© Washington State University-20101 Fundamental Exam Review Finance and Measures Segment The Theory of Constraints [email protected]

© Washington State University-2010 1

Fundamental Exam Review

Finance and Measures Segment

The Theory of Constraints

[email protected]://www.engrmgt.wsu.edu/

James R. Holt, Ph.D., PEProfessor

Engineering & Technology Management

mailto:[email protected]

http://www.engrmgt.wsu.edu/


TOCICO Segmented Fundamentals Exam

Fundamentals Certificate

Multiple Choice Exam(Identify, Exploit, Subordinate, Elevate, Go to Step 1)

Fundamentals Certificate of TOC Philosophy

Fundamentals Certificate of TOC Thinking Processes

FundamentalsCertificate of TOC Applications

Fundamentals Certificate of TOC Finance & Measures

•Inherent Potential•Inherent Simplicity•Inherent Win-Win•Five Focusing Steps•Three Questions

•Conflict Cloud

•Negative Branch

•Ambitious Target

•DBR•T, I, OE

•PQ Type Problem•Project

Management

•Replenishment


Topics in TOC Finance & Measures

• Purpose of Finance (invest in improvements)

• Purpose of Measures (keep everyone focusing on the constraint and subordination)

• Decide on Investment decision (make/buy, equipment purchase)

• Impact of poor quality/delivery on system

• Impact of poor inventory practices on the system

• Financial Buffer Management

• T, I, OE, Cash Flow, Profit, Return on Inventory/Investment

• TDD, IDD

• Throughput Accounting worksheet

T I OE

Finance Processes

The Goal: Make Excellent InvestmentsThe Measure: Systems Profit, Inventory, Operating Expense The Constraint: Knowing What to Do

$$$

$

$

$ $$

$$$$$

Cost of Raw MaterialsCost of LaborCost of EquipmentCost of OperationsCost of MarketingCost of ManagementCost of ExpansionCost of Projects Wait?

4© Washington State University-2010

Finance Processes

A. Excellent Investments

B. Excellent System wide

D. Consider everything effected

C. Excellent use of Constraint

D’. Consider only T, I, OE

The Conflict Cloud:

The Paradigm Shift: Focus on ΔT, ΔI & ΔOE Relative to the Constraint

T I OE

$$$


The Finance Results

What do we learn here to apply to

Daily Lives?Confidence, Security and Predictability Improves.

Freedom of Actions Dramatically Improves.

T I OE

$$$

Every Investment is an Improvement:

Cash Flow Improves. Profit Improves.Return-on-Investment Improves.Indebtedness Reduces.

T I OE


Financial Lessons Learned

• Manage Costs Relative to the Constraint.• Pick High T/Constraint Unit Projects• Determine Needs Prudently

Know the difference between Needs and Wants• Stop Buying Junk (no payback)• Be Frugal Everywhere but at the Constraint (Spend what

it takes to improve the Constraint wisely)• Avoid UnNecessary Debt (Earn Interest vs. Paying It)• Have Cash and Other Financial Reserves• Simplify Life and Decisions become easier



Consider a Simple Firm WXYZ

• Only two employees: Mr. M and Mr. N

• They can choose between any one of Four Products: W, X, Y, or Z

• Unlimited materials and unlimited market demand

• They each get paid $10 per hour.

• The Firm operates 8 hours a day.

• They get paid whether they produce anything or not.

Work FlowProduct W

$50Product X

$50Product Y

$55Product Z

$52

M6

M8

M5

M5

M10

N10

N20

WXYZ Poduct Flow and Routings

RM$5

RM$10

RM$10

RM$5

RM$10

RM$5

RM$5

Production and InventoryJournal, Second Quarter,1989, Fry & Cox

Times are in minutes per part.Raw material costs are dollares each.Market for W, X, Y and Z is open.M and N are only two resources-8

hrs/day at $10 per hour each 9© Washington State University-2010

WXYZ Products

Product Price Materials LaborCost/Unit

Profit Margin (Price- Materials - Labor)

W 50 20 (36 min)$6.00

$24.00

X 50 25 (38 min)$6.33

18.67

Y 55 25 (35 min)$5.83

24.17

Z 52 20 (35 min)$5.83

26.17

Production and Inventory Management Journal, Second Quarter, 1989, Fry and Cox

Cash Flow Summary



So, What Product Should They Make?

