amazon highlights: Constraint Management / Steven Bragg / 2014

Constraint Management: A Financial and Operational Guide by Steven Bragg

Last annotated on October 31, 2014

The only way to maximize throughput is to increase the amount of throughput passing through the constraint. This can be done in the following ways:

·         Increase the price of goods sold, so that the throughput is increased by the incremental increase in price.

·         Increase the amount of processing time available at the constraint,

·         Reduce the constraint processing time needed by products.

Consider the following types of constraints:

•   Physical constraint.

•   Paradigm constraint. When employees hold a belief that causes them to act in a certain way, this is called a paradigm constraint,

•   Policy constraint. This is a management-imposed guideline for how a process is to be conducted. Policy constraints are difficult to find, since you must track backwards to them by observing their effects on a business.

o   Batch sizing rule.

o   Bonus plans.

o   Break rule.

o   Cost reduction rule.

o   Discounted cash flow analysis. Fixed assets are only purchased based on their associated discounted cash flows, which ignores their impact on throughput.

o   Economic lot sizing.

o   Minimum production run.

o   Freight cost reduction rule.

o   Overtime rule.

o   Production line balance rule. Instead, sprint capacity is to be encouraged upstream from the constraint, thereby maintaining a certain amount of protective capacity.

o   Resource maximization rule.

•   Raw material constraint.

•   Sales department constraint.

•   Marketplace constraint.  

Consequently, the alteration of a policy constraint can encompass employee relations issues, added training, changes to supporting procedures and bonus plans, and possibly even the replacement of some staff.

Management may choose to have a constraint in a particular place within the company. 

it is better to have employees be underutilized and produce less inventory than to be more efficient and produce inventory that is not needed.  

In summary, a company does not even have to be especially efficient in production areas located away from the constraint. Instead, the one and only focus is on maximizing the efficiency of the bottleneck.  

excess capacity must be built into the system in order to properly manage the constraint. The capacity of a work center can be categorized in one of the following three ways:

•   Productive capacity. This is the amount of workstation capacity required to process all production work that is currently stated in the production schedule.

•   Protective capacity. This is an additional layer of production capacity that is maintained to provide additional units as needed to keep the constraint from running out of work.

•   Idle capacity. All remaining unused capacity is considered idle. Only this layer of production capacity can be safely eliminated without impacting the ability of a workstation to meet all anticipated needs.  

excess capacity located upstream from the constraint is useful, since it can be used to rebuild the inventory buffer in front of the constrained resource. downstream from the bottleneck? In this case, there is no need for any excess capacity, since any excess amount has no beneficial effect on the constraint.  

Under constraint analysis, the calculation is the entire operating cost of the facility, divided by the bottleneck’s operating hours. We use the entire cost of the facility, because the bottleneck drives the profitability of the entire facility. what is the cost of running an operation that is not the bottleneck operation? It is zero.  

Consider the following ways to find the constraint:

•   Backlogs. Every constrained resource has a backlog of work in front of it,

•   Expediter conventions.

•   Incremental throughput modeling.

•   Problems. A constrained resource is overworked, and therefore likely to fail due to a lack of adequate maintenance. Consequently, any resource that seems to constantly require ongoing management attention is more likely to be a constraint.

•   Scheduling. There is usually an ongoing battle over which jobs are scheduled to go through a constrained resource next.

•   Utilization levels. A constrained resource is in use constantly, so it probably has the highest utilization level in the company, and may involve people working multiple shifts and weekends.  

The size of the backlog in front of the real constrained resource might even increase when management pursues the improvement of the wrong workstation. Consider the following variations:

·         Engineering.

·         Procurement. This issue can be dealt with by redesigning products to avoid using the constrained raw material, or by offering to pay a higher price for raw materials.

·         Sales.

·         It is also possible to designate a resource as the official constrained resource. This is usually a capital-intensive function that the company does not want to invest additional funds in, or an area requiring a large number of highly-paid staff.

·         multiple constraints. This can happen when there are several independently-operated production lines in a business, each one with its own constrained resource. This can also happen when the mix of products to be manufactured is constantly changing, so that the mix of workstations employed also varies continually. In the latter case, it may be necessary to re-locate constraints as the work load continually shifts. it nearly always makes sense to overstaff the constraint to ensure that it is always operational.

·         Breaks. Always have experienced backup people available to continue running the constraint when the primary staff takes scheduled breaks, First, the breaks must be scheduled, so that the arrival of backup staff can be properly coordinated. Second, the backup staff must be just as experienced as the primary work crew, so that efficiency does not suffer while they are filling in. finally, consider scheduling routine maintenance for employee breaks. The last option is an especially good one when there are no qualified backup people available to fill in for the primary work crew. 

·         Shift changes. To avoid this downtime during the shift change, schedule overlapping shifts just for the constraint, so that the incoming work crew can take over immediately from the outgoing work crew.

·         Administration and maintenance. The employees operating the constraint may have to deal with a number of administrative and/or maintenance activities besides operation of the constraint.

·         Training. There must always be a well-trained group operating the constraint. training should not be conducted on the constraint, since this reduces utilization. Instead, create a practice workstation that is solely dedicated to training.

·         Overload. In general, overload the constraint with extra staff, just to ensure that any constraint downtime is not caused by a staff shortage. If the work is considered unusually boring or physically demanding, pay a higher hourly rate to ensure that there are enough personnel willing to engage in the work. A high rate of pay also tends to reduce the amount of employee absenteeism.

·         The constraint operation needs to achieve the highest possible level of first-pass quality. It is unacceptable to rework parts at the constraint, since doing so requires additional constraint time. There are a number of techniques available for increasing processing quality at the constraint, such as additional staff training, only staffing with the most experienced personnel, paying bonuses for first-pass quality, and engaging in problem analysis to determine the reasons for any rework issues found.

·         Adjacent staffing. Position a maintenance crew nearby, so they will not have to travel far to address any stoppage issues.

·         Adjacent parts storage. Maintain a parts locker next to the constraint that contains all replacement parts and maintenance tools needed to conduct repairs.

·         Schedule maintenance. Create a schedule that states exactly when preventive maintenance is to be conducted. Doing so at regular intervals makes it less likely that a catastrophic failure will occur.

·         Schedule off-hours repairs. When a major downtime repair is needed, schedule it away from the most productive working hours of the constraint.

