Theory of Constraints

Short-term Capacity Optimization

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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

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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

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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

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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

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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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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

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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

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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

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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

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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?

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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

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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

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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

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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

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Steps in the TOC Process

 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

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