Theory of constrains

19 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Quality, Time, and the

Theory of Constraints

Quality, Time, and the

Theory of ConstraintsChapter 19


Learning Objective 1Learning Objective 1

Explain the four cost categories

in a cost-of-quality program.


Two Aspects of QualityTwo Aspects of Quality

ActualPerformance

DesignSpecifications

CustomerSatisfaction

Quality ofDesignFailure

ConformanceQualityFailure


Costs of QualityCosts of Quality

Prevention costs Appraisal costs

Internal failure costs External failure costs


Costs of Quality ExampleCosts of Quality Example

Vegas Photo Corporation made 10,000photocopying machines last year.

Vegas Photo determines the costs of qualityof its photocopying machines using a 7-step

activity-based costing approach.


Costs of Quality (Steps 1 and 2)Costs of Quality (Steps 1 and 2)

Identify cost objects.

10,000 photocopying machines

Identify the direct costsof quality of the products.

No direct costs of quality

Step 1 Step 2


Costs of Quality (Step 3)Costs of Quality (Step 3)

Select the cost-allocation bases to use forallocating indirect costs of quality to the products.

• Prevention• Appraisal• Internal failure• External failure

Step 3

Information on the totalquantities of each of thesecost-allocation bases usedin all of Vegas operations

is not provided.



Identify the indirect costs of qualityassociated with each cost-allocation base.

Step 4

Information about total (fixed and variable)costs is not provided.



Compute therate per unit.

Step 5

Inspection hours is onecost-allocation base.



Prevention costs:Design engineering (R&D) $80 per hourProcess engineering (R&D) $60 per hour

Appraisal costs:Inspection (Manufacturing) $40 per hour



Internal failure costs:Rework (Manufacturing) $100 per hour

External failure costs:Customer support (Marketing) $ 50 per hourTransportation (Distribution) $240 per loadWarranty repair (Customer Service) $110 per hour



Step 6

Compute the indirect costs of qualityallocated to the product.



Prevention costs:Design engineering (R&D) 20,000 hoursProcess engineering (R&D) 22,500 hours

Appraisal costs:Inspection (Manufacturing) 120,000 hours



Internal failure costs:Rework (Manufacturing) 50,000 hours

External failure costs:Customer support (Marketing) 6,000 hoursTransportation (Distribution) 1,500 loadsWarranty repair (Customer Service) 60,000 hours



What is the total cost for design engineering?

20,000 hours × $80 = $1,600,000

What is the total cost for inspection?

120,000 hours × $40 = $4,800,000



Cost of Quality andValue Chain Category Total Costs

Prevention costs:Design engineering (R&D) $1,600,000Process engineering (R&D) 1,350,000Total $2,950,000

Appraisal costs:Inspection $4,800,000




Internal failure costs:Rework (Manufacturing) $5,000,000




External failure costs:Customer support (Marketing) $ 300,000Transportation (Distribution) 360,000Warranty repair (Customer Service) 6,600,000Total $7,260,000



Step 7

Compute the total costs of quality of the product.

Prevention costs $ 2,950,000Appraisal costs 4,800,000Internal failure costs 5,000,000External failure costs 7,260,000Total $20,010,000



Use three methods to

identify quality problems.


Techniques Used to AnalyzeQuality Problems

Techniques Used to AnalyzeQuality Problems

1. Control charts

2. Pareto diagrams

3. Cause-and-effectdiagrams


Control ChartsControl Charts

On the basis of experience, Vegas decidesthat any observation outside the arithmetic

mean ± 2 standard deviationsshould be investigated.



0 1 2 3 4 5 6 7 8 9 10

Production Line A

Days

Def

ect R

ate + 2

+

- - 2



0 1 2 3 4 5 6 7 8 9 10

+ 2+

- - 2

Production Line B

Days

Def

ect R

ate


Pareto DiagramPareto Diagram

Copies arefuzzy andunclear

Copiesare too

light/darkPaper getsjammedN

umbe

r of

Tim

esD

efec

t Obs

erve

d

600

500

400

300

200

100

0


Pareto DiagramPareto Diagram

As a first step, Vegas analyzes the causesof the most frequently occurring failure,

fuzzy and unclear copies.

