Bottlenecks, Theory of Constraints, and Throughput-Margin Analysis

Learning Objective 5 Explain how to manage bottlenecks

• keep bottlenecks busy and increase their efficiency and capacity by increasing throughput (contribution) margin

Suppose Power Recreation’s snowmobile engine must go through a forging operation before it goes to the assembly operation. The company has 1,200 hours of daily forging capacity dedicated to manufacturing snowmobile engines. It takes 3 hours to forge each snowmobile engine, so Power Recreation can forge 400 snowmobile engines per day $(\text{1,200}\text{hours}÷3\text{hours per snowmobile engine})\mathrm{.}$ Recall that it can assemble only 300 snowmobile engines per day $(600\text{machine}‐\text{hours}÷2\text{machine}‐\text{hours\hspace{0.17em}per\hspace{0.17em}snowmobile\hspace{0.17em}engine})$. The production of snowmobile engines is constrained by the assembly operation, not the forging operation.

The theory of constraints (TOC) describes methods to maximize operating income when faced with some bottleneck and some nonbottleneck operations.^* To implement TOC, we define and use three measures:

1. Throughput margin equals revenues minus the direct material costs of the goods sold.
2. Investments equal the sum of (a) material costs in direct materials, work-in-process, and finished-goods inventories; (b) R&D costs; and (c) capital costs of equipment and buildings.
3. Operating costs equal all costs of operations (other than direct materials) incurred to earn throughput margin. Operating costs include costs such as salaries and wages, rent, utilities, and depreciation.

The objective of the TOC is to increase throughput margin while decreasing investments and operating costs. The TOC considers a short-run time horizon of a few months and assumes operating costs are fixed and direct material costs are the only variable costs. In a situation where some of the operating costs are also variable in the short run, throughput margin is replaced by contribution margin—revenues minus direct material costs minus other variable operating costs. In the Power Recreation example, each snowmobile engine sells for $800. We assume that the variable costs of $560 consist only of direct material costs (incurred in the forging department), so throughput margin equals contribution margin. For ease of exposition and consistency with the previous section, we use the term contribution margin instead of throughput margin throughout this section.

TOC focuses on managing bottleneck operations, as explained in the following steps:

1. Step 1:  Recognize that the bottleneck operation determines the contribution margin of the entire system. In the Power Recreation example, output in the assembly operation determines the output of snowmobile engines.
2. Step 2:  Identify the bottleneck operation by identifying operations with large quantities of inventory waiting to be worked on. If snowmobile engines are produced to capacity at the forging operation, inventories will build up at the assembly operation because daily assembly capacity of 300 snowmobile engines is less than the daily forging capacity of 400 snowmobile engines.
3. Step 3:  Keep the bottleneck operation busy and subordinate all nonbottleneck operations to the bottleneck operation. To maximize contribution margin of the constrained or bottleneck resource, the bottleneck assembly operation is always kept running; workers are never waiting to assemble engines. How? By maintaining a small buffer inventory of snowmobile engines that have gone through the forging operation and are waiting to be assembled. The assembly operation operates at capacity based on a detailed production schedule at the forging operation that ensures the assembly operation is not waiting for work. The bottleneck assembly operation sets the pace for the nonbottleneck forging operations to avoid forging snowmobile engines that cannot be assembled. Doing so does not increase output or contribution margin; it only creates excess inventory of unassembled snowmobile engines.
4. Step 4:  Take actions to increase the efficiency and capacity of the bottleneck operation as long as the incremental contribution margin exceeds the incremental costs of increasing efficiency and capacity.

We illustrate Step 4 using data from the forging and assembly operations.

Power Recreation’s output is constrained by the capacity of 300 units in the assembly operation. What can Power Recreation’s managers do to relieve the bottleneck constraint of the assembly operation?

Desirable actions include the following:

1. ELIMINATE IDLE TIME AT THE BOTTLENECK OPERATION (TIME WHEN THE ASSEMBLY MACHINE IS NEITHER BEING SET UP TO ASSEMBLE NOR ACTUALLY ASSEMBLING SNOWMOBILE ENGINES). Power Recreation’s manager is evaluating permanently positioning two workers at the assembly operation to unload snowmobile engines as soon as they are assembled and to set up the machine to begin assembling the next batch of snowmobile engines. This action will cost $320 per day and increase bottleneck output by three snowmobile engines per day. Should Power Recreation’s managers incur the additional costs? Yes, because Power Recreation’s contribution margin will increase by $720 per day $(\mathrm{\$}240\text{per snowmobile engine}\times 3\text{snowmobile engines})\mathrm{,}$ which is greater than the incremental cost of $320 per day. All other costs are irrelevant.
2. SHIFT PRODUCTS THAT DO NOT HAVE TO BE MADE ON THE BOTTLENECK MACHINE TO NONBOTTLENECK MACHINES OR TO OUTSIDE PROCESSING FACILITIES. Suppose Spartan Corporation, an outside contractor, offers to assemble five snowmobile engines each day at $75 per snowmobile engine from engines that have gone through the forging operation. Spartan’s quoted price is greater than Power Recreation’s own operating costs in the assembly department of $60 per snowmobile engine. Should Power Recreation’s managers accept the offer? Yes, because assembly is the bottleneck operation. Getting Spartan to assemble additional snowmobile engines will increase contribution margin by $1,200 per day $(\mathrm{\$}240\text{per snowmobile engine}\times 5\text{snowmobile engines})\mathrm{,}$ while the relevant cost of increasing capacity will be $375 per day $(\mathrm{\$}75\text{per snowmobile engine}\times 5\text{snowmobile engines})\mathrm{.}$ The fact that Power Recreation’s unit cost is less than Spartan’s quoted price is irrelevant.

