© Washington State University Fundamental Exam Review Finance and Measures Segment The Theory of Constraints James R. Holt, Ph.D., PE Professor Engineering & Technology Management Disclaimer: The material in these slides were developed over time and represents Dr. Holt’s personal views and approach to TOC. It is not the view of Washington State University nor TOCICO. It may be dated, incomplete or absolutely wrong. While the text and figures in this presentation are helpful to facilitate teaching and discussion of these topics, without the words that go with the slides, the presentation is not complete and may not even make sense. This material is made available in the public domain as a service. Individuals may use this material as resources to teach their own TOC review seminars as long as they give reference to the source. There is no promise nor expectation that these materials are either necessary or sufficient to pass any of the TOCICO certification exams. Anyone using these materials should continue to study from the many other sources of excellent TOC literature available. In many cases, common knowledge is included here without reference. If you would like to improve any of these files, please do so. Your contribution will be included in future postings. Dr Holt.

© Washington State University TOCICO Segmented Fundamentals Exam Fundamentals Certificate Multiple Choice Exam (Identify, Exploit, Subordinate, Elevate, Go to Step 1) Fundamentals Certificate of TOC Philosophy Fundamentals Certificate of TOC Thinking Processes Fundamentals Certificate of TOC Applications Fundamentals Certificate of TOC Finance & Measures Inherent Potential Inherent Simplicity Inherent Win-Win Five Focusing Steps Three Questions Conflict Cloud Negative Branch Ambitious Target DBR T, I, OE PQ Type Problem Project Management Replenishment

© Washington State University 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

T I OE 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 Wait? 4 © Washington State University-2010

Finance Processes A. Excellent Investments B. Excellent System wide D. Consider everything effected C. Excellent use of Constraint D’. Consider only T, I, OE The Conflict Cloud: The Paradigm Shift: Focus on ΔT, ΔI & ΔOE Relative to the Constraint T I OE $$$ 5 © Washington State University-2010

The Finance Results What do we learn here to apply to Daily Lives? Confidence, Security and Predictability Improves. Freedom of Actions Dramatically Improves. T I OE $$$ Every Investment is an Improvement: Cash Flow Improves. Profit Improves. Return-on-Investment Improves. Indebtedness Reduces. T I OE 6 © Washington State University-2010

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 7 © Washington State University-2010

8 Consider a Simple Firm WXYZ Only two employees: Mr. M and Mr. N They can choose between any one of Four Products: W, X, Y, or Z 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.

Work Flow 9 © Washington State University-2010

Cash Flow Summary 10 © Washington State University-2010

11 So, What Product Should They Make? Decision suggested by Accounting: Produce items with the HIGHEST PROFIT MARGIN That would be Z with a $26.17 Profit Margin selling at $52 each ($52)*(16 ea) - ($20)*(16ea) - (2 workers)*(8 hours)*($10/hour) = $352 /day

© Washington State University What about Marketing Decision suggested by Marketing: Produce items with the HIGHEST SELLING PRICE (paid on Commission) That would be Y at $55 Sales Price Each ($55)*(16 ea) - ($25)*(16ea) - (2 workers)*(8 hours)*($10/hour) = $320 /day

© Washington State University What about Production? Decision suggested by Production: Produce items that keep machine at HIGHEST EFFICIENCY That would be X at $50 profit each ($50)*(24 ea) - ($25)*(24ea) - (2 workers)*(8 hours)*($10/hour) = $440 /day

© Washington State University But, If We Think Globally! Decision based upon producing items that provide the MOST THROUGHPUT PER UNIT OF CONSTRAINT TIME for the SYSTEM That would be W at $50 profit each W: ($50)*(24 ea) - ($20)*(24ea) - (2)*(8)*($10) = $560 /day

© Washington State University Product Option Summary Does it really make any difference what you choose to do? 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 Acctg-Profit Margin Z$352100% Sales-Hi Sales Price Y$320 90% Production-EfficiencyX$ % TOC Measure W$ %

© Washington State University Worse Effects from Non-Global Thinking What we have to put up with: Decisions are based on combined opinion of accounting, production and sales.  That is, “They change decisions weekly!” 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.

© Washington State University The Resulting Effects of Non-Global Thinking Product Group finds we have high efficiencies and yet our production is unacceptable to meet objectives.  Use overtime to improve numbers 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.

© Washington State University TOC Measures: T, I, OE 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?”

© Washington State University Basic Measures 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 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)

© Washington State University Trial Problem (PQ) 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 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. The production pattern (routing plan) for the two possible products follows on the next slide. 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?

Materials Flow Diagram Worker : Process Time in Minutes Three types of Raw Material and Purchase Prices Work flows upwards from RM to Assembly operation by worker D Final Goods P and Q available to Customers D makes the assembly for P including a purchased part Note: The middle common part produced by worker C is used in both Product P and Q 21 © Washington State University-2010

22 Some Typical Cost Accounting Numbers to Assist your Decision

© Washington State University A Few More Numbers 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.)

