Profitability and Risk Management
Theory of Constraints
Let’s go back to the CVP model:


TOI  USP  UVC * X  FC
What “constrains” your profit? If you can
choose X to be arbitrarily large, then there
is NO LIMIT to your profitability.
Theory of Constraints
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Profitability and Risk Management
Theory of Constraints
Constraints are those activities that slow a product’s
total cycle time.
The amount of time
between the
receipt of a
customer order and
the shipment of the
order.
Theory of Constraints
Manufacturing Cycle Efficiency
The ratio of processing time
to total cycle time
2
Profitability and Risk Management
Steps in The Theory of
Constraints Analysis
1. Identify the constraints.
2. Determine the most profitable product
mix given the constraint.
3. Maximize the flow through the constraint.
4. Add capacity to the constraint.
5. Redesign the manufacturing process for
flexibility and fast cycle time.
Theory of Constraints
3
Profitability and Risk Management
An example of steps 1 and 2
ECAT produces two printed circuit boards, PC - 102
and PC - 120.
Production and distribution requires four steps:
1. Assembly (50,000 hours per month available)
2. Installation of other components (20,000 hours
available)
3. Testing (10,000 hours available)
4. Packaging (10,000 hours available)
The PC - 120 includes a speed chip that must be
tested and installed with the other components onto
the assembly.
Theory of Constraints
4
Profitability and Risk Management
An example of steps 1 and 2
Below is a summary of the cost and production flow data:
PC - 102
Materials
Components
Speed chip
$
30.00
PC - 120
$
$
30.00
25.00
Cost per
Production flow (in minutes)
hour
Assembly
$
10.00
Component installation
$
10.00
Testing
$
18.00
chip testing
$
18.00
Monthly Speed
demand
for PC - 102 is 10,000
units
Packaging
$ PC 8.00
8,000 units.
The target prices for
- 102
$240.00 and $350.00, respectively.
Theory of Constraints
150
30
30
and for PC -120 is
and PC -15120 are
150
60
30
30
15
5
Profitability and Risk Management
Flow Diagrams
Electronic
Components
Price = $30
Speed
Chip
Price = $25
Electronic
Components
Price = $30
Assemble
Components
150 min.
Test Speed
Chip
30 min.
Assemble
Components
150 min.
Install Other
Electronics
30 min.
Install Other
Electronics
60 min.
Testing
30 min.
Testing
30 min.
Packaging
15 min.
Packaging
15 min.
PC - 102
Theory of Constraints
PC - 120
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Profitability and Risk Management
What constraints bind?
For 10,000 PC-102 and 8,000 PC-120, we would have:
Production flow
Assembly
Component installation
Testing
Packaging
Hours
2.5
2.5
0.5
1.0
0.5
1.0
0.25
0.25
Demand
Total
Demand
Hours
25,000 20,000
5,000
8,000
5,000
8,000
2,500
2,000
Hours
45,000
13,000
13,000
4,500
So, we have a deficit of 3,000 testing hours.
Testing hours cannot exceed 10,000.
Theory of Constraints
Excess
Available (Deficit)
Hours
50,000
20,000
10,000
10,000
Hours
5,000
7,000
(3,000)
5,500
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Profitability and Risk Management
Throughput Margin
Throughput margin is the measure of
interest in TOC. It is revenues (throughput)
less totally variable expenses. It is
analogous to contribution margin. Our
throughput contribution for PC-102 and PC120 are computed on the next slide.
Theory of Constraints
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Profitability and Risk Management
Throughput Margin
PC - 102
Revenue
Materials
Components
Speed chip
PC - 120
$
240.00
$
350.00
$
$
30.00
-
$
$
30.00
25.00
$
25.00
5.00
9.00
2.00
$
25.00
10.00
18.00
2.00
Total Variable Costs
$
71.00
$
110.00
Throughput Margin per unit
$
169.00
$
240.00
Cost per
Production flow
Assembly
Component installation
Testing
Packaging
Theory of Constraints
$
$
$
$
hour
10.00
10.00
18.00
8.00
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Profitability and Risk Management
Throughput margin per constraint hour
Next, we divide the throughput margin per
unit by the number of hours of the
constraint that each product requires. We
will then produce that product that yields
the greatest throughput margin per
constraint hour first (until we have met
demand).
Theory of Constraints
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Profitability and Risk Management
Throughput margin per constraint hour
PC - 102
PC - 120
Throughput
Margin
$
169.00
$
240.00
Hours of
Testing
0.50
1.00
Throughput
Margin per
Hour of Testing
$
338.00
$
240.00
So, we will produce PC-102 up to 10,000 units and
then produce PC-120.
Theory of Constraints
11
Profitability and Risk Management
Production:
PC - 102
Produced
Hours used
Hours remaining
Produced
Theory of Constraints
PC - 120
10,000
5,000
5,000
5,000
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Profitability and Risk Management
Supply effect
We should think about what we can do to relax the
constraint and maximize efficiency.
Our constraint should NEVER be idle.
We should attempt to:
1. Maximize the flow through process constraints
2. Add capacity to the constraint
3. Redesign, if necessary, the process to remove the
constraint.
Theory of Constraints
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Profitability and Risk Management
Maximize Flow Through the Constraints
1.
2.
3.
4.
5.
Simplify the operation:
a) simplify the product design
b) simplify the manufacturing process
Look for quality defects in raw materials that might be slowing
things down.
Reduce set-up time.
Reduce other delays due to unscheduled and non-value-added
activities, such as inspections, machine break-downs, etc.
Simplify the constraint by removing all activities from the
constraint that will not reduce the function of the operation.
Theory of Constraints
14
Profitability and Risk Management
Drum-Buffer-Rope System
for Production Flow Management
Electronic Components and Speed Chips
Process 1: Assemble components
Process 2: Test Speed Chips
Process 3: Install Other Electronics
Rope
Small amount of Work
in Process Inventory
Process 4: Testing
Buffer
Drum
Process 5: Packing
Finished Goods
Theory of Constraints
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