Suppose Gemini Industries, another outside contractor, offers to do the forging operation for eight snowmobile engines per day for $65 per snowmobile engine from direct materials supplied by Power Recreation. Gemini’s price is lower than Power Recreation’s operating cost of $80 per snowmobile engine in the forging department. Should Power Recreation’s managers accept Gemini’s offer? No, because other operating costs are fixed costs. Power Recreation will not save any costs by subcontracting the forging operations. Instead, its costs will increase by $520 per day $(\mathrm{\$}65\text{per snowmobile engine}\times 8\text{snowmobile engines})$ with no increase in contribution margin, which is constrained by assembly capacity.

3. REDUCE SETUP TIME AND PROCESSING TIME AT BOTTLENECK OPERATIONS (FOR EXAMPLE, BY SIMPLIFYING THE DESIGN OR REDUCING THE NUMBER OF PARTS IN THE PRODUCT). Suppose Power Recreation can assemble 10 more snowmobile engines each day at a cost of $1,000 per day by reducing setup time at the assembly operation. Should Power Recreation’s managers incur this cost? Yes, because the contribution margin will increase by $2,400 per day $(\mathrm{\$}240\text{per snowmobile}$$\text{engine}\times 10\text{snowmobile engines})$, which is greater than the incremental costs of $1,000 per day.

Will Power Recreation’s managers find it worthwhile to incur costs to reduce machining time at the nonbottleneck forging operation? No. Other operating costs will increase, while the contribution margin will remain unchanged, constrained by bottleneck capacity at the assembly operation, which has not increased.

4. IMPROVE THE QUALITY OF PARTS OR PRODUCTS MANUFACTURED AT THE BOTTLENECK OPERATION. Poor quality is more costly at a bottleneck operation than at a nonbottleneck operation. The cost of poor quality at a nonbottleneck operation is the cost of materials wasted. If Power Recreation produces five defective snowmobile engines at the forging operation, the cost of poor quality is $2,800 (direct material cost per snowmobile engine, $\mathrm{\$}560\times 5$ snowmobile engines). No contribution margin is forgone because forging has unused capacity. Despite the defective production, forging can produce and transfer 300 good-quality snowmobile engines to the assembly operation. At a bottleneck operation, the cost of poor quality is the cost of materials wasted plus the opportunity cost of lost contribution margin. Bottleneck capacity not wasted in producing defective snowmobile engines could be used to generate additional contribution margin. If Power Recreation produces five defective units at the assembly operation, the cost of poor quality is the lost revenue of $4,000 $(\mathrm{\$}800\text{per snowmobile engine}\times 5\text{snowmobile engines})$ or, alternatively stated, direct material costs of $2,800 (direct material cost per snowmobile engine, $\mathrm{\$}560\times 5$ snowmobile engines) plus the forgone contribution margin of $\mathrm{\$}\text{1,200} (\mathrm{\$}240\text{per snowmobile engine}\times 5\text{snowmobile engines})\mathrm{.}$

The high cost of poor quality at the bottleneck operation means that bottleneck time should not be wasted processing units that are defective. That is, engines should be inspected before the bottleneck operation to ensure that only good-quality parts are processed at the bottleneck operation. Furthermore, quality-improvement programs should place special emphasis on minimizing defects at bottleneck machines.

If successful, the actions in Step 4 will increase the capacity of the assembly operation until it eventually exceeds the capacity of the forging operation. The bottleneck will then shift to the forging operation. Power Recreation would then focus continuous-improvement actions on increasing forging operation efficiency and capacity. For example, the contract with Gemini Industries to forge eight snowmobile engines per day at $65 per snowmobile engine from direct material supplied by Power Recreation will become attractive because the contribution margin will increase by $1,920 per day $(\mathrm{\$}240\text{per snowmobile engine}\times 8\text{snowmobile engines})\mathrm{,}$ which is greater than the incremental costs of $\mathrm{\$}520\mathrm{\hspace{0.17em}}(\mathrm{\$}65\hspace{0.17em}\text{per\hspace{0.17em}snowmobile\hspace{0.17em}engine}\times 8\text{snowmobile engines})$.

The experience of the Apple Watch illustrates many of the issues discussed in this section. During final testing, the company found that the “taptic engine” motor (designed by Apple to produce the sensation of being tapped on the wrist) made by one of its two suppliers started to break down. As a result, Apple had to scrap some completed watches and move the production of this component to a second supplier. While the second supplier’s part did not experience the same problems, it took time for that supplier to increase production. Consequently, Apple asked other component suppliers to align their production to the output of the taptic engine bottleneck.

The theory of constraints emphasizes management of bottleneck operations as the key to improving performance of production operations as a whole. It focuses on short-run maximization of contribution margin. Because TOC regards operating costs as difficult to change in the short run, it does not identify individual activities and drivers of costs. Therefore, TOC is less useful for the long-run management of costs. In contrast, activity-based costing (ABC) systems take a long-run perspective and focus on improving processes by eliminating non-value-added activities and reducing the costs of performing value-added activities. ABC systems are therefore more useful than TOC for long-run pricing, cost control, and capacity management. The short-run TOC emphasis on maximizing contribution margin by managing bottlenecks complements the long-run strategic-cost-management focus of ABC.^*