1 Theory of Constraints Short-term Capacity Optimization

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Theory of Constraints

Short-term Capacity Optimization

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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

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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

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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

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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

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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

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The Need for TOC

Does not indicate which products will maximize profits given the constraints Doesn’t take constraints into account

Does not consider the demands each item places on limited resources

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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

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The Need for TOC

Does not indicate which products will maximize profits given the constraints Doesn’t take constraints into account

Absorption cost does not consider the demands each item places on limited resources

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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

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The Need for TOC

Traditional definition of variable cost doesn’t hold in the short-run

Labor, variable overhead aren’t 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

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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

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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

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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

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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

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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

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Steps in the TOC Process

Internal Process constraints

Machine time, etc.

Policy constraints No overtime, etc.

External Material constraints

Insufficient materials

Market constraints Insufficient demand

Identify the system constraints

How is a constraint identified?

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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

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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

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Steps in the TOC ProcessProduct 1 Product 2

Demand per month 1,000 600 Price per unit 900$ 1,500$ Material cost per unit 400$ 800$

Test components 0.25 0.40Assemble components 1.00 1.50Install electronics 0.50 0.50Final inspection and test 1.25 1.00Package and ship 0.10 0.10

Identify the constraint

Product 1 Product 2 Total

Hours available

per monthSlack hours

Test components 250 240 490 640 150Assemble components 1000 900 1900 2240 340Install electronics 500 300 800 800 0Final inspection and test 1250 600 1850 1760 (90)Package and ship 100 60 160 160 0

Hours required per unit

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Steps in the TOC ProcessIdentify the best use of the constraint

Price per unit $900 $1,500Material cost per unit $400 $800Throughput per unit $500 $700Constaint time per unit 1.25 1.00Throughput 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 generatedUnits produced 928 600 Throughput per unit 500$ 700$ Total throughput 464,000$ 420,000$ 884,000$

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Alleviate the constraint Determine how to increase its capacity

Repeat the process Always a new constraint

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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

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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

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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

Documents

1 Theory of Constraints Short-term Capacity Optimization