Professional Documents
Culture Documents
Theory of Constraints
The Theory of Constraints (TOC) maintains that operating income can be increased by carefully
managing the bottlenecks in a process.
o A bottleneck is any condition that impedes or constrains the efficient flow of a process
o A bottleneck can be identified by determining points at which excessive amounts of
work-in-process inventories are accumulating
o The buildup of inventories also slows the cycle time of production
The TOC relies on the use of three measures
o 1. Throughout contribution is the difference between revenues and direct materials for
the quantity of product sold.
o 2. Investments equal the materials costs contained in raw materials, work-in-process, and
finished goods inventories
o 3. Operating costs are all other costs, except for direct materials costs, that are needed to
obtain throughput contribution
Emphasis is on the short-run optimization of throughput contribution
Assumes that operating costs are difficult to alter in the short run
Process Layouts
All similar equipment or functions are grouped together
Production of unique products is done in small batches
Products follow a serpentine path, usually in batches
High inventory levels
Products might travel for several miles within a factory during the production process.
WIP Accumulation
Work-in-Process inventory accumulates at processing stations in a conventional organization for
three reasons:
o Handling work in batches
o F the rate at which each processing area handles work is unbalanced, work piles up at the
slowest processing station
o If processing are managers are evaluated on their ability to meet production quotas
Product Layouts
In a product layout, equipment is organized to accommodate the production of a specific product
Product layouts exist primarily in companies with high-volume production
The product moves along an assembly line beside which the parts to be added to it have been
stored
Placement of equipment or processing units is made to reduce the distance that products must
travel
Group Technology
The organization of a plant into a number of cells
Within each cell all machines required to manufacture a group of similar products are arranged in
close proximity to each other
The machines in a cellular manufacturing layout are usually flexible and can be adjusted easily or
even automatically to make different products.
The shape of a cell is often a U shape
The number of employees needed to produce a product can often be reduced due to the new
work design
U shape also provides better visual control of the work flow.
Inventory-Related Costs
Demands for inventory lead to huge costs in organizations, including:
o The cost of moving, handling, and storing the WIP
o Obsolescence
o Damage
Factory layouts and inefficiencies that create the need to hold work-in-process inventory may
hide other problems leading to excessive costs of rework.
Processing Time
Processing time is the time expended for the product to be made
Processing cycle efficiency (PCE) is a measure of the efficiency o the manufacturing process
PCE = Processing Time / (Processing Time + Moving Time + Storage Time + Inspection Time)
Quality Standards
Global competition has led to the development of international quality standards
In 1987, the International Organization for Standardization (ISO) developed the first ISO 9000
Series of Standards
These standards have been updated several times and the new standard is called ISO 9001-2008
Company certification under these standards indicates to customers that management has
committed to the production of the highest quality goods and services
If the quality of products and services does not conform to quality standards, then the
organization incurs a cost known as the cost of nonconformance (CONC) to quality standards
Quality usually may be viewed as hinging on two major factors:
o Satisfying customer expectations regarding the attributes and performance of the
product
o Ensuring that the technical aspects of the product’s design and performance conform to
the manufacturer’s standards
Prevention Costs
Prevention costs are incurred to ensure that companies produce products according to quality
standards
Examples:
o Quality engineering
o Training employees
o Statistical process control
o Training and certifying suppliers
Appraisal Costs
Appraisal costs relate to inspecting products to make sure they meet both internal and external
customers’ requirements
Examples:
o Inspection of incoming materials
o Maintenance of test equipment
o Process control monitoring
Cost-of-Quality Report
Information is compiled in a cost-of-quality (COQ) report, developed for several reasons:
o Illustrates the financial magnitude of quality factors
o Helps managers set priorities for the quality issues and problems they should address
o Allows managers to see the big picture of quality issues
o Allows managers to try to find the root causes of their quality problems
Just-in-Time Manufacturing
Just-in-time (JIT) manufacturing is a comprehensive and effective manufacturing system
Just-in-time production requires making a product or service only when the customer, internal or
external, requires it
It uses a product layout with a continuous flow
Kaizen Costing
A system that provides relevant data to support lean accounting production systems
Focuses on reducing costs during the manufacturing stage of the total life cycle of a product
Kaizen is the Japanese term for making improvements to a process through small, incremental
amounts rather than through large innovations
Benchmarking
A way for organizations to gather information regarding the best practices of others
Often highly cost effective
Selecting appropriate benchmarking partners is a critical aspect of the process
The process typically consists of five stages
Benchmarking – Stage 1
Internal study and preliminary competitive analyses