·         A better approach is to simplify the operation of the constraint as much as possible by removing the additional operation from the responsibility of the work crew dealing with the constraint. With a narrower focus, they are more likely to achieve a higher utilization level on the constraint.

o    the business may have old machinery that is considered outmoded, but which can still process work at a vastly reduced rate. If so, compare the incremental cost of using these alternatives to the amount of throughput they can generate. This comparison might lead you to conclude that equipment scheduled for disposal should be retained and refurbished.

o   Another option is to outsource work. Suppliers will charge higher fees in order to generate a profit, but this is acceptable as long as the incremental increase in cost does not exceed the incremental amount of throughput generated by using outsourcing.

o   Inspection location. Set up a quality inspection station immediately in front of the constraint.

o   Supplier report card. If there is a risk of low quality in the parts being delivered by suppliers, create a report card system that tracks the quality of these parts.

o   Supplier certification. Certify the ability of suppliers to produce goods to specifications; these suppliers are allowed to ship directly to the production area, bypassing incoming inspections.

·         A longer-term solution to constraint management is to redesign company products so that they require less processing time at the constraint, or none at all.

·         A final management option is to add capacity to the constraint. 

If ongoing industrial engineering efforts have succeeded in reducing inconsistencies in the flow of goods to the bottleneck, the constraint buffer can be relatively small. The existence of a large buffer is particularly important if a company does not have a sufficient amount of excess capacity upstream from the constraint, since these upstream operations will not be able to easily build up a surge of new parts to rebuild the buffer in the event that the buffer is depleted. A large buffer cannot substitute for the addition of production capacity to upstream workstations, especially since it takes lots of excess capacity to build the buffer in the first place. Another option is to increase capacity in those areas where labor is needed, rather than fixed assets, by engaging in a considerable amount of cross-training and then calling in the extra staff when there is a sudden need to increase production volume. 

A portion of the inventory buffer may be designated as an expedite zone. This is the final tranche of inventory that is accessed before the buffer is emptied.  

The issue is not a shortfall of parts arriving from the constraint – after all, this is the most heavily monitored operation in the company, and the constraint does not have sufficient capacity to provide a buffer of constraint-originating parts. Instead, the buffer is used to guard against shortages of all other types of parts.  

Every buffer hole should be investigated in detail to ascertain the reason for its existence, which is then documented in a buffer penetration report. 

A more time-consuming way to manage the buffer than the expedite zone is dynamic buffering. This approach is usually only necessary when the cost of upgrades in upstream capacity is considerable, and there is a large monetary investment in inventory. The amount of monitoring work required may mean that a full-time staff person is needed,

If it is unusually critical to maintain a large stock of inventory in the buffer, especially when there is dynamic buffering, it may be cost-effective to hire a buffer manager. This person’s sole responsibility is the buffer – to monitor current usage patterns, predict which items will be depleted, and work with the upstream workstations to refill the buffer as expeditiously as possible. This should not be considered an entry-level clerk position, but rather a person with significant experience in inventory management and production control. 

Sprint capacity is an excess amount of production capacity located upstream from the constrained resource, possibly in several different workstations. The intent of having sprint capacity is to ensure that any inventory shortages at the constraint can be rapidly refilled. 

The production scheduler faces demands every day from numerous parties to release production jobs onto the shop floor. These demands come from the following parties:

•   Customers. Customers in immediate need of products will demand through the sales department or order entry staff that their orders be released to the shop floor at once, under the mistaken impression that an order release will result in an earlier completion of their order.

•   Managers (ethical issue). A cannier manager with a reduced ethical sense may demand that jobs be released, solely because doing so means that the jobs can begin to accumulate factory overhead, which defers the recognition of that overhead to a later period, resulting in increased profits.

•   Managers (utilization). One of the most damaging policy constraints is that management likes to see all workstations in the production area fully utilized.

•   Managers (filled process flow). A manager not experienced in constraint management might associate having a large number of released jobs with a busy manufacturing operation, not realizing that doing so slows down the production process. 

One issue that the production scheduler does not try to maximize is throughput. Throughput is more of a strategic issue that is addressed by management when it sets product prices and decides which products to actively market to customers. Scheduling priorities:

1.   Late deliveries. If a delivery will be late, this job is typically given the highest priority.

2.   Regular deliveries. Normal customer orders are to be scheduled in the order in which they were received, subject to any raw material or subassembly shortages that might cause a delay.

3.   Inventory replenishment. If there is room left in the schedule and management wants to bolster the amount of finished goods deliberately kept on hand, these replenishment orders are scheduled last.  

An additional work priority that is usually addressed separately is goods requiring rework. These items tend to pile up in the production area and interfere with the flow of goods. However, they are usually of lower priority, since customers have already been shipped new replacement goods. 

A reasonable basis for initial scheduling purposes is to use an estimate of available constraint time that incorporates scheduled maintenance, plus the average amount of unscheduled downtime that has occurred over the past few weeks.  

One of the worst things that a production scheduler can do is to release a vast amount of raw materials onto the shop floor when only a small proportion of it can be immediately used. Instead, raw materials should only be released at the rate at which they can be consumed at the constraint. 

Proper consideration of the use of certain positions can be enhanced with the use of labor routings. A labor routing is a listing of the quantity and types of labor required to manufacture a product. The production scheduler combines labor routings with the prospective production schedule to see if any labor shortages are flagged, and alters the schedule accordingly.  

Batch sizing:

•   Proportion of setup time. If there are a large number of small jobs, and those jobs require a significant amount of setup time, this reduces the number of minutes in the period that are available for actual processing work.

•   Delivery speed. The speed with which batches of parts are delivered to the next downstream workstation is increased when the size of each batch decreases.

•   It is acceptable to have small batch sizes upstream from the constraint, since these workstations have excess capacity that can absorb the extra time required for the many machine setups associated with small batch sizes. These small batch sizes are useful for reducing the size of the inventory buffer.

•   It is substantially less acceptable to follow the same philosophy for the constraint, where there is no excess time to waste on additional setups. If there are many setups and the setups are time-consuming, the total amount of throughput generated will decline. Instead, if setups at the constraint are lengthy, focus on larger batch sizes just in this one area. A larger batch size that still produces throughput can be created when several customer orders are combined for production purposes. 

Expediting involves assigning an expediter to a specific high-priority job, who then walks it through the entire production process, shifting other jobs out of the way to make room for the designated job. Expediting can destroy the efficiency of a production area and also delay other customer orders, since the bulk of all orders are given a lower priority and must also contend with the removal of assigned materials in favor of higher-priority jobs. 

A good way to view the sales department constraint is to first examine the typical sales process, which is:

1.   Locate prospects

2.   Meet with prospects in an initial sales call

3.   Conduct a product demonstration

4.   Issue a quote to the prospect

5.   Negotiate the terms of the contract.  

Thus, an examination of actual to available capacity at each step in the sales process will reveal where there are bottlenecks. Another clue is that there should be a backlog of work in front of these work areas.

•   Position the best salespeople in the most customer-dense sales regions, so that the proportion of their travel time to sales meetings is minimized.

•   Assign a large proportion of administrative staff to the best salespeople, so the salespeople can spend most of their time on sales calls.

•   If there are technically competent people on staff who do not have the skills to be salespeople, assign them to the sales staff to make technical presentations as needed.  

