Transcript Slide 1
The Theory of Constraints Fundamental Exam Review
Finance and Measures Segment James R. Holt, Ph.D., PE Professor
Engineering & Technology Management
© Washington State University-2010 http://www.engrmgt.wsu.edu/ 1
TOCICO Segmented Fundamentals Exam
Fundamentals Certificate of TOC Philosophy • Inherent Potential • Inherent Simplicity • Inherent Win-Win • Five Focusing
Fundamentals Certificate Multiple Choice Exam (Identify, Exploit, Subordinate, Elevate, Go to Step 1)
Steps • Three Questions Fundamentals Certificate of TOC Thinking Processes • Conflict Cloud • Fundamentals Certificate of TOC Applications DBR • Negative Branch • Project Management • Ambitious Target • Replenishment © Washington State University-2010 Fundamentals Certificate of TOC Finance & Measures • T, I, OE • PQ Type Problem 2
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
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Finance Processes
The Goal: Make Excellent Investments The Measure: Systems Profit, Inventory, Operating Expense The Constraint: Knowing What to Do Cost of Raw Materials Cost of Labor Cost of Equipment Cost of Operations Cost of Marketing Cost of Management Cost of Expansion Cost of Projects T I OE $$$ Wait?
$ $$$$$ $ $ $ $ © Washington State University-2010 4
Finance Processes
The Conflict Cloud: The Paradigm Shift: Focus on ΔT, ΔI & ΔOE Relative to the Constraint T I OE $$$ B. Excellent System wide D. Consider everything effected A. Excellent Investments C. Excellent use of Constraint © Washington State University-2010 D’. Consider only T, I, OE 5
The Finance Results
Every Investment is an Improvement: T I OE Cash Flow Improves. Profit Improves.
Return-on-Investment Improves.
Indebtedness Reduces.
Confidence, Security and Predictability Improves.
Freedom of Actions Dramatically Improves.
T I OE $$$ What do we learn here to apply to Daily Lives?
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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 © Washington State University-2010 7
Consider a Simple Firm WXYZ
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Only two employees: Mr. M and Mr. N They can choose between any one of Four
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Products: W, X, Y, or Z
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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.
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WXYZ Poduct Flow and Routings Product W $50 Product X $50 M 6 M 8 RM $5 RM $10 M 10 RM $5 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 RM $10 N 20 RM
Work Flow
Product Y $55 Product Z $52 M 5 M 5 RM $5 N 10 RM $5 Production and Inventory Journal, Second Quarter, 1989, Fry & Cox 9
Cash Flow Summary
WXYZ Products Product Price
W X Y Z
Materials Labor Cost/Unit
50 50 55 20 25 25 (36 min) $6.00
(38 min) $6.33
(35 min) $5.83
52 20 (35 min) $5.83
Production and Inventory Management Journal, Second Quarter, 1989, Fry and Cox © Washington State University-2010 Profit Margin (Price - Materials - Labor)
$24.00
18.67
24.17
26.17
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So, What Product Should They Make?
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Decision suggested by Accounting: Produce items with the HIGHEST PROFIT MARGIN
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That would be
Z
with a $26.17 Profit Margin selling at $52 each
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($52)*(16 ea) - ($20)*(16ea) - (2 workers)*(8 hours)*($10/hour) = $352 /day
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What about Marketing
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Decision suggested by Marketing: Produce items with the HIGHEST SELLING PRICE (paid on Commission)
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That would be Y at $55 Sales Price Each ($55)*(16 ea) - ($25)*(16ea) - (2 workers)*(8 hours)*($10/hour) = $320 /day
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What about Production?
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Decision suggested by Production: Produce items that keep machine at HIGHEST EFFICIENCY
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That would be X at $50 profit each ($50)*(24 ea) - ($25)*(24ea) - (2 workers)*(8 hours)*($10/hour) = $440 /day
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But, If We Think Globally!
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Decision based upon producing items that provide the MOST THROUGHPUT PER UNIT OF CONSTRAINT TIME for the SYSTEM
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That would be W at $50 profit each W: ($50)*(24 ea) - ($20)*(24ea) - (2)*(8)*($10) = $560 /day
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Product Option Summary
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Does it really make any difference what you choose to do?