• Decision suggested by Accounting: Produce items with the HIGHEST PROFIT MARGIN

• That would be Z with a $26.17 Profit Margin selling at $52 each

• ($52)*(16 ea) - ($20)*(16ea) - (2 workers)*(8 hours)*($10/hour) = $352 /day


What about Marketing

• Decision suggested by Marketing: Produce items with the HIGHEST SELLING PRICE (paid on Commission)

• That would be Y at $55 Sales Price Each



What about Production?

• Decision suggested by Production: Produce items that keep machine at HIGHEST EFFICIENCY

• That would be X at $50 profit each



But, If We Think Globally!

• Decision based upon producing items that provide the MOST THROUGHPUT PER UNIT OF CONSTRAINT TIME for the SYSTEM

• That would be W at $50 profit each

• W: ($50)*(24 ea) - ($20)*(24ea) - (2)*(8)*($10) = $560 /day


Product Option Summary

• Does it really make any difference what you choose to do?

• Mr. N is 100% busy for every product! That’s 100% efficiency! You can’t get better than that, can we?

• Product Profit/Day Compare

• Acctg-Profit Margin Z $352 100%

• Sales-Hi Sales Price Y $320 90%

• Production-Efficiency X $440 125%

• TOC Measure W $560 159%


Worse Effects from Non-Global Thinking

• What we have to put up with:

• Decisions are based on combined opinion of accounting, production and sales. That is, “They change decisions weekly!”

• Shop is measured on performance/efficiency Shop floor struggling for efficiencies. So, we

produce extra when machines running. We pull jobs out of sequence. We shift parts ahead or back to meet efficiency quotas. Out of Synch.


The Resulting Effects of Non-Global Thinking

• Product Group finds we have high efficiencies and yet our production is unacceptable to meet objectives. Use overtime to improve numbers

• Plant Manager sees frequent overtime, late shipments, long queues. Orders additional capacity (more machines, out sources work). Increases costs to produce more of the low

throughput products. Reduces the profit of the firm.


TOC Measures: T, I, OE

• We have touched on measures and their impact. It’s time to properly define then and work through and example that shows how valuable using the right measures can be. Throughput (T): “The Rate at which the System Generates Income” ( (This is

Sales Price-Truly Variable Cost)/Time). It is often referred to as Octane: The

income/unit of constraint for a particular product. Priority 1 Inventory (I): “The things we buy with the intent to sell” (Sum total of the

costs spent in buying things up and until the moment someone actually pays us for them). Dollar-Days is I*Number of days held. Priority 2

Operating Expense (OE) The cost of converting “I” into “T”. All costs associated with the business lumped into one. Labor is OE. Don’t be confused by using allocated costs. Costs may be good for reporting, but not for managing. A low priority 3

Profit (P): T-OE Return on Investment (ROI): (T-OE)/I Cash Flow (CF): “Is there money on hand to pay what we need to do?”


Basic Measures

• T= (Sales - Truly Variable Costs)/time (T is a rate)

• I = Things we buy with the intent to turn them to T

• OE=All costs of turning I into T

• Profit=T-OE

• Return on Investment = (T-OE)/I

• Cash Flow=T-OE >0 (more in than out)(poor cash flow can only be supported by increasing loans

for so long)


Trial Problem (PQ)

• Now we know what to measure, lets take a case. This case is described in The Haystack Syndrome (shifting information out of Data) by Eli Goldratt

• Four employees (A, B, C, D) work to make either of two products (P, Q). They buy raw material and perform operations. Each employee performs two different operations.

• The production pattern (routing plan) for the two possible products follows on the next slide.

• Each employee works 8 hours a day, 5 days a week.

• At the end of the week, Operating Expenses are $6000 which includes labor and overhead. Which product should they make? Or, how many of each one should they make? How many can they make?

Materials Flow Diagram

A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20

Worker:Process Time in Minutes

Three types of Raw Material and Purchase Prices

Work flows upwards from RM to Assembly operation by worker D

Final Goods P and Q available to Customers

D makes the assembly for P including a purchased part

Note: The middle common part

produced by worker C is used in both Product P and Q



Some Typical Cost Accounting Numbers to Assist your Decision

P Demand100/wkPrice $ 90 eaLess RM -45Max Profit $ 45Overhead -37.80Margin $ 7.20 ea

Q Demand 50/wkPrice $ 100 eaLess RM -40Max Profit $ 60Overhead -31.50Margin $ 28.50 ea

Operating Expense$6000 per week

5 Days * 8 Hours*60mins = 2400 min/wk

($6000/wk)/(4 stations *2400min ea) = ~$0.63 /station min

Minutes / Cost per Station (@$0.63 per minute)