Final Draft of aSales ContractFinal Draft of aSales Contract


Cause-and-effect DiagramsMethods and

Design FactorsHuman Factors

Machine-related Factors

Materials andComponents Factors

Multiple suppliersIncorrect specification

Variation in purchasedcomponents

Flawed part designIncorrect

manufacturingsequence

Inadequate toolsIncorrect speed

Poormaintenance

Inadequatesupervision

Poor trainingNew operator



Identify the relevant costs and

benefits of quality improvements.


Relevant CostsRelevant Costs

Careful analysis of Vegas cause-and-effectdiagram reveals that the frame of the copier

is often mishandled as it travels from thesuppliers’ warehouses to Vegas’ plant.

Mishandling causes the dimensions of theframe to vary from specifications, resulting

in fuzzy and unclear copies.



Alternative solutions:

Improve the inspection of the framesimmediately upon delivery.

Redesign and strengthen the framesand the containers used to transport

them to better withstand mishandlingduring transportation.



What must management do to evaluateeach alternative?

Additional AdditionalInspection Cost Redesign Cost Difference

$200,000 $230,000 $30,000

Vegas determines the fixed and variablecost component of each activity involved.



Further Redesigning Inspection Frames

Relevant savings:Rework costs $480,000 $ 640,000Customer-support costs 20,000 28,000Transportation costs 45,000 63,000Warranty repair costs 450,000 630,000Total $995,000 $1,361,000


ComparisonComparison

Further Redesigning Inspection Frames

Relevant savings $995,000 $1,361,000Additional cost 200,000 230,000Difference $795,000 $1,131,000

What should Vegas do?

Redesigning the frames provides a $336,000incremental benefit over further inspection.



Provide examples of nonfinancial

quality measures of customer

satisfaction and internal

performance.


Nonfinancial MeasuresNonfinancial Measures

Nonfinancial measures of customer satisfaction:

• Number of customer complaints

• Defective units as a percentage of total units shipped to customers

• Percentage of products that experience early or excessive failure

• On-time delivery rate


Nonfinancial MeasuresNonfinancial Measures

Nonfinancial measures of internal performance:

• Number of defects for each product line

• Process yield (ratio of good output to total output)

• Employee turnover (ratio of the number of employees who left the company to the total number of employees)



Describe the benefits of

financial and nonfinancial

measures of quality.


Evaluating Quality PerformanceEvaluating Quality Performance

Financial measures are helpful to evaluatetrade-offs among prevention costs,appraisal costs, and failure costs.

Nonfinancial measures help focus attentionon the precise problem areas that need

improvement and also serve as indicatorsof future long-run performance.



Describe customer-response

time and explain why delays

happen and their costs.


Customer-Response TimeCustomer-Response Time

Order isplaced

Order isreceived

Order isset up

Order ismanufactured

Order isdelivered

WaitingTime

Mfg.Time

ReceiptTime

ManufacturingLead Time

DeliveryTime

Customer-Response Time


On-Time PerformanceOn-Time Performance

On-time performance refers to situations in whichthe product or service is actually delivered at

the time it is scheduled to be delivered.


Time Drivers and Costs of Time

Time drivers

1. Product or service order uncertainty

2. Bottlenecks due to limited capacity


Time Drivers and Costs of TimeTime Drivers and Costs of Time

Average waiting time equals:

Average number of orders × (Manufacturing time)2

÷

Annual machine Average no. Manufacturing capacity of orders time of product– ×[

[



Fredonia uses one machine to convertsteel bars into a special component (SC).

Fredonia expects it will receive 30 orders,but it could actually receive 10, 30, or 40

orders for the special component.

Each order is for 1,000 units and will take100 hours of manufacturing time.