A constraint in the engineering department can be particularly difficult to resolve, since this is the type of skilled resource that may be inordinately difficult to enhance. Possible ways to manage it are:

•   Reduce the level of product customization in favor of a small number of pre-packaged solutions that require a reduced amount of customization.

•   Charge more for highly customized work.

•   Give the engineering staff a large amount of administrative support, so that the engineers spend as much of their time as possible on client-oriented activities.

•   Create an in-house apprenticeship program to develop the necessary skill sets.

•   Offer above-market compensation and benefits to reduce the amount of engineer turnover.  

In a small business, the constraint is very likely to be the founder of the business.  

Projects have a strong tendency to run longer than their expected due dates. There are several ways to deal with this problem. The key step is to not issue a due date for each task. An additional improvement is for the project manager to maintain a large time buffer for the project as a whole, which is positioned at the end of the project timeline. A final concern with project management is that certain individuals involved in a project may be tasked with different deliverables for different sections of the project at the same time. 

In a traditional cost accounting environment, accountants are trained to look at transactions at a much more detailed level than is the case with constraint management. Instead of looking at the impact on the entire system of throughput generation, they instead look at the costs of individual products and activities. In doing so, their overwhelming emphasis is to find ways to reduce costs everywhere.  

A constraint management orientation takes the reverse view of costs. Under constraint management, costs are to be incurred in whatever amount is necessary (within reason) to ensure that throughput is generated. The implication of this viewpoint is that cost control is vastly less important than throughput generation. Both the traditional cost accounting and constraint management viewpoints have the right intention, which is to enhance net profits.

 

In short, the opportunity for profit improvement is much higher in a constraint management environment than in a cost control environment. Each cost reduction must be carefully examined to ensure that it does not interfere with the ability of the entity to create throughput. Traditional capacity focus implications:

•   The sales staff only contains a sufficient headcount to deal with current customer demand.

•   The production area only has sufficient production capacity for the current demand level.

•   In a service business, headcount can only handle the anticipated level of customer demand.  

The only situation in which capacity reduction could be considered a valid issue is when certain types of capacity have been rendered entirely unusable.  

A common cost accounting activity is to derive the gross margin for a variety of items, such as products, product lines, sales regions, and customers. This formula requires the cost accountant to engage in the allocation of overhead costs to whatever the object of the analysis may be. In a constraint management environment, the gross margin is considered useless precisely because of the overhead allocation component of the formula. The contribution margin is the same as throughput, except that contribution margin is expressed as a percentage of revenue, while throughput is expressed as a dollar amount.  

cost accountants continue to insist on long production runs. Their insistence is based on the following fallacies:

·         Unique setup cost. One incorrect assumption is that there is a unique setup cost associated with each setup.

·         Out of spec parts. Cost accountants do not factor in the effect of a workstation in a production run that creates out-of-specification parts that are then produced in large volume as part of a long production run.

·         All time is valuable. Cost accountants labor under the misconception that the time of all workstations is valuable, because they tend to focus on the cost of the equipment and personnel needed to operate a workstation.

·         Low cost of inventory. It is incorrect to assume that there is a minimal cost associated with maintaining excess inventory in storage.

·         Obsolescence. Inventory may become unusable over time (especially for perishable items), or it may be superseded by technological advances.

·         Cost of funds. This is the interest cost of any funds that a company borrows in order to purchase inventory (or, conversely, the foregone interest).

·         Taxes. The business district in which the inventory is stored may charge some form of property tax on the inventory.

·         Facility cost. This is the cost of the warehouse, which includes depreciation on the building and interior racks, utilities, building insurance, and warehouse staff.

·         Risk mitigation. This is not only the cost of insuring inventory, but also of installing any risk-management items needed to protect the inventory, such as fire suppression systems, flood mitigation planning, burglar alarms, and security guards.

In short, excessively long production runs reduce company profitability.  

In a traditional cost accounting environment, direct labor is considered a variable expense, on the assumption that the amount of direct labor incurred varies directly with the volume of units produced. This means that direct labor is included in the contribution margin calculation for products and product lines. Under a traditional cost accounting view, direct labor could be included in the fixed cost classification. However, this would only mean that the fixed cost would then be rolled into the factory overhead classification and allocated to products as a form of overhead, so that the cost would still be indirectly applied to individual products. Under the constraint management viewpoint, direct labor is considered part of operating expenses, which are those expenses required to maintain the entire system of production.  

Under a traditional cost accounting system, the cost of work-in-process inventory gradually increases as it moves through the production process. This usually begins with a full charge for the cost of all raw materials associated with a job, when a complete kit of materials is moved onto the production floor. Under this cost accumulation system, it appears that the cost of work-in-process is building up over time. This system would lead one to believe that scrap occurring late in the production process is more expensive to the company than scrap occurring early in the process. Under a system of constraint management, this entire cost accumulation approach would be seriously questioned, for the following two reasons:

•   Nature of variable costs. Only variable costs should be assigned to a job, but all of the costs incurred by workstations are fixed.

•   Location of the constraint. There is a direct relationship between the location of the constraint and when scrap is created. If scrap is created prior to the constraint, then its cost is indeed just the variable cost of materials, as just noted. However, once work-in-process has been processed through the constraint, it has now consumed the time of the constraint, which must be used again to process replacement work-in-process. In this situation, the cost to be added to the scrap is the lost throughput that the company would have earned if the inventory had not been scrapped. This means that scrap occurring either at or downstream from the constraint has a much higher cost than scrap occurring prior to the constraint.  

An additional point is that no cost is assigned to work-in-process based on the amount of processing time applied to the inventory by any other workstation than the constraint. These other workstations have excess capacity, so their processing time is essentially free. Under the constraint management approach, there is a much stronger incentive to find ways to avoid scrap at the constraint and at every point thereafter, since the cost of scrap is much higher once the constraint is reached. Under a constraint management system, there will likely be an inspection point immediately in front of the constraint, so that all parts that are out of specification can be removed from the queue before they waste the time of the constrained resource. More specifically, the inspection point is just in front of the inventory buffer, so that all buffer inventory can be inspected prior to use. There is also likely to be an intensive focus in a constraint management system on scrap prevention anywhere downstream from the constraint, so that none of the time spent at the constraint is subsequently wasted.  

Cost accountants sometimes review all products issued by a company, carefully allocating costs to each one, to see if any are losing money. If so, management may agree to cancel them. If a cost accountant were to follow the more traditional approach of assigning overhead to products and then deciding if they are unprofitable, the result would be the ongoing elimination of products, as overhead costs are gradually shifted to the smaller number of remaining products, driving up the cost of each one in turn and forcing management to conclude that each one should be cancelled. Formun Üstü

This does not mean that low-throughput products will necessarily be cancelled, only that they will not be produced if there are higher-throughput customer orders available that can be produced first. 

