Theory of constrains

Quality, Time, and
the
Theory of Constraints
Chapter 19

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

Learning Objective 1

Explain the four cost categories
in a cost-of-quality program.


Two Aspects of Quality
Actual Design Customer
Performance Specifications Satisfaction

Conformance Quality of
Quality Design
Failure Failure


Costs of Quality

Prevention costs Appraisal costs

Internal failure costs External failure costs


Costs of Quality Example

Vegas Photo Corporation made 10,000
photocopying machines last year.
Vegas Photo determines the costs of quality
of its photocopying machines using a 7-step
activity-based costing approach.


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

Identify the direct costs
Identify cost objects.
of quality of the products.
10,000 photocopying No direct costs of
machines quality


Costs of Quality (Step 3)
Step 3
Select the cost-allocation bases to use for
allocating indirect costs of quality to the products.
Information on the total
• Prevention
quantities of each of these
• Appraisal
cost-allocation bases used
• Internal failure
in all of Vegas operations
• External failure
is not provided.

Step 4
Identify the indirect costs of quality
associated with each cost-allocation base .
Information about total (fixed and variable)
costs is not provided.


Step 5

Compute the
rate per unit.

Inspection hours is one
cost-allocation base.



Prevention costs:
Design engineering (R&D) $80 per hour
Process 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 hour
Transportation (Distribution) $240 per load
Warranty repair (Customer Service) $110 per hour


Step 6
Compute the indirect costs of quality
allocated to the product.



Prevention costs:
Design engineering (R&D) 20,000 hours
Process engineering (R&D) 22,500 hours
Appraisal costs:
Inspection (Manufacturing) 120,000 hours



Rework (Manufacturing) 50,000 hours
Customer support (Marketing) 6,000 hours
Transportation (Distribution) 1,500 loads
Warranty 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 and
Value Chain Category Total Costs
Prevention costs:
Design engineering (R&D) $1,600,000
Process engineering (R&D) 1,350,000
Total $2,950,000
Appraisal costs:
Inspection $4,800,000

Cost of Quality and
Rework (Manufacturing) $5,000,000



Cost of Quality and
Customer support (Marketing) $ 300,000
Transportation (Distribution) 360,000
Warranty repair (Customer Service) 6,600,000
Total $7,260,000

Step 7
Compute the total costs of quality of the product.
Prevention costs $ 2,950,000
Appraisal costs 4,800,000
Internal failure costs 5,000,000
External failure costs 7,260,000
Total $20,010,000



Use three methods to
identify quality problems.


Techniques Used to Analyze
Quality Problems

1. Control charts

2. Pareto diagrams

3. Cause-and-effect
diagrams

Control Charts
On the basis of experience, Vegas decides
that any observation outside the arithmetic
mean µ ± 2σ standard deviations
should be investigated.


Control Charts
Production Line A
µ + 2σ
Defect Rate

µ+σ
µ
µ-σ
µ - 2σ

0 1 2 3 4 5 6 7 8 9 10
Days

Control Charts
Production Line B
µ + 2σ
Defect Rate

µ+σ
µ
µ-σ
µ - 2σ

0 1 2 3 4 5 6 7 8 9 10
Days

Pareto Diagram
600
Number of Times
Defect Observed

500
400
300
200 Copies are Copies
fuzzy and are too Paper gets
100 jammed
unclear light/dark
0

Pareto Diagram

As a first step, Vegas analyzes the causes
of the most frequently occurring failure,
fuzzy and unclear copies.

Final Draft of a
Sales Contract


Cause-and-effect Diagrams
Methods and
Human Factors
Design Factors
Inadequate Flawed part design
supervision Incorrect
Poor training manufacturing
New operator sequence
Inadequate tools Multiple suppliers
Incorrect speed Incorrect specification
Poor Variation in purchased
maintenance components
Machine-related Materials and
Factors Components Factors


Identify the relevant costs and
benefits of quality improvements.


Relevant Costs

Careful analysis of Vegas cause-and-effect
diagram reveals that the frame of the copier
is often mishandled as it travels from the
suppliers’ warehouses to Vegas’ plant.
Mishandling causes the dimensions of the
frame to vary from specifications, resulting
in fuzzy and unclear copies.

