# Profitability and Risk Management 1 Theory of Constraints Let’s go back to the CVP model: What “constrains” your profit? If you can choose X to be arbitrarily.

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Profitability and Risk Management 1 Theory of Constraints Let’s go back to the CVP model: What “constrains” your profit? If you can choose X to be arbitrarily large, then there is NO LIMIT to your profitability. Theory of Constraints

Profitability and Risk Management 2 cycle time 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. Manufacturing Cycle Efficiency The ratio of processing time to total cycle time Theory of Constraints

Profitability and Risk Management 3 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

Profitability and Risk Management 4 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

Profitability and Risk Management 5 An example of steps 1 and 2 Below is a summary of the cost and production flow data: Monthly demand for PC - 102 is 10,000 units and for PC -120 is 8,000 units. The target prices for PC - 102 and PC - 120 are \$240.00 and \$350.00, respectively. Theory of Constraints

Profitability and Risk Management 6 Flow Diagrams Electronic Components Price = \$30 Electronic Components Price = \$30 Assemble Components 150 min. Assemble Components 150 min. Install Other Electronics 30 min. Install Other Electronics 30 min. Testing 30 min. Testing 30 min. Packaging 15 min. Packaging 15 min. Speed Chip Price = \$25 Speed Chip Price = \$25 Test Speed Chip 30 min. Test Speed Chip 30 min. Install Other Electronics 60 min. Install Other Electronics 60 min. Electronic Components Price = \$30 Electronic Components Price = \$30 Assemble Components 150 min. Assemble Components 150 min. Testing 30 min. Testing 30 min. Packaging 15 min. Packaging 15 min. PC - 102 PC - 120 Theory of Constraints

Profitability and Risk Management 7 What constraints bind? For 10,000 PC-102 and 8,000 PC-120, we would have: So, we have a deficit of 3,000 testing hours. Testing hours cannot exceed 10,000. Theory of Constraints

Profitability and Risk Management 8 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 PC- 120 are computed on the next slide. Theory of Constraints

Profitability and Risk Management 9 Throughput Margin Theory of Constraints

Profitability and Risk Management 10 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

Profitability and Risk Management 11 Throughput margin per constraint hour So, we will produce PC-102 up to 10,000 units and then produce PC-120. Theory of Constraints

Profitability and Risk Management 12 Production: Theory of Constraints

Profitability and Risk Management 13 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

Profitability and Risk Management 14 Maximize Flow Through the Constraints 1.Simplify the operation: a)simplify the product design b)simplify the manufacturing process 2.Look for quality defects in raw materials that might be slowing things down. 3.Reduce set-up time. 4.Reduce other delays due to unscheduled and non-value-added activities, such as inspections, machine break-downs, etc. 5.Simplify the constraint by removing all activities from the constraint that will not reduce the function of the operation. Theory of Constraints

Profitability and Risk Management 15 Drum Electronic Components and Speed Chips Process 4: Testing Rope Process 1: Assemble components Process 2: Test Speed Chips Process 3: Install Other Electronics Small amount of Work in Process Inventory Small amount of Work in Process Inventory Buffer Process 5: Packing Finished Goods Drum-Buffer-Rope System for Production Flow Management Theory of Constraints

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