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Sharmin Nahar Tanha Rashid Jumi Pal Shehrin Saleh Israt Zahan 14054 14062 14082 14085 14151

THE THEORY OF CONSTRAINTS AND THROUGHPUT ACCOUNTING

Constraint & its Strategic Implications:

Constraint: Anything that limits an organization from moving toward or achieving its goal.

Theory Of Constraint (TOC):

A systems management philosophy Developed by Eliyahu Goldratt in the mid 1980s with his business novel The Goal. Looks at the entire supply chain and synchronizes the chain to achieve ultimate performance.

Based on two assumptions: Every organization has a set of processes working together to achieve a common goal. Every process has a [single] constraint that limits it from higher performance
Assumes current constraints cannot be changed in the short-run -What should be produced now, with current resources, to maximize profits?

Theory Of Constraint (TOC): is a way to manage constrained processes in order to maximize profits by increasing system throughput. Throughput= Sales Revenue Direct Materials

Constraints & Quality, Cost & Time:

Strategic Position of TOC:

TOC linkage to product strategy:

Step 1 : Product strategy defines the market segments The firm will sell in , the specific products to be produced for those markets and the profits expected.

Product Concept and feasibility:

Step- 2 Translate product and profit plans into specific products concepts. Feasibility is determined by making preliminary estimates of life cycle costs, evaluating required investment in technology, training and estimating capacity needs.

Product / process design and development:

Step -3 Detailed specifications for manufacturing and assembly are developed at this stage for physical goods.

Production and logistics:

Physical process of creating goods and services.

 TOC at product development stages: Assures that daily activities produce the proper product and services to satisfy customer demand and profitability

TOC at production stages: Provides information about managing capacity optimally.

 Assure efficient use of Searches areas where existing capacity. customer are waiting ( bottlenecked area) Identifies processes that need immediate Assist efficient additional resources. production.

Drums, buffers , ropes:

Drums:
Sets the pace of the work of the plant and is particularly useful for downstream operations (operations after the bottleneck) to help anticipate working process inventory output flow from the bottleneck.

Buffers:
A minimal of inventory kept in front of bottleneck keeps it running at full capacity.

ROPES:
Restraints the upstream operations (operations before the bottleneck) from overloading the bottleneck with too much work in process inventory input flow.

Bank Load Process

Application
Assemble Packets

Credit agency info

Release of Funds

Research and Credit History

Make decision and establish credit limit

Production Data:
Work Center Work description Minutes per hour Minutes per unit Units per hour Production hour per day Maximum Units per day 1 2 Assembl Insert e Case board 60 12 60 8 3 Insert Cards 60 20 4 Mount Drives 60 16 5 Check quality 60 4

5 X 8 40

7.5 x 8 60

3.0 x 8 24

3.75 x 8 30

15 x8 120

TOC Management of Work processes

TOC Based Schedule 1 2 3 4 5

Balanced units per day Capacity Used Work -in- progress inventory

24 60% 0

24 40% 3

24 100% 0

24 80% 0

24 20% 0

Developing a TOC Operation:

TOC defines profit in terms of throughput. Organization using TOC will do three things to maximize throughput. 1) establish sales price > total variable costs 2) focus on providing goods and services that have the largest difference between totally variable cost and price. 3) minimize the time between spending money to produce and receiving money from selling goods and services.

The Five-Step TOC Process

Step 1. Identify the system's constraint(s). Step 2. Decide how to exploit the system's constraint(s). Step 3. Subordinate everything else to the above decision. Step 4. Elevate the constraint(s). Step 5. If a constraint has been broken, go back to step 1.

Step-1 Identify the systems constraints

Constraints

Internal

External

Process

Policy

Material

Market

Process Constraints
Occur when a given process or operation in the company has insufficient capacity to fully satisfy market demand. Example: the loan officer is physically unable to perform the three steps on all loans requested in the allotted time.

Policy Constraints:
Occurs when management or employee unions enforce a rule that limits an organizations operating abilities or restricts its flexibility. Example: bank requires every loan to go through a formal process regardless of size, or nature of customer.

EXTERNAL:
Material constraints: occurs when outside source of material becomes restricted. Example: the bank lacks sufficient load fund to satisfy the number of loans approved.

 Market constraints: Market demand does not fully utilize a company's capacity to make the product. Example: bank customers are not demeaning as many loans as the bank is able and willing to supply.

Step-2: Decide how to exploit the systems constraints:

Once a bottleneck is unidentified the organization must effectively maximize the money making capacity of the bottleneck by calculating the throughput yield per unit of constrained resources. Example: Officers inability to process loan Accountant could measure the loan revenue potential of each hour spent approving loans.

Step-3 :Subordinate everything else to the preceding decision:

Constraints other than exploited constraints are secondary. The goal is to coordinate production efforts at non-bottleneck operations to keep the constraints operating at optimal capacity.

Step-4: Elevate the constraints:

Involve offloading some of the processing work to non-bottleneck operation despite their less efficient product capability. Example: in the loan approval process assign much of the packet assembly and credit check work to less experienced bankers.

Step-5
If a constraint is broken go back to step 1 In this step, the objective is to ensure that the Five Focusing Steps are not implemented as a one-off improvement project. Instead, they should be implemented as a continuous improvement process. If the constraint has been broken (the normal case), recognize that there is a new constraint. Finding and eliminating the new constraint is the new priority (restart at Step One). If the constraint has not been broken, recognize that more work is required, and a fresh look needs to be taken, including verifying that the constraint has been correctly identified (restart at Step One).