P Q A 15 / $ 9.45 10 / $ 6.30 B 15 / $ 9.45 30 / $18.90 C 15 / $ 9.45 5 / $ 3.15 D 15 / $ 9.45 5 / $ 3.15Total 60 / $37.80 50 / $31.50


A Few More Numbers

Time to produce total dem andStation P Q Total@ (100) (50)A 1500 500 2000 m insB 1500 1500 3000 minsC 1500 250 1750 m insD 1500 250 1750 m ins

Production DecisonHow m any Psshould be m ade? _____How m any Qsshould be m ade? _____Gross Sales $______Less Raw Materials $-______Less Operating Expense $-$6000Profit $ ______

Before you go on, take a shot at filling out the form below. How many Ps should be made? How many Qs? Commit yourself before you look at the

solution on the following pages. (Go back a few slides if you need to, but don’t look ahead. If you cheat, you won’t learn as much as you should.)


Well? Q looks tempting. Try making Q first.

Production DecisonHow many Psshould be made? 60How many Qsshould be made? 50Gross Sales $ 10,400Less Raw Materials $ - 4,700Less Operating Expense $ - 6,000Profit $ - 300

All we can make with the time remaining

All market wants


Well then, Try P first

Production DecisionHow many Psshould be made? 100How many Qsshould be made? 30Gross Sales $ 12,000Less Raw Materials $ - 5,700Less Operating Expense$ - 6,000Profit $ + 300

All we can make with the time remaining

All market wants


Consider Traditional Measures

• Sales Price: Q $100 P $90 Should sell Q

• Margin: Q $ 28.50 P $ 7.20 Should sell Q

• Raw Material: Q $ 40 P $45 Should sell Q

• Labor: Q 50 Min P 60 Mins Should sell Q

• Throughput: Q $ 60 P $ 45 Should Sell Q

• Quantity Q 50 ea. P 100 ea. Should Sell P

What is missing?

Octane! Throughput / Constraint Minute!

Where is the Constraint?


What is the Difference?

• Consider the Constraint worker B. The constraint is 100% Busy no matter what we choose. But…

• Individual Throughput for P is $90-45=$45

• Individual Throughput for Q is $100-40=$60

• Octane for P is T/time=$45/15=$3/min

• Octane for Q is T/time=$60/30=$2/min

• Producing P versus Q delivers $1 per minute difference. So, if we can’t make all Ps and all Qs, we should not waste our precious constraint time making Qs at the expense of Ps.

• Be sure to make all Ps and then make as many Qs as you can.


Now you are proficient with TOC Measures...

• Lets consider a series of possible changes that could occur to our PQ factory.

• What would you recommend if: You could rent a Jig to speed up worker A? You could rent a Jig to speed up worker B? You could buy the Left RM with the first

process already complete? If you could buy the Center RM with the first

process already complete? Should we add a new product O? Should we add a new product R?


Consider Alternative 1: Jig for A

• New Jig works at both A locations.

• Saves 5 minutes at each A operation

• Rental cost only $100 per week

• Saves (5*100 +5*30)= 630 Minutes

• 630 Minutes at $0.63 = $400

• Reduces OE by $400

• Wow! $400-$100=Saved $300 Dollars!

• Really?

• What happened to the OE really? Did it go down? Or did it go up as we added

equipment rental costs?A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20


Consider Alternative 2: Jig for B

• Only works at middle B operation.

• Costs $200 per week

• Only saves 2 minutes on one operation

• Saved time (2*130) = 260 minutes

• Reduced OE: 260 Minutes @ $0.63 = $165

• Looks pretty bad

• Really?

• What happens when we reduce the time required on the Constraint? Now many components flow through

that operation? (100 P + 30 Q = 130) How much time is gained?

2*130=260 minutes. How many more Qs can we make? 260/30=8 with T of $60 each = +$480!

A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20


Consider Optional Raw Material Purchase

• Suppose we could purchase the left Raw Material Pre-Processed to eliminate the Left A process

• Cost only $5 extra each * 100 each or $500

• Savings 15 Minutes * 100 = 1500 Minutes

• 1500 Minutes @ $0.63 = $950

• Looks Real Good!

• Really?

• Does it save any overhead at all? We must continue to have A working,

so nothing gained. And, we increase overhead by $500.

A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20


Consider Optional Raw Material Purchase

• Now consider the option of purchasing the Middle Raw Material Pre Processed to bypass the Middle B process

• Cost only $10 each extra * 130 each or $1300

• Savings 15 Minutes * 130 = 1950 Minutes

• 1950 Minutes @ $0.63 = $1230

• Doesn’t look too good!

