Theory of constraints
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The Theory of Constraints (TOC) is a management philosophy that identifies the constraints limiting an organization from achieving its goals and focuses on restructuring processes to better exploit constraints. The key steps are to identify the system's constraints, decide how to best exploit each constraint to maximize throughput or productivity, and subordinate all other decisions and processes to supporting the constraint. TOC uses linear programming to determine the optimal product mix and production levels given capacity constraints. The goal is to keep constraints fully utilized to maximize profits in the short-term.
Theory of constraints
- 1. 1 Theory of Constraints Short-term Capacity Optimization
- 2. 2 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
- 3. 3 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
- 4. 4 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
- 5. 5 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
- 6. 6 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
- 7. 7 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
- 8. 8 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
- 9. 9 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
- 10. 10 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
- 11. 11 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-of- pocket selling costs, etc. Each additional unit produced or sold causes more of the cost to be incurred
- 12. 12 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
- 13. 13 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
- 14. 14 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
- 15. 15 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
- 16. 16 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
- 17. 17 Steps in the TOC Process Internal Process constraints Machine time, etc. Policy constraints No overtime, etc. External Material constraints Insufficient materials Market constraints Insufficient demand Identify the system constraints How is a constraint identified?
- 18. 18 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
- 19. 19 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
- 20. 20 Steps in the TOC Process Product 1 Product 2 Demand per month 1,000 600 Price per unit 900$ 1,500$ Material cost per unit 400$ 800$ Test components 0.25 0.40 Assemble components 1.00 1.50 Install electronics 0.50 0.50 Final inspection and test 1.25 1.00 Package and ship 0.10 0.10 Identify the constraint Product 1 Product 2 Total Hours available per month Slack hours Test components 250 240 490 640 150 Assemble components 1000 900 1900 2240 340 Install electronics 500 300 800 800 0 Final inspection and test 1250 600 1850 1760 (90) Package and ship 100 60 160 160 0 Hours required per unit
- 21. 21 Steps in the TOC Process Identify the best use of the constraint Price per unit $900 $1,500 Material cost per unit $400 $800 Throughput per unit $500 $700 Constaint time per unit 1.25 1.00 Throughput per hour $400 $700 Identify the most profitable product mix Total demand 1,000 600 Units produced in best mix 928 600 Unmet demand 72 - Throughput generated Units produced 928 600 Throughput per unit 500$ 700$ Total throughput 464,000$ 420,000$ 884,000$
- 22. 22 Steps in the TOC Process Alleviate the constraint Determine how to increase its capacity Repeat the process Always a new constraint
- 23. 23 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
- 24. 24 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
- 25. 25 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