Traditional cost accounting requires that the costs of direct materials, direct labor, and factory overhead are applied to all units produced in a period. If these produced units are sold within the same period, then the result is that all costs incurred to produce the goods are charged to the cost of goods sold. However, if the goods are not sold, these incurred costs are instead recorded as assets and appear on a company’s balance sheet. The costs are thereby deferred until such time as the goods are sold, at which point they will be charged to the cost of goods sold. 

Constraint management is fundamentally at odds with this deferral of expense. The reason is that direct labor and factory overhead are both operating expenses of the production system that relate to the period in which they are incurred. If there is no production in a period, these costs will still be incurred, so they are really period costs. 

Another problem with assigning direct labor and factory overhead costs to inventory is that it creates an incentive for managers to build more inventory than is needed to fill customer orders. The extra inventory items accumulate costs and then sit in storage until a later reporting period, thereby deferring the recognition of what are really period expenses. This issue is particularly prevalent when the management team is being paid a bonus based on net profit, and needs to defer expenses in order to attain the budgeted profit target. This incentive is absent under constraint management, since all direct labor costs and operating expenses are charged to expense as incurred – there is no way to defer the recognition of these expenses. 

When there are multiple subsidiaries governed by a corporate management group, a common accounting practice is to impose an allocation of the corporate overhead cost onto the subsidiaries. The allocation may be based on a number of formulations, such as the sales, profits, or headcount of the subsidiaries. No matter how this allocation is made, the essential outcome is that the results of the subsidiaries are obscured by the extra cost imposition. A more appropriate way to deal with corporate overhead is to not allocate it, and simply judge each subsidiary based on the throughput that it generates. 

The cost variances that can potentially be calculated are as follows:

•   Purchase price variance.

•   Material yield variance.

•   Labor rate variance.

•   Labor efficiency variance.

•   Variable overhead spending variance.

•   Variable overhead efficiency variance.

•   Fixed overhead spending variance.

Issues with the use of variances:

•   The use of standards.  If standards are politically created, variance analysis becomes useless from the perspective of controlling a business.

•   Feedback loop. The accounting department does not calculate variances until after it has closed the books and created financial statements, so there is a gap of potentially an entire month from when a variance arises and when it is reported to management.

•   Information drill down. Many of the issues that cause variances are not stored within the accounting database.

•   Level of management control. Can management even control some of these variances?

•   Efficiency orientation. Certain variances have a built-in orientation toward forcing management to operate all workstations as efficiently as possible.  

The preceding points do not include the most important consideration of all, which is that the classical variance reporting system does not consider the existence of the constraint, or how it should be operated. The real problem with all of these cost-based variances is that they are, as the name implies, focused solely on costs. When there is continual pressure to reduce costs, it is more difficult to increase revenue, which is an outcome of constraint management. Instead, the primary focus is on just two items:

•   Inventory buffer variance.

•   Constraint production variance.  

Both direct costing and constraint management maintain a tight focus on variable costs, and assume that all other costs are period costs that should be charged to expense as soon as they are incurred. However, there are several key differences between the two concepts, which are:

•   Focus of analysis. Instead, direct costing is used to evaluate contribution margins irrespective of their impact on the constraint.

•   Return on investment. throughput modeling can be used to derive the return on investment for a number of proposed transactions. This is not the case for direct costing, which is primarily concerned with margin analysis.

The central difference between ABC and constraint management is that ABC does not recognize the existence of a bottleneck operation, preferring instead to focus management’s attention on the reduction of overhead costs throughout a facility. ABC is only a cost reduction tool. It does not consider or even recognize the existence of a constraint or throughput, and so cannot assist in increasing throughput. An additional concern is the inherent complexity of the ABC system.

•   Cost accounting focuses on local optimization, which tends to trigger an overinvestment in inventory.

•   The system of variance reporting diffuses management attention into many areas, rather than focusing it on the constraint.

•   There is a cost accounting emphasis on judging the profitability of individual products or services, rather than the throughput of the entire system.

•   The cost accounting emphasis on allocating overhead tends to defer period costs into future periods, while also obscuring the amount of throughput generated. 

GAAP is promulgated by the Financial Accounting Standards Board (FASB), and is used primarily by entities operating within the United States. It is a rules-based assemblage of accounting standards, which means that it uses a large amount of highly specific rules to describe the circumstances under which various accounting transactions are to be recorded and reported. 

IFRS is promulgated by the International Accounting Standards Board (IASB), and is used in more than 120 countries in various forms – essentially everywhere that GAAP is not used, with a few exceptions. It is a principles-based system, which means that general principles are outlined that one should follow, using one’s own judgment. The result is a much more streamlined and easy to follow accounting framework than GAAP. 

The most critical difference between constraint management and the frameworks is that both frameworks require direct labor and factory overhead to be assigned to manufactured goods, while constraint management holds that these are operating costs that should be charged to expense as incurred. 

A more subtle difference between the accounting frameworks and constraint management is that the frameworks are designed to automatically treat inventory as an asset. from a practical perspective, the characteristics of inventory are quite similar to a liability. 

To calculate constraint utilization, divide the actual hours of usage of the operation by the total hours available. Depending on how closely management watches this metric, you may want to re-calculate it every day. this metric should be used in combination with an analysis of the throughput of the products scheduled for production. Ideally, the constraint should have both a high utilization rate and high effectiveness, in order to maximize the total amount of throughput generated. 

To calculate constraint effectiveness, divide the total amount of throughput dollars generated by the number of hours that the constraint was in operation. Note that the throughput figure used in the numerator is not just the throughput passing through the constraint, but rather the throughput of the entire production operation.

•   Shifting work away from the constraint to increase throughput without using the constraint

•   Improving the speed of operation of the constraint, so that more units can be processed per hour

•   Increasing product prices to increase throughput per unit

•   Reducing the cost of materials to increase throughput per unit

•   Altering product designs to require less processing time  

To measure fulfillment of the constraint schedule, aggregate the number of jobs completed at the constraint operation by the number of jobs scheduled for the operation. This measurement works best when there are a large number of jobs scheduled at the constrained operation. If there are just a few massive jobs during the measurement period, this measurement could vary wildly from period to period. use of this measurement should be coupled with an examination of the throughput associated with each job assigned to the constraint operation. If the assigned throughput is low, the company has pricing problems with the products it is selling.  

the level of buffer penetration must be examined continually to determine how close it has come to being eliminated, possibly resulting in some adjustment to the size of the buffer. To calculate buffer penetration, divide the number of jobs at the constraint for which materials had to be accessed from the buffer by the total number of jobs at the constraint.  

A good way to measure the amount of downtime associated with maintenance is to compare maintenance time to the amount of time that the constrained resource is functioning. Doing so emphasizes to the maintenance staff the importance of minimizing the time that the constraint is not available for production purposes. While this measurement does a good job of focusing attention on maintenance, it could promote the use of short-term fixes, rather than more extensive overhauls that could reduce the long-term amount of maintenance required.  