© Washington State University Well? Q looks tempting. Try making Q first. All we can make with the time remaining All market wants

© Washington State University Well then, Try P first All we can make with the time remaining All market wants

© Washington State University Consider Traditional Measures Sales Price: Q $100P $90Should sell Q Margin: Q $ P $ 7.20Should sell Q Raw Material: Q $ 40P $45Should sell Q Labor: Q 50 Min P 60 MinsShould sell Q Throughput: Q $ 60P $ 45Should Sell Q Quantity Q 50 ea. P 100 ea.Should Sell P What is missing? Octane! Throughput / Constraint Minute! Where is the Constraint?

© Washington State University 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.

© Washington State University Now you are proficient with TOC Measures... 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?

© Washington State University Consider Alternative 1: Jig for A 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! Really? What happened to the OE really?  Did it go down?  Or did it go up as we added equipment rental costs?

© Washington State University Consider Alternative 2: Jig for B 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 $0.63 = $165 Looks pretty bad Really? What happens when we reduce 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!

© Washington State University Consider Optional Raw Material Purchase Suppose we could purchase the left Raw Material Pre- Processed to eliminate the Left A process Cost only $5 extra each * 100 each or $500 Savings 15 Minutes * 100 = 1500 Minutes 1500 $0.63 = $950 Looks Real Good! Really? Does it save any overhead at all?  We must continue to have A working, so nothing gained.  And, we increase overhead by $500.

© Washington State University Consider Optional Raw Material Purchase Now consider the option of purchasing the Middle Raw Material Pre Processed to bypass the Middle B process Cost only $10 each extra * 130 each or $1300 Savings 15 Minutes * 130 = 1950 Minutes 1950 $0.63 = $1230 Doesn’t look too good! Should you do it? YES! WHY?  For only $10 extra, we gain 15 minutes of Constraint time. That costs $0.66 per minute.  We can earn $2.00 per minute making more Qs  We need 600 more minutes to make all Qs.  So, we buy 40 of the pricey Middle RMs (But no more).

© Washington State University Consider Adding a New Product We can add a new product O O doesn’t flow through the constraint. 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. O O Sells for $40 RM is $25 Overhead $15.75 Looks like - $0.75 A Loss in Profit!

O O Sells for $40 RM is $25 Overhead $15.75 Looks like a $0.75 Loss in Profit Octane on O is $15/0=$  We should make O. We can make up to the point A can no longer support or other operations. Cheeri-O! 34 © Washington State University-2010

35 Consider Adding a New Product 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 What do you think? Is it a lose- R ? R Sells for $40 RM is $20 Overhead $15.75 Looks like a winner at $4.75 Profit! R

R Sells for $40 RM is $20 Overhead $15.75 Looks like a winner at $4.75 Profit! R 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! 36 © Washington State University-2010

37 Putting T, I OE in Practice Suggest using a simple form: Option_______________________ Date _______ Proposal by __________________ Sales - Materials = Throughput -Operating Expense = Profit Current Change Future $K/yr Refn: The Theory of Constraints and Its Implications for Management Accounting, Western Textile.

© Washington State University Putting T, I OE in Practice (Simple form continued) Profit Inventory + Accts Receivable - Accts Payable = Working Capital + Fixed Assets = Assets Profits ÷ Assets ROA Current Change Future $K/yr$K $K $K/yr $K

© Washington State University Putting T, I OE in Practice (Simple form continued) Profits ÷ Employees ROE Current Change Future $K/yr # $K/E/yr = Assets Profits ÷ Assets ROA $K $K/yr $K

© Washington State University Look for High Octane ($/min) TOC Marketing Approach Throughput -> $0 $$ - $ Low -> Volume of Sales -> High High Profit Items $ Good Solid Products $$ Low Profit High Volume $$ Needed to flesh out market offer Required to obtain a related good product. $$ $$$$ -$-$ Goal Net Marketing Direction High Velocity!

© Washington State University 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 Number of problems

© Washington State University Subordinate Inventory 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.

© Washington State University Economic Order Quantity Small Order Quantity Q Large Cost of Operation $ Holding Costs (Q/2)*Cost Holding Ordering Costs (D/Q)*Cost Ordering Total Cost=(D/Q)*Cost Order +(Q/2)*Cost Holding

© Washington State University Solving for Q at Optimal Position Small Order Quantity Q Large Cost of Operation $ -> Optimal Order Quantity Q= ((2*D*Co)/CH/h)**0.5

© Washington State University For the Same Profit, Invest a little in Inventory or Alot? Small Order Quantity Q Large Cost of Operation $ -> Profit Measure-> Low Investment High

© Washington State University Next Topics TOC Thinking Processes TOC Applications  Operations  Project Management  Replenishment TOC Finances and Measures Some TOC Philosophy will be blended into these additional topics.