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Topic 4 Introduction: Operational Efficiency

The changes in manufacturing arising from the introduction of just-in-time production


systems, theory of constraints, and outsourcing have dramatically altered the type of
information needed for decision making and the methods used to collect that data. This
topic compares the practices used in traditional manufacturing with these recent
developments and their impact on the efficiency and effectiveness of information reporting.

This topic discusses:


Material requirements planning
Just-in-time manufacturing
Outsourcing
Theory of constraints
Capacity concepts
Other production management theories

Materials Requirements Planning

The system of production traditionally used in manufacturing is materials requirements


planning (MRP), in which a product is "pushed" from the raw material stage through to
delivery. The premises underlying MRP push- though systems include:

Demand forecasts

A materials order specifying the materials, components, and subunit tasks required to
produce a final product.

A production order specifying the quantities of materials, components, subunits, and


product inventories needed to meet the demand forecast.

In MRP, a master production schedule dictates the quantities and timing of each part to be
produced. Once the scheduled production run begins, departments push output through a
system.

The advantages of this system include predictability and efficient inventory control. The
disadvantage is potential inventory accumulation; workstations may receive materials
before they are ready to process them. In addition, any quality control problems may not be
identified until items shipped from inventory reach the end user.

Just-in Time Manufacturing

The objective of a just-in-time (JIT) system is a lean manufacturing process that reduces or
eliminates waste by producing components as they are required, rather than holding large
safety stocks of inventory.

Theoretically, demand triggers every step and pulls a product through production, from
customer demand for a finished product, all the way back to the demand for raw materials.
This demand-pull feature of a JIT system requires high levels of quality at each point in the
system because only the minimum number of items demanded will be produced and close
coordination is required among all participants to ensure a smooth flow of goods and
operations.

JIT systems use some type of a trigger or signal mechanism to indicate the need for a
specified quantity of materials or parts to move from one part of the process to the next.
Kanban is a Japanese term for the visual record or card initially used for this purpose. E-

kanban applications provide an automated approach that can be integrated with


communications and enterprise resource planning systems.

Advantages and Limitation of JIT Systems


Click each column head to view the advantages and limitations of JIT systems.
Advantages

Limitations

No buffer inventory; production may


wait

Potential for overtime, added costs to fill


unexpected orders

Heavily dependent on reliability of every


supplier in supply chain

Potential stockout at a supplier can shut


down entire line

No overproduction, so no resources are


tied up in inventory and inventory
management

Reduced set-up and lead time

Production priorities build into system

Faster feedback for quality control;


items do not sit in warehouse, so
problems spotted sooner

Simplified ordering, built into production


process

Strong supplier relationships, based on


sustained business instead of competitive
rebidding

Question 1
What is the primary benefit of just-in-time systems compared with traditional materials
requirement planning systems?
What is the primary benefit of just-in-time systems compared with traditional materials
requirement planning systems?
a. Increased stock quantities at all levels in a system.
b. Maximization of production runs to accommodate complete product lines.
c. Replacement of a push-through manufacturing strategy with a demand-pull strategy.
d. Reduced risk of overproduction and savings from holding less inventory.

Outsourcing

Outsourcing allows a firm to capitalize on the expertise of another company that is more
efficient, effective, or knowledgeable at performing a specialized task that is peripheral to
the firm's core business competencies. Common examples include information technology
services, human resources (such as benefit plan administration), and customer service
functions.

A make versus buy analysis examines the relevant costs of keeping activities in-house
versus outsourcing.

Some firms have extended the idea of outsourcing to contract manufacturing, in which
another company actually manufactures a portion of the first firms products. This can be
successful for both organizations if one has excess capacity or specific capabilities the
other lacks.

Advantages and Limitation of Outsourcing


Click each column head to view the advantages and limitations of outsourcing.
Advantages

Limitations

Focus on strategic revenue-generating activities


effectiveness
Outside expertise improves efficiency and
risk
of obsolescence
Access
to current technology at low cost and no
variable
Reduce overhead
expenses without incurring fixed and
or
services
May
improve quality and timeliness of products

Theory of Constraints

Potential for higher cost


Loss of in-house expertise
Lessened process control
Potential for reduced quality control
supplier)
Limited flexibility (depending on external
confidentiality
issues
Potential for knowledge
"give-away and
internal
jobs
are
outsourced
Potential for employee
morale issues, when

The objective of the theory of constraints (TOC) is to improve speed of manufacturing by


optimizing throughput. The theory holds that every system has at least one constraint
limiting its output in pursuit of some goal. Removing one constraint will not infinitely improve
the system; another constraint will then become the top priority.
The terms used in TOC are defined in a specific way.
System
Inventory
Constraint
Operating expenses
Cycle time
Throughput contribution
Constraint management
Drum-buffer-rope

Theory of Constraints Steps


The theory of constraints includes five focusing steps designed to concentrate improvement
efforts on the constraint most likely to have a positive impact on a system.
Step Description
1

Identify the system constraint either a physical or a policy constraint, such as one step
that is taking too long or is idle too long.