To measure the amount of constraint rework processing, divide the total amount of rework time at the constraint by the total hours of operation of the constraint.  

The amount of constraint time lost through scrap can be calculated by aggregating the constraint time consumed by each item scrapped, and multiplying by the average amount of throughput per minute generated by the constraint. The amount of scrap that occurs after the constraint is not to be confused with scrap that occurs before the constraint. When scrap is flushed out of the system before the constraint, this is actually a benefit to the company, since these items are being spotted and removed before they waste precious constraint time.  

The entire manufacturing function should be able to generate the largest possible amount of throughput at the lowest possible cost, which is known as manufacturing productivity. A well-run operation should be able to reduce the cost of operations while maintaining or increasing the level of throughput generated.  

In short, the manufacturing productivity measurement can be used to model how changes in production expenses incurred will alter the amount of throughput generated.  

To determine the level of manufacturing effectiveness, divide the total amount of throughput generated during the measurement period by the number of hours during which the constrained resource was in use. However, a change in manufacturing effectiveness may not be caused by the production staff at all. Instead, it is quite possible that the mix of products sold has changed. 

The concept of manufacturing throughput time is primarily oriented toward the reduction of time required by the manufacturing process, so that you can increase the amount of throughput flowing through the system and thereby boost profitability.  

To determine the order cycle time, subtract the order placement date from the shipment date for each individual order, and then calculate the average for this group. This calculation is only designed to include those orders that have already shipped. In addition, there will be a pool of orders that have not yet shipped. The measurement logic to use for these orders is:

1.   If an order has not shipped and is not yet scheduled to ship, do not include it in the calculation. Otherwise, the result will be a very short order cycle time that skews the overall measurement to produce an artificially short average cycle time.

2.   If an order has not yet shipped and was already scheduled to have shipped, include it in the calculation, assuming that the ship date was as of the end of the reporting period. Doing so ensures that orders guaranteed to have long cycle times are included in the measurement.

A variation on the measurement is to separately measure order cycle time for complex orders and simple orders. Simple orders, such as for items that are routinely kept in stock, may ship with a turnaround time of just a few hours. Complex orders may require detailed sourcing efforts and complex work routings, and so require vastly longer cycle times.  

This problem arises when there are problems in the production process downstream from the constrained resource that delay shipments.  

The revised calculation is to divide annual throughput dollars by the variable cost of inventory. This variable cost is usually interpreted to be the acquisition cost of the raw material component of inventory; direct labor and factory overhead costs are not included.

 

Measurements to avoid:

•   Gross profit percentage. A standard line item on the income statement is the gross profit percentage, which is revenue minus the cost of goods sold. Since the cost of goods sold includes a factory overhead allocation, the gross profit percentage is always too low in comparison to the amount of throughput being generated. If this measurement is applied at the level of individual products or product lines, it is possible that an excessively low gross margin could lead to the termination of products that actually generate positive throughput.

•   Overtime percentage. When the proportion of overtime hours worked is reported, the natural response of management is to clamp down on the allowable amount of overtime. However, if this policy is extended to the constrained resource, it means that overtime will be restricted in the one area where it is desperately needed in order to ensure that the amount of available constraint time is maximized.

•   Sales per person. This measurement tends to force management to minimize headcount in order to drive up the amount of sales per person. They may do so by shrinking the headcount in areas where there is a constraint, which can worsen the productivity of the constraint. Also, management may be tempted to outsource work in order to eliminate the associated positions, which may (depending on the circumstances) also have a negative impact on throughput.

•   Work-in-process turnover. This measurement draws attention to the amount of inventory located on the production floor, and typically results in a drive to reduce inventory levels by cutting back on the inventory queued up in front of each workstation. This is a real problem when inventory is withdrawn from the buffer located in front of the constrained resource, since a buffer must be maintained here to ensure full-time operation of the constraint.  

A cost object is any item for which costs are separately measured. It may be necessary to report on a cost object in order to derive pricing from a baseline cost, or to see if costs are reasonable, or to derive the full cost of a relationship with another entity. Here are several types of cost objects:

•   Output. The most common cost objects are a company’s products and services, since it wants to know the cost of its output for profitability analysis and price setting.

•   Operational. A cost object can be within a company, such as a department, machining operation, or process. Examples are the design of a new product, a customer service call, or the reworking of a returned product.

reveals the problem that management faces when evaluating product costs that could change with purchasing volumes; there is a possibility that expected throughput could severely underperform. 

Management may need to consider the cost of its various sales channels, to see if they are being operated in a cost-effective manner that produces profits. If so, the analysis should certainly include the variable costs of all goods and services generated by that sales channel, as well as the support costs required to maintain the channel, which could involve any separate distribution infrastructure. Unfortunately, the cost accounting system is not designed to track costs for individual customers, so new systems are needed to track the customer service time devoted to each customer, salesperson time by customer, and the cost of returned goods.  

It can be difficult to judge from a single performance measurement whether a business is properly managing its constrained resource, since there is no basis of comparison. This difficulty can be resolved by conducting a trend line analysis to see if there is a gradual change in those measurements used to monitor the constraint.

•   Sales backlog dollars. An increasing sales backlog can indicate problems processing orders through the constrained resource.

•   Throughput. An excellent trend report is one that tracks the gross amount of throughput generated in each reporting period.

•   Constraint down time. The amount of time during which a constrained resource is unavailable to process work should certainly be tracked, possibly on a daily basis.  

Whenever the inventory buffer in front of the constrained resource is unintentionally drawn down, the event should be noted and its cause investigated. The information is then summarized in a standard report and distributed for immediate action. By engaging in this ongoing investigation, management can react to upstream production problems that are causing variations in the flow of goods to the constrained resource. The report does not have to be overly detailed – just state the circumstances, the location of the problem, and the underlying cause.  

An excellent tool for monitoring the inventory buffer is the buffer management report. The report contains high and low boundaries, which define the threshold limits for which it is considered allowable for work orders at the constrained resource to require some penetration of the inventory buffer. The data points on the report reveal the percentage of work orders in each day that require some degree of buffer penetration. The line running through the report states the average penetration level through the reporting period.  

When considering the proper balance of controls that a business needs, also consider the types of controls being installed. A preventive control is one that keeps a control breach from occurring. Another type of control is the detective control. This control is useful, but only detects a control breach after it has occurred; thus, its main use is in making management aware of a problem that must be fixed. A control system needs to have a mix of preventive and detective controls.  

If a control is operated by the computer system through which transactions are recorded, this is considered to be an automated control. If a control requires someone to manually perform it, this is considered a manual control.  

