Follow the constraint and you find the profit. How do you know which machine/manufacturing unit generates this constraint? Rather than reviewing all the assets a product touches (which cost accounting would have you do), look only to the specific machine that is the primary constraint or bottleneck unit within the supply chain. Doing so allows you not only to find the constraint but to exploit it. Don’t worry if you did a “double take” at the word exploit. Knowing where the constraints are will allow your organization to leverage them to a profitable advantage. The following example shows how TOC works to exploit the constraint.
A fictional organization, Perfect Co, has two products for sale: FG1 (Finished Good) and FG2. FG1 has sales price of $90 and total demand of up to 100 units per week. FG2 has a sales price of $100 and a total demand of up to 50 units per week. Perfect Co’s plant has four machines. Each machine can run five days a week, eight hours a day. No setup or changeover times are required to shift between products. Overall plant operating expense is $6,000 per week.
How much of each FG should Perfect Co produce each week to optimize their profit? The traditional product cost approach would answer 100 units of FG1 and 50 units of FG2:
This answer would be wrong. The calculation ignores the constraints in the system and looks only at weekly demand and margin per unit. Once we consider the loads for each resource, we begin to see a problem. There are 2,400 minutes of production time in a week, but there are not enough working minutes in the week for Machine B to produce all the components that are needed for the weekly demand.
Therefore, Perfect Co. must decide what is to be produced.
WHERE THE COST APPROACH FAILS
When using the product costing approach, Perfect Co. will consider 1) profit per unit; 2) cost per unit; and 3) time/effort per unit prioritizing the finished goods making the highest margins.
Following a standard product costing approach will encourage Perfect Co. to make as many of the higher margin product (FG2) as possible and fill in the remaining capacity with the lower margin product (FG1).
With these criteria, Perfect Co. could decide to satisfy the demand for FG2s first, and then produce as many FG1s as possible, since the margin generated by a unit of FG2 is 33% higher. Selling 50 FG2s per week would use 1,500 minutes of capacity, leaving 900 minutes to make FG1s.
In the cost approach, Perfect Co has promised a weekly Net Profit of $1,500 but is actually losing $300! Why? Because they’re not exploiting their constraint.
WHERE TOC SUCCEEDS
What TOC teaches us is to exploit the constraint by maximizing the productivity of the constrained resource. In this case, Perfect Co. must examine the activity performed by Machine B and determine which finished good generates the most margin per hour, or margin velocity through this machine.
The margin velocity through the constrained Machine B is higher for FG1 ($180/hr) than that of FG2 ($120/hr), and therefore, in order to exploit the constrained Machine B to its maximum productivity, Perfect Co. should produce FG1s first and only produce as many FG2s as the remaining capacity will allow.
Using this approach, the new product mix formula is:
Now Perfect Co has an accurate picture of what its net profit is, which allows for better decision making across the board. By exploiting the constraint, Perfect Co changes a potentially unprofitable scenario into a profitable one.
Contact Venetia Partners today to find your constraint!