The annual capacity of the machineis 4,000 hours.

What is the expected manufacturingtime required on the machine?

(100 × 30) = 3,000 hours

What is the average waiting time?



30 × 1002 = 30 × 10,000 = 300,000

300,000 ÷ 2 × [4,000 – (30 × 100)]

300,000 ÷ 2 × (4,000 – 3,000)

300,000 ÷ 2,000

150 hours average waiting time



What is the average manufacturinglead time for an order?

150 hours of average waiting time+ 100 hours of manufacturing time

= 250 hours

Suppose that Fredonia is consideringintroducing a regular component (RC).



Fredonia expects to receive 10 ordersfor RCs (each order for 800 units).

Each order will take 50 hours ofmanufacturing time.

The expected demand for specialcomponents will be unaffected.



Assume that introducing RCs would causeaverage waiting time to more than double,

from 150 hours to 325 hours.

The average manufacturing lead time fora special component order becomes

425 hours (325 + 100).

Average manufacturing lead time for a regularcomponent order is 375 hours (325 + 50).


Relevant Revenues andRelevant Costs of TimeRelevant Revenues andRelevant Costs of Time

The average selling price per order is: Average

manufacturing Product lead time SC RC

Less than 300 hours $22,000 $10,000More than 300 hours $21,500 $ 9,600



Product SC RCAverage number of orders 30 10Direct material costs per order $16,000 $8,000Inventory carrying costs/order/hour 1.00 0.50

Should Fredonia introduce RCs?



Introduce RCs

Expected revenues:($21,500 × 30) + ($9,600 × 10) = $741,000

Expected variable costs:($16,000 × 30) + ($8,000 × 10) = $560,000

Expected other costs: $ 14,625



How was the $14,625 other costs computed?

(Average manufacturing lead time for SCs× Unit carrying costs per order for SCs× Expected number of orders for SCs)

+ (Average manufacturing lead time for RCs× Unit carrying costs per order for RCs× Expected number of orders for RCs)

(425 × $1.00 × 30) + (375 × $0.50 × 10) = $14,625



Do Not Introduce RCs

Expected revenues:$22,000 × 30 = $660,000

Expected variable costs:$16,000 × 30 = $480,000

Expected other costs: $ 7,500



How was the $7,500 other costs computed?

Average manufacturing lead timefor SCs without RCs

× Unit carrying costs per order for SCs× Expected number of orders for SCs

250 × $1.00 × 30 = $7,500



Relevant Introduce Do NotItems RC Introduce RC

Expected revenues $741,000 $660,000Expected total costs 574,625 487,500Difference $166,375 $172,500

Falcon Works should not introducethe regular component.



Apply the three measures

in the theory of constraints.


Theory of ConstraintsTheory of Constraints

The three main measurements in the theoryof constraints are:

1. Throughput contribution equal to revenuesminus direct material costs.

2. Investments equal the sum of material costsin direct materials inventory, work in process

inventory, finished goods inventory, R&Dcosts, and costs of equipment and buildings.


Theory of ConstraintsTheory of Constraints

3. Operating costs equal to all operating costs(other than direct materials) incurred to earn

throughput contribution.

The objective of TOC is to increase throughputcontribution while decreasing investments

and operating costs.



Manage bottlenecks.


Managing BottlenecksManaging Bottlenecks

The four steps in managing bottlenecks are:

1. Recognize that the bottleneck operationdetermines throughput contribution

of the system as a whole.

2. Search and find the bottleneck operation byidentifying operations with large quantities

of inventory waiting to be worked on.


Managing BottlenecksManaging Bottlenecks

3. Keep the bottleneck busy and subordinateall nonbottleneck operations to the

bottleneck operations.

4. Take actions to increase bottleneck efficiencyand capacity – the objective is to increase

throughput contribution minus the incrementalcosts of taking such actions.


End of Chapter 19End of Chapter 19

Theory of constrains

Education

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