A business can lose a considerable amount of throughput if goods are scrapped after they have been processed through the constraint. The “recurring” flag is of particular interest to the reader of the report, since it indicates whether the scrap event is continuing to occur. A preventive control for scrap is to reconfigure the production area so that the batch sizes sent from one workstation to the next are reduced to just one unit at a time.  

A good detective control (though a highly manual one) is to create a report that notes these delays and the problem that caused each one. The report is issued to the responsible managers as soon as an issue is noted, so that they can take corrective action at once. Another possible control is to (literally) raise a warning flag as soon as an inventory shortage at the buffer accesses the expedite zone. 

Tip: Construct a trend line report to track the persistence of expedite zone penetrations. The report may reveal a pattern of increasing penetrations, which could indicate that the sprint capacity of the upstream workstations is not sufficient to overcome continuing shortages at the inventory buffer.  

Production flow controls:

•   Manual review. The production manager can conduct a visual inspection of the shop floor to note chokepoints, and manually examine the jobs to see which ones were released too early.

•   Accounting review. At the end of each reporting period, the accounting staff may compile the dollar cost of all work-in-process inventory.

•   Release approval. Have the production manager approve all job releases to the production floor.

•   Supplier certification. Have the industrial engineering staff visit each supplier and verify that their systems and quality controls are sufficient to ensure that deliveries made to the company will be on time and within specifications.

•   Supplier report cards. Compile information about the quality and timeliness of supplier deliveries, and share this information with suppliers.

•   Advance shipping notices. Have suppliers issue electronic notifications to the company’s purchasing department, detailing the contents of each upcoming delivery, and noting when it is expected to be delivered.  

There are two scenarios under which certain project proposals may avoid any kind of bottleneck or cash flow analysis. The first is a legal requirement to install an item. The second scenario is when a company wants to mitigate a high-risk situation that could imperil the company.  

From the perspective of constraint management, the only capital investments that should be made in a business are ones that will either increase throughput or reduce operating expenses.  

The analyst can attach a variety of suggestions to a proposal, which management may incorporate into a revised proposal.

•   Asset capacity. Does the asset have more capacity than is actually needed under the circumstances?

•   Asset commoditization. Wherever possible, avoid custom-designed machinery in favor of standard models that are readily available.

•   Asset features. Managers have a habit of wanting to buy new assets with all of the latest features. Are all of these features really needed?

•   Asset standardization. If a company needs a particular asset in large quantities, adopt a policy of always buying from the same manufacturer, and preferably only buying the same asset every time.

•   Extended useful life. A manager may be applying for an asset replacement simply because the original asset has reached the end of its recommended useful life. But is it really necessary to replace the asset?

•   Facility analysis. If a capital proposal involves the acquisition of additional facility space, consider reviewing any existing space to see if it can be compressed, thereby eliminating the need for more space.

•   Monument elimination. A company may have a large fixed asset, around which the rest of the production area is configured; this is called a monument. If there is a monument, consider adopting a policy of using a larger number of lower-capacity assets.  

There are a number of ways to configure the approvals for a capital request form, besides the fairly standard approval requirements noted in the preceding approval form.

•   Constraint improvement approvals. An improvement to the constrained resource is likely to be expensive.

•   Cost reduction approvals. The main point with these requests is to achieve a high level of certainty that the outcome will indeed be a cost reduction.

•   Environmental/legal compliance approvals. These types of investments require different approvals, depending on the circumstances.

•   Risk reduction approvals. These investments should be approved by the corporate risk manager or safety officer.  

•   Scheduled equipment replacement approvals. If equipment is nearing the end of its useful life, consider having the industrial engineering staff conduct an inspection of the equipment to see if a replacement is actually necessary, and require their approval before a replacement is acquired.  

When compiling a revenue budget, the traditional approaches are either to ask for projections from the sales staff (the bottom-up option) or to have senior managers impose revenue expectations (the top-down approach). No matter which approach is taken, these budgeting methods suffer from two problems, which are:

•   Throughput outcome. These budgets only describe top-line revenue expectations. There is no evaluation of how much throughput can be expected from each dollar of sales.

•   Impact on the constraint. These budgets do not state the amount of processing time required at the constrained resource.

These issues can be resolved by altering the revenue budget to reveal throughput and total processing time at the constraint.  

A more precise system of expense analysis can be devised by using zero-base budgeting. A zero-base budget requires managers to justify all of their budgeted expenditures, rather than the more common approach of only requiring justification for incremental changes to the budget or the actual results from the preceding year. Thus, a manager is theoretically assumed to have an expenditure base line of zero (hence the name of the budgeting method).  The basic process flow under zero-base budgeting is:

1.   Identify business objectives

2.   Create and evaluate alternative methods for accomplishing each objective

3.   Evaluate alternative funding levels, depending on planned performance levels

4.   Set priorities  

constraint management requires the sponsorship of someone in senior management. If this person leaves the company, the support level is likely to decline, and managers may shift to other priorities.

•   Internal advancement policy. One of the best ways to ensure the longevity of constraint management is to continually replace outgoing senior managers with existing staff, rather than hiring in outsiders.

•   Board of directors training. The board of directors is typically comprised of outsiders, and so they will be less knowledgeable about constraint management.

•   Reporting package. Revise the reporting package issued to the senior management group and the board of directors, so that constraint-related issues are continually positioned as being critical aspects of company success.  

In a more oppressive top-down, command-and-control environment, the senior management team expects everyone in the company to rigidly adhere to their mandated expenditures throughout the year. In effect, the management team attempts to mold the company to the plan. If this is the current state of the budgeting environment, constraint management will suffer. The situation is somewhat different when the budget is treated by management as more of an advisory document, indicating where expenditures are more likely to be incurred. In this situation, the management team can easily re-route funds designated for other purposes to ensure that the constraint is properly maintained and operated. One way to arrive at this situation is to only block out funds for a department as a single line item in the budget, rather than attempting to apportion it amongst many types of expense line items. This more aggregated approach gives management maximum flexibility in how to spend funds. A good replacement for a budget is the rolling forecast. This is a simple forecast that contains information only at an aggregate level, such as:

•   Revenues by product line

•   Expenses aggregated into a few line items

•   Customer order backlog

•   Cash flow  

The intent of a rolling forecast is to create a system that is easily updated, and which gives the organization a reasonable view of what the future looks like for at least the next few months. A key reason for having a rolling forecast is to bring up issues as soon as possible, so that a company can initiate corrective actions to deal with them.