Decide how to exploit the constraint making adjustments to component without


expensive upgrades, such as changing scheduling for a key process.

Subordinate everything else adjust the rest of the system to operate at maximum
effectiveness and evaluate the results. Conduct further analysis to maximize flow
through the constraint, eliminating non-value-added activities.

Elevate the constraint if steps 2 and 3 prove to be insufficient. Actions may include
additional investments and capital improvements.

Go back to Step 1, to look for the next constraint.

Statement on Management Accounting Theory of Constraints (TOC) Management System


Fundamentals differentiates exploiting and elevating a constraint:
Exploiting the constraint changes how the organization uses the constraint without
spending more money (for example, if setup time is a constraint, adjusting the
schedule to have fewer setup times).
Elevating the constraint requires spending more money to increase the constrained
resources capacity (purchase or outsource).

TOC and Throughput Costing

The theory of constraints focuses on improving a companys profits by managing its


operating constraints. Companies that employ a TOC approach use a form of variable
costing called throughput costing. Throughput costing, also called super-variable costing, is
a costing method where the only costs included in inventory are the costs of direct
materials. All other costs are classified as period costs. TOC has a short-term focus, so an
assumption is made that all operating costs are fixed costs. Throughput costing is an
internal reporting tool.

In the theory of constraints, throughput contribution, inventory or investments, and operating


expenses link operational and financial measures.

Throughput contribution = Sales revenue Direct material costs


Inventory = (Materials
costs +in(Costs
direct of
materials,
Work-in-process,
inventories)
+ (R & D costs)
equipment
and buildings)and Finished goods
Operating expenses = All costs of operations, not including direct materials

Using this method, the objective is to maximize throughput contribution while reducing
investments and operating costs.

Net profit increases when throughput goes up or operating expenses go down. Throughput
can go up by increasing sales revenues or by reducing variable costs of production.
Measures that increase net profit increase return on investment, as long as inventory
remains the same. If inventory can be decreased, then ROI will increase, even without an
increase in net profit.

Cash flow increases when either throughput goes up or the time to generate throughput is
reduced, assuming the time saved is applied toward generating more throughput.

Unlike traditional performance measures, which focus on direct labor efficiency and unit
costs and how efficiently the company must produce a product, TOC emphasizes how
efficiently an organization must manufacture products for optimum market success.

TOC and ABC

Organizations that implement the theory of constraints often use activity-based costing as
well. Both methods assess product profitability but there are a few differences:

Theoretical capacity - TOC takes a short-term approach to profitability analysis


with an emphasis on materials-related costs. ABC examines long-term costing,
including all product costs.

Practical Capacity - TOC considers how to improve short-term profitability by


focusing on production constraints and plausible short-term product mix
adjustments. Practical capacity does not take into consideration the amount of
unused capacity in allocating costs. The benefits of this approach are that it
encourages managers to focus their attention on the amount of unused capacity and
user departments are not overcharged for a portion of costs related to unused
capacity.

ABC does not consider resource constraints and process capability; it analyzes cost
drivers and accurate unit costs for long-term strategic pricing and profit planning
decisions.

ABC is generally used as a tool for planning and control.

The short-term aspects of TOC and the long-range focus of ABC make them
complementary profitability analysis methods.

Capacity Concepts

A key issue in costing is choosing the capacity level for computing the allocation of
manufacturing overhead. The choice of capacity level used to allocate overhead can have a
great effect on product cost information.

Theoretical capacity is the level of capacity that can be achieved under ideal
conditions, when there are no machine breakdowns or maintenance, delays, etc.
Theoretical capacity represents the largest volume of output possible, but is
unattainable and unrealistic.

Practical capacity represents the highest level of capacity that can be realistically
achieved, allowing for unavoidable losses of productive time, such as machine
breakdowns, employee vacations, maintenance, etc.

Using theoretical capacity when calculating overhead allocations would mean that a large
denominator activity level would be used, resulting in a lower overhead allocation to
individual units of product. This would make allocated costs too low and misrepresent
product cost information. Practical capacity is a better choice because it generates product
costs that accurately reflect the cost of the product.