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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
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Acctg-Profit Margin Sales-Hi Sales Price Z Y Production-Efficiency X TOC Measure W $352 $320 $440 $560
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100% 90% 125% 159%
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Worse Effects from Non-Global Thinking
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What we have to put up with:
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Decisions are based on combined opinion of accounting, production and sales.
That is, “They change decisions weekly!”
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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.
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The Resulting Effects of Non-Global Thinking
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Product Group finds we have high efficiencies and yet our production is unacceptable to meet objectives.
Use overtime to improve numbers
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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.
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TOC Measures: T, I, OE
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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?”
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Basic Measures
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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
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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)
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Trial Problem (PQ)
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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
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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.
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The production pattern (routing plan) for the two possible products follows on the next slide.
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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?
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Materials Flow Diagram P
D makes the assembly for P including a purchased part
Purchased Part $5
Note: The middle common part produced by worker C is used in both Product P and Q
C:10
Worker
:
Process Time in Minutes
A:15 D:15 C:5 B:15 Q D:5
Final Goods P and Q available to Customers Work flows upwards from RM to Assembly operation by worker D
B:15 A:10
Three types of Raw Material and Purchase Prices
Raw Raw Material Material $20 $20
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Raw Material $20
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Some Typical Cost Accounting Numbers to Assist your Decision
Operating Expense $6000 per week 5 Days * 8 Hours*60 mins = 2400 min/wk ($6000/wk)/ (4 stations *2400 min ea) = ~$0.63 / station min P Demand100/wk Price $ 90 ea Less RM Max Profit -45 $ 45 Overhead -37.80
Margin $ 7.20 ea 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 / $ 3.15
Total 60 / $37.80 50 / $31.50
Q Demand 50/wk Price $ 100 ea Less RM Max Profit -40 $ 60 Overhead -31.50
Margin $ 28.50 ea
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A Few More Numbers
Time to produce total demand Station P Q Total @ A B C D (100) 1500 1500 1500 1500 (50) 500 2000 mins 1500 3000 mins 250 1750 mins 250 1750 mins
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.)
Production Decison How many Ps should be made? _____ How many Qs should be made? _____ Gross Sales $______ Less Raw Materials $-______ Less Operating Expense $-$6000 Profit $ ______
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Well? Q looks tempting. Try making Q first.
Production Decison How many Ps
All we can make with the time remaining
should be made? 60 How many Qs
All market wants
should be made? 50 Gross Sales $ 10,400 Less Raw Materials $ - 4,700 Less Operating Expense $ - 6,000 Profit $ - 300
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Well then, Try P first Production Decision How many Ps should be made? 100 How many Qs should be made? 30
All market wants All we can make with the time remaining
Gross Sales $ 12,000 Less Raw Materials $ - 5,700 Less Operating Expense$ - 6,000 Profit $ + 300
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Consider Traditional Measures
• • • • • •
Sales Price: Q $100 Margin: Labor: Quantity P $90 Q $ 28.50 P $ 7.20
Raw Material: Q $ 40 P $45 Q 50 Min P 60 Mins Throughput: Q $ 60 Q 50 ea.
P $ 45 P 100 ea.
Should sell Q Should sell Q Should sell Q Should sell Q Should Sell Q Should Sell P What is missing?
Where is the Constraint?
Octane! Throughput / Constraint Minute!
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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.
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Now you are proficient with TOC Measures...
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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?
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Consider Alternative 1: Jig for A
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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!
Purchased Part $5 Really?
What happened to the OE really?
Did it go down?
Or did it go up as we added equipment rental costs?
C:10 A:15
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Raw Material $20 P D:15 C:5 B:15 Raw Material $20 Q D:5 B:15 A:10 Raw Material $20
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Consider Alternative 2: Jig for B
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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?
Purchased Part $5 What happens when we reduce C:10
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!
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A:15 Raw Material $20 P D:15 C:5 B:15 Raw Material $20 Q D:5 B:15 A:10 Raw Material $20
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Consider Optional Raw Material Purchase
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Suppose we could purchase the left Raw Material Pre Processed to eliminate the Left A process
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Cost only $5 extra each * 100 each or $500 Savings 15 Minutes * 100 = 1500 Minutes 1500 Minutes @ $0.63 = $950 Looks Real Good!
Really?
Purchased Part $5 P D:15 Does it save any overhead at all?
C:10 We must continue to have A working, so nothing gained.