 

Employees should update their parts of the rolling forecast about once a month, and only spend a short time doing so – a fine level of detail is not expected. Since the forecast is updated regularly, it does not have a great deal of impact on the organization if the forecast proves to be incorrect – after all, a new version will replace it shortly, so there is very little time during which a bad forecast can impact the business. The rolling forecast is accompanied by a rough work plan that is adjusted as frequently as the forecast. No one has to submit the work plan to a higher authority for approval. Instead, employees formulate their direction, document it in the work plan, and adjust it to compensate for both current and expected future events. Whomever is managing the constrained resource must be copied on all changes to the rolling forecast, in order to adjust his or her expectations regarding the likely direction of demand, and how that will impact the constraint. In short, the best environment for constraint management is a loosely-followed budget that is used more as a general guideline than as a tight control over activities.  

it is better to base all bonus compensation on a single company-wide profit sharing pool. One type of compensation that has no place in a constraint-managed corporation is the stock option. A stock option generates a return for its holder if the price of the underlying stock increases. However, there is not necessarily a relationship between the price of the stock and the actual throughput performance of the company.  

A better use of marketing that does not impinge on the constraint is to continually build awareness of the corporate brand and of the existence of company products, which should gradually increase customer demand over a long period of time. Another issue to be avoided in the marketing area is short-term alterations of product prices. price alterations should only be for special situations, such as to clear out excess stocks of finished goods that have already passed through the constraint.  

In some organizations, the constraint is a highly-talented individual whose skills are extremely rare. To grow the company, it will be necessary to find similar people. This is a difficult situation, for this person may consider his uniqueness to be a defensive measure for preserving his job. The result is resistance to interviewing new hires to assist him, not training anyone who is hired, and undermining anyone who tries to cross-train on his skills. This is a disastrous constraint situation, and is quite difficult to circumvent.

Production policies:

·         The ideal batch size is one unit; the company will continually strive to reduce batch sizes in order to meet this goal.

·         The designated constraint workstation shall operate continually. This shall be achieved by scheduling replacements during employee breaks, and by using overlapping shifts.

·         All production workstations are to be operated only as needed to fulfill necessary production requirements. Workstation operators are not judged based on high utilization levels. 

Cost reduction policies:

·         Expenditures required for the constrained resource are at the discretion of the constraint manager. Cost reductions in this area must be approved by the chief executive officer.

·         No excess production capacity is to be sold off or otherwise disposed of without the express prior consent of the chief executive officer.  

Constraint management financial analysis terminology:

•   Throughput. This is the margin left after you subtract totally variable costs from revenue. This tends to be a large proportion of revenues, since all overhead costs are excluded from the calculation.

•   Totally variable costs. This is usually just the cost of materials, since it is only those costs that vary when you manufacture one incremental unit of a product. This does not normally include the cost of labor, since employees are not usually paid based on one incremental unit of output. There are a few other possible costs that may be totally variable, such as commissions, subcontractor fees, customs duties, and freight costs.

•   Operating expenses. This is all company expenses other than totally variable costs. There is no differentiation between overhead costs, administrative costs or financing costs – quite simply, all other company expenses are lumped into this category.

•   Investment. This is the amount invested in assets. The term includes changes in the level of working capital resulting from a management decision.

•   net profit 

When you look at a company from the perspective of constraints, it no longer makes sense to evaluate individual products, because overhead costs do not vary at the individual product level. In reality, most companies spend a great deal of money to maintain a production infrastructure, and that infrastructure is what really generates a profit – the trick is making that infrastructure produce the maximum profit with the best mix of products having the highest possible throughput.

•   Increase throughput. This is by either increasing revenues or reducing the amount of totally variable costs.

•   Reduce operating expenses. This is by reducing some element of overhead expenses.

•   Improve the return on investment. This is by either improving profits in conjunction with the lowest possible investment, or by reducing profits slightly along with a correspondingly larger decline in investment.  

Revenue – totally variable expenses = throughput

Throughput – operating expenses = net profit

Net profit ÷ investment = return on investment  

The best system improvements are those that increase the amount of throughput generated, since there is no theoretical upper boundary on the amount of throughput. Conversely, an action taken to reduce operating expenses is less important, since expenses can only be reduced to zero.  

The basic thrust of the model is to give priority in the constraint to those products that generate the highest throughput per minute of constraint time. The constraint analysis model is essentially a production plan that itemizes the amount of throughput that can be generated, as well as the total amount of operating expenses and investment.

•   Throughput per minute. This is the total amount of throughput that a product generates, divided by the amount of processing time at the constrained resource.

•   Constraint usage. This is the number of minutes of processing time required by a product at the constrained resource. This figure is the sum total of both the setup time for a job and the actual run time for the job.

•   Units scheduled. This is the number of units scheduled to be processed at the constrained resource.

•   Total constraint time. This is the total number of minutes of processing time required by a product, multiplied by the number of units to be processed.

•   Total throughput. This is the throughput per minute multiplied by the number of units processed at the constrained resource.

This grid produces a total amount of throughput to be generated if production proceeds according to plan. Below the grid of planned production, there is a subtotal of the total amount of throughput, from which the total amount of operating expenses are subtracted to arrive at the amount of profit. Finally, the total amount of investment in assets is divided into the profit to calculate the return on investment. Thus, the model provides a complete analysis of all three ways in which you can improve the results of a company – increase throughput, decrease operating expenses, or increase the return on investment.  

Since throughput is less than revenue, we are overstating the profit percentage as compared to the traditional profit percentage calculation. Use the constraint analysis model in a before-and-after mode, to see what effect a proposed change will have on profitability or the return on investment. If the model improves as a result of a change, then implement the change.  

•   Price points. A product may be sold at multiple price points to different customers, which affects the throughput per minute listed in the model for each product.

•   Production volume. The variable cost component of a product may change, depending on the number of units sold. This means that a product being marketed less aggressively may also experience a throughput decline, because the reduced number of units sold does not allow the company to buy raw materials in bulk anymore.

•   Location. If the production facility is moved to a different location, the local labor rates may differ from those in the old location, which impacts the operating expenses in the model.

•   Unions. If the production department is represented by a union, their work rules may reduce the total number of minutes that the constraint can be operated.  

Cost-Based Pricing Strategies. These pricing strategies are based on the cost of the underlying product or service. They are:

•   Absorption pricing. Includes all variable costs, as well as an allocation of fixed costs. It may include a profit markup. The intent is to ensure that prices are set that will ensure a long-term profit.

•   Break even pricing. Includes all variable costs, as well as an allocation of fixed costs. It may include a profit markup. The intent is to find that price point at which a business earns a profit of zero.

•   Cost plus pricing. Includes all variable costs, an allocation of fixed costs, and a predetermined markup percentage. This approach is frequently used in government contracts.

•   Marginal cost pricing. Prices are set near the marginal cost required to produce an item, usually to take advantage of otherwise-unused production capacity. This method is used to develop prices for special deals.

•   Time and materials pricing. Customers are billed for the labor and materials incurred by the company, with a profit markup. This method is commonly used for construction projects.  

Value Pricing Strategies. These pricing strategies do not rely upon cost, but rather the perception of customers of the value of the product or service. They are:

•   Dynamic pricing. Technology is used to alter prices continuously, based on the willingness of customers to pay. This is a common pricing strategy in the airline industry.

