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Two Different Thinking Bridges Part 3

Two Different Thinking Bridges Part 3

By Bob Sproull

Review

In my last post, we presented the same case study as the previous post, only this time we used the Global Thinking Bridge to analyze the purchase proposal. As we saw, the two conclusions were very different when we compared them. Using the Least Cost Analysis method, we concluded that the first year cost savings were a little over $17,000 and that the purchase was a good investment. When we used the Global Thinking Bridge method a $5,000 loss was shown; the conclusion was that the purchase wasn’t a good investment. We then laid the foundation for answering four questions asked by the Casparis:

  • Since the payback period is less than three months, this appears to be an excellent proposal. What do you think?
  • Is this proposal an improvement?
  • Is the example typical of how decisions are made in your organization?
  • Does your organization pursue production efficiencies with the purpose of increasing the bottom line?

In today’s post, we will look at a second scenario, using much of the same data we used in scenario 1, but with a couple of modifications. We will, once again, use both thinking bridge techniques to analyze the same proposal made by the engineer. As I pointed out in my last two posts, we will present material based upon a book entitled Management Dynamics–Merging Constraints Accounting to Drive Improvement, written by John and Pamela Caspari[1]. I recommend this book for anyone trying to drive profitability to new levels.

Initial Data

In scenario 2, we assume that everything is the same as in scenario 1, except that the firm is currently producing and selling at its capacity of 4,992 widgets. The engineer makes the same proposal as in scenario 1. Production times before and after the proposed change are shown in the following table.

Work Station

Original Processing Time

Proposed Processing Time

101

15 minutes

10 minutes

102

25 minutes

27 minutes

103

10 minutes

10 minutes

104

5 minutes

5 minutes

Total Time

55 minutes

52 minutes

Scenario 2: Least Product Cost Thinking Bridge

The reduction in standard cost is the same in the second scenario as it was in scenario 1, so the following two tables apply equally to scenario 2. After all, none of the variables that we used to calculate the $6.31 reduction in the standard cost has changed.

New Cost Element

Original Cost

Cost

Raw Materials

$ 80.00

$ 80.00

Direct Labor (52 minutes @ $0.3000

$ 16.50

$ 15.60

Overhead (52 minutes @ $1.8029)

$ 99.16

$ 93.75

Standard Unit Cost

$ 195.66

$189.35

Difference in Cost (Original–New)

$ 6.31

Cost savings per widget

$ 6.31

Annual volume of widgets

x 3,500

Total annual cost savings

$ 22,085

Less cost of fixture

$ 5,000

First year cost savings

$ 17,085

One thing that did change, however, was the first year cost savings because of the significantly higher volume of sales. The new first year cost savings has grown to $26,500. The payback and rate of return analysis based on the cost savings look even better than it did before as it has grown from 442% to an astounding 630% with the payback period of the investment now being about two months. So based on these numbers, this investment looks quite good. But what do you think? Should the company take on this investment? Let’s look at it from the perspective of the Global Thinking Bridge.

Scenario 2: Using the Global Thinking Bridge

As a refresher, the Global Thinking Bridge (aka Throughput Accounting) uses Throughput (T), Investment/Inventory (I), and Operating Expense (OE) as its cornerstone. When using this bridge technique for financial analysis of a proposed expenditure, we ask a series of five questions:

  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? The answer to this question has changed. The company is currently producing and selling at its capacity of 4,994 units, a limit established by workstation 102. The engineer’s proposal increases the time required at workstation 102 to produce a widget from 25 minutes to 27 minutes. As previously shown, the number of widgets that now can be produced actually drops by 370 widgets from 4,992 to 4,622. In this case there are plenty of sales; the ability of the overall system to generate greater throughput is limited by the capability of workstation 102

Q2: Will the total amount of Throughput (T) change? The answer is yes, based upon the following calculations.

Lost Sales Volume: Original capacity 4,992 units per year – new capacity with proposal implemented 4,622 = -370 units

Throughput per unit: Price $400 – variable expense $80 = $320

Throughput lost: Throughput per units $320 x 370 units per year lost = $118,400 per year

The proposal reduces the available capacity below that which is currently being sold. This means that the organization will be late delivering (or not able to fill) about 370 of the existing orders (4,992) for which it has contracted. Because there would be a $5,000 investment, the actual first year loss would be roughly $123,400 with losses in the years to come of $118,400.

Q3: Will the Operational Expenses (OE) change? No, as explained in scenario 1, OE will not change.

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

Q5: What is the real economic effect of this proposal? Scenario 2 involves reducing the effect on the available capacity of an existing fully utilized resource. The real economic effect of the proposal in scenario 2 combines the $5,000 investment with the $118,400 Throughput reduction for a total loss of $123,400 in the first year, and $188,400 each year thereafter. Based on this analysis, it appears as though this company should avoid this investment.

Next Time

In my next post, we will present a third scenario using much of the same data we used in scenario 1, but with a couple modifications. We will once again use both thinking bridge techniques 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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