• Should you do it? YES! WHY? For only $10 extra, we gain 15 minutes

of Constraint time. That costs $0.66 perminute.

We can earn $2.00 per minute making more Qs

We need 600 more minutes to make all Qs. So, we buy 40 of the pricey Middle

RMs (But no more).

A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20


Consider Adding a New Product

• We can add a new product O

• O doesn’t flow through the constraint.

• Just uses the left side of the plant A and C

• Also uses $5 purchased part.

• What do you think?

• Is it a Cheeri- O ?• We can make lots of Os

and sell them at anything above $25. A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20

O

O Sells for $40RM is $25Overhead $15.75Looks like - $0.75A Loss in Profit!

A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20

O

O Sells for $40RM is $25Overhead $15.75Looks like a $0.75Loss in Profit

Octane on O is

$15/0=$We should make O. We can make up to the point A can no longer support or otheroperations. Cheeri-O!



Consider Adding a New Product

• We can add a new product R

• R flows through the constraint on the Right.

• Just uses the right side of the plant A and B

• What do you think?

• Is it a lose- R ?

A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20

R Sells for $40RM is $20Overhead $15.75Looks like a winner at $4.75Profit!

R

A:15 B:15 A:10

C:10 C:5 B:15

D:15 D:5

QP

PurchasedPart $5

RawM aterial

$20

RawM aterial

$20

RawM aterial

$20

R Sells for $40RM is $20Overhead $15.75Looks like a winner at $4.75Profit!

R

Octane on R is $20/15=$1.33We should Not make R. The Octane for Q is $2.00 per minute.It’s a Lose-R!



Putting T, I OE in Practice

•Suggest using a simple form:

•Option_______________________ Date _______

•Proposal by __________________

Sales- Materials

= Throughput-Operating Expense

= Profit

Current Change Future$K/yr$K/yr$K/yr

$K/yr

Refn: The Theory of Constraints and Its Implications for Management Accounting, Western Textile.



• (Simple form continued)

ProfitInventory

+ Accts Receivable- Accts Payable

= Working Capital+ Fixed Assets

= AssetsProfits

÷ AssetsROA

Current Change Future$K/yr$K$K$K$K$K$K$K/yr$K



• (Simple form continued)

Profits÷ Employees

ROE

Current Change Future

$K/yr#$K/E/yr

= Assets

Profits÷ Assets

ROA

$K$K/yr$K


Look for High Octane ($/min)

TOC Marketing Approach

Th

rou

ghp

ut

->

$0

$$

- $

Low -> Volume of Sales -> High

High ProfitItems $

Good Solid Products $$

Low ProfitHigh Volume $$

Needed to flesh out market offer

Required to obtain a related good product.

$$

$$$$$$

-$

Goal

Goa

l

Net M

arketi

ng Dire

ction

High Velocity!


A Word about Inventory?

• Inventory is a big part of subordination.

• Is too much Inventory Bad?

• Is too little Inventory Bad?

• Which is worse?

Low Amount of Inventory HighNu

mb

er o

f p

rob

lem

s


Subordinate Inventory

• Having Inventory is not the Goal.

• Inventory is what we buy with the intention of converting it to Money

• Move inventory to where it will do some good.

• Move Inventory Quickly to the Constraint (Keep Buffer close to Constraint)

• Move Inventory Quickly away from the Constraint (quickly convert inventory to money)

• Think “Protection of the System” when you think of inventory.


Economic Order Quantity

Small Order Quantity Q Large

Cos

t of

Op

erat

ion

$

Holding Costs (Q/2)*Cost Holding

Ordering Costs (D/Q)*Cost Ordering

Total Cost=(D/Q)*Cost Order +(Q/2)*Cost Holding


Solving for Q at Optimal Position

Small Order Quantity Q Large

Cos

t of

Op

erat

ion

$->

Optimal Order Quantity

Q= ((2*D*Co)/CH/h)**0.5


For the Same Profit, Invest a little in Inventory or Alot?

Small Order Quantity Q LargeCost of O

peration

$->

Pro

fit

Mea

sure

->

Low Investment High


Next Topics

• TOC Thinking Processes

• TOC Applications Operations Project Management Replenishment

• TOC Finances and Measures

• Some TOC Philosophy will be blended into these additional topics.

Documents

© Washington State University-20101 Fundamental Exam Review Finance and Measures Segment The Theory of Constraints [email protected]