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Categories: Theory of Constraints
Local Optimum Versus Global Optimum Part 5

Local Optimum Versus Global Optimum Part 5

By Bob Sproull

Effect of Changes in T, I and OE on Performance

Using our wood shop example from part 4, we will summarize how the financial performance of this wood shop changes as a result of changes in T, I and OE.  In this example, the monthly net profit is equal to throughput minus operating expense and works out to be, $15,000 minus $13,450 or $1,550.  At this rate, the annual net profit was projected to be, $1,550 per month x 12 months or $18,600.  We will now consider three cases, where T, I, and OE are each improved ten percent.

  • Throughput increases by ten percent, with no change in inventory and operating expense:  This can be accomplished in one of three ways:  sales price per desk increases, material costs decrease, or additional desks are sold. In this example the authors elected to have five additional desks sold each month using the same work force (because there was excess capacity). T increases by $1,500 per month (i.e. 5 desks x $300 per desk = $1,500) and OE does not change.  Remember that the cost of the extra materials to make the extra desks has already been subtracted out of the calculation of the total Throughput (T).  Therefore, net profit (NP) increases by $1,500 per month, from $1,550 to $3,050 or an increase of 97 percent.

 

  • Inventory is reduced by 10 percent, with no change in throughput or operating expense:  Since the inventory value was $32,000, this means there was a reduction of $3,200.  Inventory, as the authors have defined it, will eventually affect profitability through a reduction in the inventory carrying cost, which is part of operating expense.  The authors considered just one aspect of this reduction in carrying cost – a reduction in the interest paid to the bank.  Because there is less money tied up in inventory, less money will be borrowed from the bank.  If the interest rate charged by the bank is 10 percent, then a reduction of $3,200 will result in savings of $320 annually and the net profit would go up by this amount.  The additional net profit of $320 per year represents an increase of 1.72 percent (based upon annual net profit of $18,600).

  

  • Operating Expense is reduced by 10 percent, with Throughput and Inventory remaining unchanged:  The old operating expense was $13,450 per month, so the monthly decrease in expenses is $1,345.  This means that the new monthly operating expenses would be $12,105.  With throughput remaining the same, the net profit would become $2,895 per month ($15,000 - $12,105) for an increase of 87 percent.

The authors are very clear in stating that in their Synchronous Management approach, the appropriate question is not “what are the cost savings for a specific action?” Instead, the appropriate question is “what is the impact of the action on the operational measures of T, I and OE?”  It has been shown that changes in T, I and OE will ultimately have a financial impact on the entire business.  They further explain that these same operational measures represent a superior alternative to the standard cost system when evaluating the financial impact of manufacturing actions.

It is also important to understand that these operational measures are not intended to replace those required for GAAP reporting since they are required by law.  But for real-time decision making, using T, I and OE will always result in much better decisions.  The bottom line is the performance measurement and evaluation systems inherent in the standard cost system have contributed significantly to inappropriate actions, poor decisions and dysfunctional behaviors in many manufacturing companies.

Next Time

In my next post, we will begin a new discussion series related to improving the profitability of companies and better use of existing resources.  Before closing this series of blog posts, I want to, once again recommend L. Srikanth and Michael Umble’s wonderful book, Synchronous Management – Profit-Based Manufacturing for the 21st Century, Volume One.  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] L. Srikanth and Michael Umble, Synchronous Management – Profit-Based Manufacturing for the 21st Century, Volume One – 1997, The Spectrum Publishing Company, Wallingford, CT

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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