The Process in short:

A comparison of Throughput and traditional accounting systems

GAAP Assumptions Contribution Margin Assumptions
All direct labor and direct material costs are specifically assigned to inventory All MOH costs are allocated to inventory using predetermined OH application rate. Inventory costs are not expensed to the income statement until inventory is sold.

Throughput Assumptions

Only variable product cost (DL, DM, VMOH) are specifically assigned to inventory. Rather than allocating to inventory FMOH costs are immediately expensed to the income statement. Variable product cost are not expensed to the income statement until the inventory is sold.

No cost (including DM costs) are specifically assigned to inventory. All product costs are immediately expensed to the income statement , regardless of when inventory is sold.

Comparing Three Profit and Loss statement

GAAP Basis Revenue COGS $500000 (120000) CM Basis Revenue Variable costs Throughput Basis $ 500000 Revenue $ 500000 (155000) Direct materials (50000)

Gross Margin

$380000

Contribution Margin
Fixed Costs

$345000

Throughput Margin

$ 450000

Selling and Gen. admin expenses (350000) Operating Income $30000

(315000) Operating expense (42000) Operating Income $30000

Operating Income $30000

Inventory Effects of GAAP versus Throughput Accounting

Assumptions: Sales price is $5,000 per ton; Materials costs are $500 per ton, Conversion costs (labor and manufacturing overhead are $70,000 per period GAAP Basis Throughput Basis Scenario 1: Scenario 2: Production Build equals sales Inventory 100 tons 100 tons 100 tons 110 tons $500,000 $500,000 50,000 f 63,636 350,000 $ 36,364 ___________
e
f a

Sales Production Revenue Expenses: a Materials 50,000 e Conversion 70,000 Sell. & Gen. Admin. Exp. 350,000 Operating Income $ 30,000 ___________ Calculations: a 100 tons sold x $500 per ton b 100 tons produced x $500 per ton c 110 tons produced x $500 per ton d 90 tons produced x $500 per ton

Scenario 3: Shrink Inventory 100 tons 90 tons $500,000 50,000 g 77,778 350,000 $ 22,222 ___________
a

Scenario 1: Scenario 2: Production Build equals sales Inventory 100 tons 100 tons 100 tons 110 tons $500,000 $500,000 50,000 h 70,000 350,000 $ 30,000 ___________
b

Scenario 3: Shrink Inventory 100 tons 90 tons $500,000 45,000 h 70,000 350,000 $ 35,000 ___________
d

55,000 h 70,000 350,000 $ 25,000 ___________

100 tonssold x ($70,000 produced ) 100 tons 100 tons sold x ($70,000 110 tons produced) g 100 tons sold x ($70,000 90 tons produced) h Assumed fixed in the short run at $70,000 per period

Attributes of Throughput Accounting:

Technical Attributes: By enhancing process understanding within the organization, TOC and throughput accounting provide information that is relevant to making good decisions.

 Decision Relevance
Much of the management focus in a TOC operation is on the bottleneck. Because f its central importance to the organizations capacity to make money, the bottleneck must necessarily receive the lions share of management attention. Managerial accounting plays an important part in the management of bottlenecks by improving capacity use avoiding inventory buildup.

 Throughput accounting is not a cost system

The full costs of production are not assigned to products Does not integrate with the general ledger

Most organizations need more than one accounting system, some traditional costing System like ABC.

 Process Understanding : TOC required a through understanding of work processes, the flow of product from one operation to another and capacity & throughput time of each. It provides a financial system wise view of the organization.

Behavioral Attributes:
Whenever information systems change and mgt introduces new performance measurement, behaviors are affected. Benefits:
Avoids local optimization: encourages cooperation through the organization to achieve company profit goals instead of rewarding for optimization of individual process. Improved Communication between departments

Cultural Attributes
Creating and receptive culture for TOC: Introducing a new process in an existing organizational culture is always hard. People have their existing beliefs, values and mindsets. Mgt. should use training, speeches, and internal literature to demonstrate the impact of TOC on a business unit or product line.

 Mindset change: Making the shift to a TOC based operation often requires that management make significant mindset adjustments. Unlike traditional system, TOC the focus is on producing what customers want instead of the maximum output.

Assumptions versus The Facts:

Prior Assumption Current Fact
Keeping people busy is the key to making money. A focus on labor utilization hinders cash flow due to high inventory and the emphasis on keeping people busy. By keeping utilization high, employees help the company perform well financially. High labor-utilization rates ensure high levels of customer satisfaction. High utilization of resources does not correlate to profitability. High utilization of resources does not necessarily correlate to high customer satisfaction.

If managers release workers to other areas of the Managers will willingly release workers to go operation, they may not get them back when they where the work is when right performance need them. measures are used. Traditional accounting standards tell managers whether they are effective as a total enterprise. Maximizing the production output per setup and building inventory is key to making money. Traditional standards are subjective, inaccurate, and require constant monitoring. Making only what customers order is the key to making money, and on-time delivery is the critical success factor.

 Creating cross-functional cooperation: TOC implementation requires cooperation across functions and processes in an organization.
Information has to be shared on customers want and on the availability of the capacity. Teamwork must be the norm. Everyone must work on elevating the constraint. Non- constrained operations must subordinate their needs to needs of the constraint.

Thank You