output of the constraint is the drumbeat
Sets the tempo for other operations
Tells upstream operations what to produce
Tells downstream operations what to expect

15
Theory of Constraints
Buffer
Stockpile of work in process in front of constraint
Precaution to keep constraint running if upstream
operations are interrupted

Rope
Sequence of processes prior to and including the
constraint
Want to pull the rope at the maximum speed
Speed of the constraint

16
Steps in the TOC Process

Identify the system constraints

Internal External
Process constraints Material constraints
Machine time, etc. Insufficient materials
Policy constraints Market constraints
No overtime, etc. Insufficient demand

How is a constraint identified?

17
Steps in the TOC Process

Decide how to exploit the constraint

Produce the most profitable product mix
Want it working at 100%
How much of a buffer?
Holding costs
Including risk, quality costs
Stock-out costs

18
Steps in the TOC Process

Subordinate everything else to the preceding

decision
Plan production to keep constraint working at
100%
May need to change performance measures to
conform upstream activities to the rope speed

19
Steps in the TOC Process
Product 1 Product 2
Demand per month 1,000 600
Price per unit $ 900 $ 1,500
Material cost per unit $ 400 $ 800

Hours required per unit

Test components 0.25 0.40

Assemble components 1.00 1.50
Install electronics 0.50 0.50
Final inspection and test 1.25 1.00
Package and ship 0.10 0.10

Identify the constraint

Hours
available Slack
Product 1 Product 2 Total per month hours
Test components 250 240 490 640 150
Assemble components 1000 900 1900 2240 340
Install electronics 500 300 800 800 0
Final inspection and test 1250 600 1850 1760 (90)
Package and ship 100 60 160 160 0

20
Steps in the TOC Process
Identify the best use of the constraint

Price per unit $900 $1,500

Material cost per unit $400 $800
Throughput per unit $500 $700
Constaint time per unit 1.25 1.00
Throughput per hour $400 $700

Identify the most profitable product mix

Total demand 1,000 600

Units produced in best mix 928 600
Unmet demand 72 -

Throughput generated
Units produced 928 600
Throughput per unit $ 500 $ 700
Total throughput $ 464,000 $ 420,000 $ 884,000

21
Steps in the TOC Process

Alleviate the constraint

Determine how to increase its capacity
Repeat the process
Always a new constraint

22
Evaluation of TOC

Advantages
Improves capacity decisions in the short-run
Avoids build up of inventory
Aids in process understanding
Avoids local optimization
Improves communication between departments

23
Evaluation of TOC

Disadvantages
Negative impact on non-constrained areas
Diverts attention from other areas that may be the next
constraint
Temptation to reduce capacity

24
Evaluation of TOC

Ignores long-run considerations

Introduction of new products
Continuous improvement in non-constrained
areas
May lead organization away from strategy
Not a substitute for other accounting
methods

25