A:15
And, we increase overhead by $500.
Raw Material $20 C:5 B:15 Raw Material $20 Q D:5 B:15 A:10 Raw Material $20
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Consider Optional Raw Material Purchase
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Now consider the option of purchasing the Middle Raw Material Pre Processed to bypass the Middle B process
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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!
P
Should you do it? YES! WHY?
Purchased For only $10 extra, we gain 15 minutes Part $5 of Constraint time. That costs $0.66 per minute.
C:10
We can earn $2.00 per minute making more Qs A:15 We need 600 more minutes to make all Qs.
Raw So, we buy 40 of the pricey Middle Material $20 RMs (But no more).
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D:15 C:5 B:15 Raw Material $20 Q D:5 B:15 A:10 Raw Material $20
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• • • • • • •
Consider Adding a New Product O
Sells for $40 RM is $25
We can add a new product O
Overhead $15.75
Looks like - $0.75
O doesn’t flow through the constraint.
A Loss in Profit!
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 O s and sell them at anything above $25.
Purchased Part $5 O C:10 A:15 P D:15 C:5 B:15 Q D:5 B:15 A:10 Raw Material $20 Raw Material $20 Raw Material $20
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P Q O D:15 Purchased O
Sells for $40
Part $5
RM is $25 Overhead $15.75
Looks like a $0.75
Loss in Profit
C:10 C:5
Octane on
O
$15/0=$ is We should make O. We
A:15
can make up to the point A can no longer support or other operations. Cheeri-O!
B:15 Raw Raw Material Material $20 $20
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D:5 B:15 A:10 Raw Material $20
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• • • • •
Consider Adding a New Product R
Sells for $40
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 P Q
RM is $20 Overhead $15.75
Looks like a winner at $4.75
Profit!
R What do you think?
D:15 D:5 Is it a lose R ?
Purchased Part $5 C:10 C:5 B:15 A:15 Raw Material $20 B:15 Raw Material $20
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A:10 Raw Material $20
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P Q Purchased Part $5 C:10 A:15 Raw Material $20 R D:15 D:5 C:5 B:15 R
Sells for $40 RM is $20 Overhead $15.75
Looks like a winner at $4.75
Profit!
B:15 A:10 Raw Material $20
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Raw Material $20
Octane on
R
is $20/15=$1.33
We should Not make R. The Octane for Q is $2.00 per minute.
It’s a Lose-R!
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Putting T, I OE in Practice
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Suggest using a simple form:
•
Option_______________________ Date _______
•
Proposal by __________________
$K/yr $K/yr $K/yr Sales - Materials = Throughput -Operating Expense $K/yr = Profit Current Change Future Refn:
The Theory of Constraints and Its Implications for Management Accounting,
Western Textile.
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Putting T, I OE in Practice
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(Simple form continued)
$K/yr Profit $K $K $K Inventory + Accts Receivable - Accts Payable Current Change Future $K $K $K $K/yr $K = Working Capital + Fixed Assets = Assets Profits ÷ Assets ROA © Washington State University-2010 38
Putting T, I OE in Practice
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(Simple form continued)
Current Change Future $K $K/yr $K $K/yr # $K/E/yr = Assets Profits ÷ Assets ROA Profits ÷ Employees ROE © Washington State University-2010 39
$$ TOC Marketing Approach $$ High Profit Items $ High Velocity!
$$$$ Good Solid Products $$ Goal $$ Low Profit High Volume $$ $0 Low -> Volume of Sales -> High - $ Look for High Octane Needed to flesh out market offer $ Required to obtain a related good product.
($/min)
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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 High
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Subordinate Inventory
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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.
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Economic Order Quantity
Ordering Costs (D/Q)*Cost Ordering Total Cost=(D/Q)*Cost Order +(Q/2)*Cost Holding Holding Costs (Q/2)*Cost Holding Small Order Quantity Q Large
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Solving for Q at Optimal Position
Optimal Order Quantity Q= ((2*D*Co)/CH/h)**0.5
Small Order Quantity Q Large
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For the Same Profit, Invest a little in Inventory or Alot?
Low Investment High Small Order Quantity Q Large
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Next Topics
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TOC Thinking Processes TOC Applications
Operations Project Management Replenishment
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TOC Finances and Measures
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Some TOC Philosophy will be blended into these additional topics.
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