Theory of Constraints
Short-term Capacity Optimization
1
Theory of Constraints

Significance of bottlenecks

Maximum speed of the process is the speed of
the slowest operation

Any improvements will be wasted unless the
bottleneck is relieved

Bottlenecks must be identified and improved if the
process is to be improved
2
Theory of Constraints

Purpose is to identify bottlenecks or other
constraints and exploit them to the extent
possible

Identification of constraints allows management to
take action to alleviate the constraint in the future

Reduce cycle time


Time from receipt of customer order to shipment
Improve manufacturing cycle efficiency (MCE)

Processing time / total cycle time
3
Theory of Constraints

Assumes current constraints cannot be
changed in the short-run

What should be produced now, with current
resources, to maximize profits?

Question cannot be answered by traditional accounting
methods
4
Theory of Constraints


Management tool, not an accounting tool

Not used to determine inventory values

Not used to allocate overhead to inventory

Does not comply with GAAP
Does indicate how to use available resources
most effectively
5
The Need for TOC

Standard costing

Can promote undesirable behavior


Work to keep people busy

Local optimization

Inventory is produced regardless of need
Does indicate what it should cost to produce a
product
6
The Need for TOC

Does not indicate which products will maximize
profits given the constraints

Doesn’t take constraints into account

Does not consider the demands each item places on
limited resources
7
The Need for TOC

Absorption costing

Can promotes undesirable behavior


Production costs are assets until sold

Accumulation of inventory keeps costs off the income
statement

Illusion of profitability
Does indicate what it costs to produce a product
8
The Need for TOC

Does not indicate which products will maximize
profits given the constraints

Doesn’t take constraints into account

Absorption cost does not consider the demands each
item places on limited resources
9
The Need for TOC

Variable (direct) costing

Identifies the incremental costs of producing a
product

Identifies product that provides the greatest
contribution margin, or contribution margin per unit of
constrained resource

Cannot deal with more than one constraining
resource at a time
10
The Need for TOC

Traditional definition of variable cost doesn’t hold
in the short-run


Labor, variable overhead aren’t really variable
on a day-to-day basis
Some costs are truly variable in the short-run

Material, commissions, delivery costs, out-ofpocket selling costs, etc.

Each additional unit produced or sold causes
more of the cost to be incurred
11
The Need for TOC

Theory of Constraints

Uses linear programming to determine best use of
limited resources

Indicates what should be produced and in what
quantities
12
Theory of Constraints

Constraining resource must be maximized

All other operations must be geared toward this
goal

May require suboptimization in other areas

Upstream operations must provide only what the
constraint can handle

Downstream operations will only receive what the
constraint can put out
13
Theory of Constraints

Constraint must be kept operating at its full
capacity


If not, the entire process slows further
Focus is on maximizing throughput


Sales – totally variable costs
All other costs treated as fixed operational
expenses

Cannot vary much in the short-run
14
Theory of Constraints

Based on the concepts of drum, buffer and
ropes

Drum

Output of the constraint is the drumbeat

Sets the tempo for other operations

Tells upstream operations what to produce

Tells downstream operations what to expect
15
Theory of Constraints

Buffer

Stockpile of work in process in front of constraint


Precaution to keep constraint running if upstream
operations are interrupted
Rope

Sequence of processes prior to and including the
constraint

Want to “pull” the rope at the maximum speed

Speed of the constraint
16
Steps in the TOC Process
 Identify the system constraints

Internal

Process constraints


External

Machine time, etc.
Policy constraints


No overtime, etc.
Material constraints


Insufficient materials
Market constraints

Insufficient demand
 How is a constraint identified?
17
Steps in the TOC Process

Decide how to exploit the constraint

Produce the most profitable product mix

Want it working at 100%

How much of a buffer?

Holding costs


Including risk, quality costs
Stock-out costs
18
Steps in the TOC Process

Subordinate everything else to the preceding
decision

Plan production to keep constraint working at
100%

May need to change performance measures to
conform upstream activities to the “rope” speed
19
Steps in the TOC Process
Demand per month
Price per unit
Material cost per unit
Product 1
1,000
$
900
$
400
Product 2
600
$
1,500
$
800
Hours required per unit
Test components
Assemble components
Install electronics
Final inspection and test
Package and ship
0.25
1.00
0.50
1.25
0.10
0.40
1.50
0.50
1.00
0.10
Identify the constraint
Test components
Assemble components
Install electronics
Final inspection and test
Package and ship
Product 1
250
1000
500
1250
100
Product 2
240
900
300
600
60
Total
490
1900
800
1850
160
Hours
available
per month
640
2240
800
1760
160
Slack
hours
150
340
0
(90)
0
20
Steps in the TOC Process
Identify the best use of the constraint
Price per unit
Material cost per unit
Throughput per unit
Constaint time per unit
Throughput per hour
$900
$400
$500
1.25
$400
$1,500
$800
$700
1.00
$700
Identify the most profitable product mix
Total demand
Units produced in best mix
Unmet demand
Throughput generated
Units produced
Throughput per unit
Total throughput
$
$
1,000
928
72
600
600
-
928
500
464,000
600
700
420,000
$
$
$
884,000
21
Steps in the TOC Process

Alleviate the constraint


Determine how to increase its capacity
Repeat the process

Always a new constraint
22
Evaluation of TOC

Advantages

Improves capacity decisions in the short-run

Avoids build up of inventory

Aids in process understanding

Avoids local optimization

Improves communication between departments
23
Evaluation of TOC

Disadvantages

Negative impact on non-constrained areas

Diverts attention from other areas that may be the next
constraint

Temptation to reduce capacity
24
Evaluation of TOC

Ignores long-run considerations

Introduction of new products

Continuous improvement in non-constrained
areas

May lead organization away from strategy

Not a substitute for other accounting
methods
25