Relevant Costs

Alternative solutions:
Improve the inspection of the frames
immediately upon delivery.
Redesign and strengthen the frames
and the containers used to transport
them to better withstand mishandling
during transportation.

Relevant Costs

What must management do to evaluate
each alternative?
Additional Additional
Inspection Cost Redesign Cost Difference
$200,000 $230,000 $30,000
Vegas determines the fixed and variable
cost component of each activity involved.


Relevant Costs

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

Comparison
Further Redesigning
Inspection Frames
Relevant savings $995,000 $1,361,000
Additional cost 200,000 230,000
Difference $795,000 $1,131,000
What should Vegas do?
Redesigning the frames provides a $336,000
incremental benefit over further inspection.


Provide examples of nonfinancial
quality measures of customer
satisfaction and internal
performance.


Nonfinancial 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 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 Performance

Financial measures are helpful to evaluate
trade-offs among prevention costs,
appraisal costs, and failure costs.
Nonfinancial measures help focus attention
on the precise problem areas that need
improvement and also serve as indicators
of future long-run performance.


Describe customer-response
time and explain why delays
happen and their costs.


Customer-Response Time
Order is Order is Order is Order is Order is
placed received set up manufactured delivered

Waiting Mfg.
Time Time

Receipt Manufacturing Delivery
Time Lead Time Time

Customer-Response Time


On-Time Performance

On-time performance refers to situations in which
the 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 2. Bottlenecks due to
order uncertainty limited capacity



Average waiting time equals:

Average number of orders × (Manufacturing time)2

÷

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



Fredonia uses one machine to convert
steel 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 take
100 hours of manufacturing time.



The annual capacity of the machine
is 4,000 hours.
What is the expected manufacturing
time 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 manufacturing
lead time for an order?
150 hours of average waiting time
+ 100 hours of manufacturing time
= 250 hours
Suppose that Fredonia is considering
introducing a regular component (RC).



Fredonia expects to receive 10 orders
for RCs (each order for 800 units).
Each order will take 50 hours of
manufacturing time.
The expected demand for special
components will be unaffected.


Assume that introducing RCs would cause
average waiting time to more than double,
from 150 hours to 325 hours.
The average manufacturing lead time for
a special component order becomes
425 hours (325 + 100).
Average manufacturing lead time for a regular
component order is 375 hours (325 + 50).

Relevant Revenues and
Relevant Costs of Time

The average selling price per order is:
Average
manufacturing Product
lead time SC RC
Less than 300 hours $22,000 $10,000
More than 300 hours $21,500 $ 9,600



Product SC RC
Average number of orders 30 10
Direct material costs per order $16,000 $8,000
Inventory 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 time
for 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 Not
Items RC Introduce RC
Expected revenues $741,000 $660,000
Expected total costs 574,625 487,500
Difference $166,375 $172,500
Falcon Works should not introduce
the regular component.


Apply the three measures
in the theory of constraints.


The three main measurements in the theory
of constraints are:
1. Throughput contribution equal to revenues
minus direct material costs.
2. Investments equal the sum of material costs
in direct materials inventory, work in process
inventory, finished goods inventory, R&D
costs, and costs of equipment and buildings.


3. Operating costs equal to all operating costs
(other than direct materials) incurred to earn
throughput contribution.
The objective of TOC is to increase throughput
contribution while decreasing investments
and operating costs.



Manage bottlenecks.


Managing Bottlenecks

The four steps in managing bottlenecks are:
1. Recognize that the bottleneck operation
determines throughput contribution
of the system as a whole.
2. Search and find the bottleneck operation by
identifying operations with large quantities
of inventory waiting to be worked on.


Managing Bottlenecks

3. Keep the bottleneck busy and subordinate
all nonbottleneck operations to the
bottleneck operations.
4. Take actions to increase bottleneck efficiency
and capacity – the objective is to increase
throughput contribution minus the incremental
costs of taking such actions.

End of Chapter 19


Theory of constrains

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