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Applying Theory of Constraints: Two Different Thinking Bridges Part 4

Applying Theory of Constraints: Two Different Thinking Bridges Part 4

By Bob Sproull

Review of Part 3

In Part 3 of our Two Different Thinking Bridges series, we used the Least Cost and the Global Thinking Bridge (TB) techniques to evaluate a purchase proposal. The evaluation was similar to the scenario in Part 2 of the series, with a couple of modifications.

Our Part 3 scenario results were completely different for each Thinking Bridge, similar to our results in the Part 2 scenario.

Applying the Least Cost TB, the new first year cost savings grew to $26,500. Based on those savings, the payback/rate of return grew from 442% to an astounding 630%. The payback period for the investment was about two months.

In applying the Global TB, the proposal reduces the available production capacity below the 4,992 unit sales order level. Now the company is unable to fill 370 of the existing orders for which it has contracted. With a $5,000 investment, the first year loss is about $123,400, with subsequent losses of $118,400 in each of the following years.

Today’s Scenario

In Part 4 of our Two Different Thinking Bridges series, we will look at a new scenario, applying much of the same data from our original scenario in Parts 1 and 2, with a couple of modifications. Once again, we will apply both Thinking Bridges to analyze the same proposal made by the engineer. We will again be presenting material from the highly recommended book entitled Management Dynamics—Merging Constraints Accounting to Drive Improvement written by John and Pamela Caspari[1].

Initial Data

Today we start from the original scenario and apply one variable: the firm’s market has now grown to at least 6,000 widgets. The production capacity is still 4,992 widgets. The plant engineer makes the suggestion to purchase a piece of equipment, which raises the total time to produce the product by three minutes.

As the table below shows, five minutes are added to workstation 101’s processing time, while processing for workstation 102 is reduced by two minutes. The net increase is three minutes.

Work Station

Original Processing Time

Proposed Processing Time

101

15 minutes

20 minutes

102

25 minutes

23 minutes

103

10 minutes

10 minutes

104

5 minutes

5 minutes

Total Time

55 minutes

58 minutes

Applying the Least Cost TB

In today’s scenario, the standard cost of a widget increases by $6.31 as shown in the table below. Since the only adjusted variable is the net increase in processing time, we have gone from a $6.31 savings in our first two scenarios to a $6.31 increase.

New Cost Element

Original Unit Cost

Proposed Unit Cost

Raw Materials

$ 80.00

$ 80.00

Direct Labor (52 minutes @ $0.3000

$ 16.50

$ 17.40

Overhead (52 minutes @ $1.8029)

$ 99.16

$104.57

Standard Unit Cost

$ 195.66

$201.97

Difference in Cost (Original – New)

$ 6.31

This table summarizes the estimated cash flows for this proposal, based on the increased unit cost:

Cost increase per unit

$ 6.31

Annual volume (units) x

4,992

Annual cost increase

$ 31,500

Cost of fixture

$ 5,000

First year cost increase

$ 36,500

This proposal costs the company $36,500 in the first year and $31,500 each year thereafter. It should be rejected, based on the analysis using the Least Cost TB.

Applying the Global TB

The Global TB, otherwise known as Throughput Accounting, uses three cornerstones: 1) Throughput, 2) Investment/Inventory, and 3) Operating Expense. The Global TB requires that we ask five questions about the proposal:

  1. What prevents the firm from increasing Throughput?
  2. Will the total amount of Throughput change?
  3. Will the Operational Expenses of the firm change?
  4. Will the amount of Inventory/Investment in the firm change?
  5. What is the real economic effect of this proposal?

Q1: What prevents the firm from increasing Throughput? Just as in the scenario in Part 3, workstation 102 restricts this company’s ability to serve all of its potential customers.

Q2: Will the total amount of Throughput change? Even though the proposal raises the standard cost of the product, it also increases the relative capacity of workstation 102. The time required to process a widget is reduced from 25 to 23 minutes. This decrease in processing time raises the workstation’s annual capacity by 434 widgets to 5,426 (124,800 minutes per year/23 minutes per widget).

Because the new market potential is 6,000 widgets, the additional 434 widgets produced can all be sold. With a Throughput of $320 per widget, the result is a gain of $138,880 per year.

Q3: Will the Operational Expenses of the firm change? No. As explained in the scenario in Parts 1 and 2, OE will not change.

Q4: Will the amount of Inventory/Investment in the firm change? Yes. As explained in the scenario in Parts 1 and 2, Investment increases by $5,000, which is the cost of the new fixture.

Q5: What is the real economic effect of this proposal? The company realizes a gain of $133,880 in year 1 and $138,880 in subsequent years, as summarized in the table below:

Global Measurement

First Year

Future Years

T

+ $138,880

+ $138,880

I

+ $ 5,000

No change

OE

No change

No change

Cash Flow

+ $133,880

+ $138,880

Based on the Global Thinking Bridge analysis, the company should absolutely pursue this investment.

Coming in the Next Post

We will present a final scenario in the Two Different Thinking Bridges series, using the same data we have been using, with modifications to a couple variables. As we have throughout this series, we will use both Thinking Bridges to analyze the same proposal made by the engineer.

As always, if you have any questions or comments about any of my posts, leave me a message and I will respond.

Until next time,

Bob Sproull

References:

[1] Management Dynamics – Merging Constraints Accounting to Drive Improvement, written by John and Pamela Caspari, published by John Wiley & Sons, Inc, 2004

Bob Sproull

About the author

Bob Sproull has helped businesses across the manufacturing spectrum improve their operations for more than 40 years.

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