•   Premium pricing. The practice of setting prices higher than the market rate in order to create an aura of exclusivity. This is used by sellers of high-end consumer goods.

•   Price skimming. The practice of initially setting prices high to reap unusually high profits when a product is initially introduced. This is used by first-to-market innovators.

•   Value pricing. Prices are set based on the perceived value of the product or service to the customer. This tends to be used for higher-value services, such as investment banking.  

Teaser Pricing strategies. These strategies are based on the concept of luring in customers with a few low-priced or free products or services, and then cross-selling them higher-priced items. They are:

•   Freemium pricing. The practice of offering a basic service for free, and charging a price for a higher service level. Commonly used by Internet web sites.

•   High-low pricing. The practice of pricing a few products below the market rate to bring in customers, and pricing all other items above the market rate. Used by retailers.

•   Loss leader pricing. The practice of offering special deals on a few items, in hopes of drawing in customers to buy other, regularly-priced items. Used by retailers.  

Strategic Pricing These strategies involve the use of product pricing to position a company within a market or to exclude competitors from it. They are:

•   Limit pricing. The practice of setting an unusually low, long-term price that will deter potential competitors from entering a market.

•   Penetration pricing. The practice of setting a price below the market rate in order to increase market share.

•   Predatory pricing. The practice of setting prices low enough to drive competitors from the market.

•   Price leadership. When one company sets a price point that is adopted by competitors. This company is usually the one having the greatest market share.  

In short, four broad types of pricing have developed over the years. The first two types, cost-based and value pricing, are the most common. Teaser pricing and strategic pricing are less frequently used.

The theory behind constraint-based pricing is that any price exceeding the totally variable cost of a product should be considered, since it will generate some profit for the business. Some objections have been raised to the use of constraint analysis in the derivation of prices. These objections are:

•   Short-term pricing. If many orders are accepted at low price points, not all expenses will be covered, resulting in losses over the long-term. This is true, if a large proportion of orders are sold at low price points. However, if price points are higher for most orders, and constraint analysis is only used to fill any remaining unused production capacity, it can incrementally increase profits.

•   Equipment changeovers. The cost of equipment setup is not included in the derivation of throughput-based prices, because these costs are not totally variable.

•   Lowest-price guarantee. If the seller has entered into any contracts with the government that require it to offer the government the lowest price offered to any customer, the sales staff should be mindful of the issue when offering prices to other customers when trying to take orders to fill up remaining production capacity.

•   Premium pricing impact. A company that uses its marketing function to create an aura of exclusivity would have a hard time selling at any price other than the maximum one used for all of its customers.  

If a product already has a high throughput per minute, the marketing staff should be more interested in developing sales campaigns that will increase the sales of this item, while giving decreased emphasis to marketing expenditures for items that have lower throughput per minute.  

What about situations in which a product or service does not use the constrained resource at all? In this case, there are several extra issues to consider, which are:

•   Impact on sprint capacity. A product may not impinge upon the constrained resource, but it could impinge indirectly, by using up a portion of the excess sprint capacity in the workstations upstream from the constrained resource.

•   Impact on raw materials. A product may not use any time at the constrained resource, but it requires some of the same raw materials used by other products that do use the constrained resource.

 

If neither of the preceding issues is present, consider setting the price at a level that creates sufficient demand to soak up any excess production capacity that is not related to sprint capacity.  

If there is no constraint anywhere in a business that can interfere with the sale of goods, the constraint is said to be in the marketplace. If so, the key pricing decision is whether a reduction in price will generate more sales, and whether the price reduction will still yield a net increase in throughput. If working capital turns out to be the constraint that keeps a business from generating additional sales, the focus on new sales should be on any transactions involving cash payments or short credit terms, while transactions involving longer credit terms are given a lower priority or not accepted.  

Much of the discussion in this chapter might lead one to believe that a company using constraint-based pricing is continually cutting deals with customers and altering its prices, perhaps on a daily basis. This is not the case – we are merely spending time discussing what to do when certain pricing situations arise, which will probably be at long intervals. Most of the time, prices are set for standard products, and are not changed. In this latter situation, there is no question about which products have the highest throughput per minute, and the entire sales and marketing function is designed to maximize the sales of these products.  

Investment Decision Priorities:

Priority 1 – Increases Throughput

If a proposed action will increase total throughput, this recommendation always has first priority. It is a rare proposal indeed that can reduce expenses while increasing throughput.

Priority 2 – Reduces Invested Funds When a proposal involves reducing the amount of invested funds, this is given a secondary priority after throughput-generating activities.

Priority 3 – Reduces Expenses The lowest priority is to eliminate or reduce expenses.  

What if a company is located in an industry that is subject to sudden, unexpected spikes in sales, as is common in the fashion industry? In this situation, sales may be lost if orders are not filled at once, so there is a need for a large amount of excess capacity. Also, this demand probably cannot be offloaded to a supplier, since the demand period is so short. If these demand spikes are associated with highly profitable goods (again, as is common in the fashion industry) it can make sense to invest heavily in excess capacity, even though that capacity may not be used most of the time.  

it should be no surprise that changing the constraint to a different location within a company may create a major problem; doing so means that all of the supporting bonus plans, policies and procedures, metrics, reports, and so on must be altered to maximize the use of the new constraint. In many cases, it is easier to keep the constraint where it is, and design the organization around that location.  

One of the best possible constraint-based strategies is to compete by charging a premium to deliver faster than the competition. When there is a capability to produce with speed, do not give away this capability for free. Instead, a company should charge a premium price for rapid deliveries, perhaps also with accelerated payment terms. Doing so has multiple repercussions:

•   Sales increase. Once customers realize that the company can always deliver on time, the basis of competition shifts to delivery speed, which no one else can match. The result is a prolonged increase in sales.

•   Profit increase. The increased delivery speed is gained at no additional cost to the company, so it is charging a premium price while incurring no additional cost. The result is a major profit boost.

•   Nature of the customer. The company can fill its constraint with orders from those customers demanding better service, which are usually the higher-quality customers. This leaves the competition having to sell to the remaining group of customers who are more price-sensitive, and from which much smaller profits can be generated.

•   Cash reserves. Since the company is earning higher profits at the expense of its rivals, the company will be able to set aside a much larger cash reserve than the competition, which can be invested to further increase the company’s advantage.  

the best way to treat constraint management is as a service improvement for customers. This may be offered as shorter lead times or a broader product mix, but the outcome should be the same – being able to charge a higher price. Doing so allows a business to reserve for itself the most discerning customers in the industry, which also tend to be the ones with the largest cash reserves and therefore the greatest willingness to pay for better service. If competitors can be kept in the dark about constraint management, this may mean that a business can maintain a strong competitive position for an extended period of time.