o The organization decides which key areas to benchmark for study
o The company determines how it currently performs on these dimensions by initiating:
Preliminary internal competitive analyses
Preliminary external competitive analyses
Both types of analyses will determine the scope and significance of the study for each area
Benchmarking – Stage 2
Developing long-term commitment to the benchmarking project and coalescing the
benchmarking team
o The level of commitment to benchmarking must be long term
o Long-term commitment requires
Obtaining the support of senior management to give the benchmarking team the
authority to spearhead the changes
Developing a clear set of objectives to guide the benchmarking effort
Empowering employees to make change
The benchmarking team should include individuals from all functional areas in the organization
An experienced coordinator is usually necessary to organize the team and develop training in
benchmarking methods
Lack of training will often lead to the failure of the implementation
Benchmarking – Stage 3
Identifying benchmarking partners—willing participants who know the process
o Some critical factors include:
Size of the partners
Number of partners
Relative position within and across industries
Degree of trust among partners
Benchmarking – Stage 4
Information gathering and sharing methods
o Two related dimensions emerge from the literature:
Type of information that benchmarking organizations collect
Methods of information collection
Benchmarking – Stage 5
Taking action to meet or exceed the benchmark
o The organization takes action and begins to change
o After implementing the change, the organization makes comparisons to the specific
performance measures selected
o The decision may be to perform better than the benchmark to be more competitive
o The implementation stage is perhaps the most difficult stage of the benchmarking
process, as the buy-in of members is critical for success
Capital Budgeting
Capital budgeting is making long-run planning decisions for investing in projects.
Capital budgeting is a decision-making and control tool that spans multiple years.
Payback Method
Payback measures the time it will take to recoup, in the form of expected future cash flows, the
net initial investment in a project.
Shorter payback periods are preferable.
Organizations choose a project payback period. The greater the risk, the shorter the payback
period.
Easy to understand.
The two weaknesses of the payback method are:
o Fails to recognize the time value of money
o Doesn’t consider the cash flow beyond the payback point
With Uniform annual cash flows:
o Payback period = Net Initial Investment / Uniform Increase in Annual Future Cash Flows
With non-uniform annual cash flows:
Investment
Cash Cumulative
Year yet to be
Savings Cash Savings
Recovered
0 - - $ 150,000
1 $ 50,000 $ 50,000 100,000
2 60,000 110,000 40,000
3 80,000 190,000 -
4 90,000 190,000 -
5 100,000 190,000 -
Sensitivity Analysis
Useful to compare how the evaluation of the projects will change if there is a change in:
o Projected cash flows
o Timing of the cash flows
o Required rates of return change
Tax Shield
NPV if investment is
NPV of PV of the PV of tax Initial cost of Salvage
= + – +
investment cash flow shield investment value
Tax shield formula:
o Formula for calculating the present value of the tax savings from deducting capital cost
allowance
Present value of tax
=
shield on CCA
( Cdt
d+r ) ( X
1 + 0.5r
1+r ) ( –
d+r
SdT
) ( X
1
(1 + r)n )
Relevant Cash Flows in DCF Analysis
Relevant cash flows are the differences in expected future cash flows as a result of making an
investment.
Categories of cash flows:
o 1. Net initial investment
o 2. After-tax cash flow from operations
o 3. After-tax cash flow from terminal disposal of an asset and recovery of working capital
Financial Control
This chapter focuses on broader issues in financial control, including the evaluation of
organization units and of the entire organization
Managers use and consider:
o Internal financial controls
Information used internally and not distributed to outsiders
o External financial controls
Developed by outside analysts to assess organization performance
Decentralization
Decentralization is the process of delegating decision-making authority to frontline decision
makers
Highly centralized organizations tend not to respond effectively or quickly to their environments
Centralization is best suited to organizations that:
o Are well adapted to stable environments
o Have no major information differences between the corporate headquarters and the
employees
o Have no changes in the organization’s environment that require adaptation by the
organization
Centralized Organizations
In centralized organizations:
o Technology and customer requirements are well understood
o The product line consists mostly of commodity products for which the most important
attributes are price and quality
To accomplish this, organizations develop standard operating procedures to ensure that:
o They are using the most efficient technologies and practices to promote both low cost
and consistent quality
o There are no deviations from the preferred way of doing things
Changing Environment
In response to increasing competitive pressures and the opening up of former monopolies to
competition, many organizations are changing the way they are organized and the way they do
business
This is necessary because they must be able to change quickly in a world where technology,
customer tastes, and competitors’ strategies are constantly changing
Degrees of Decentralization
The amount of decentralization reflects the organization’s need to have people on the front lines
who can make good decisions quickly and:
o The organization’s trust in its employees
o The employees’ level of skill and training
o The employees’ ability to make the right choices
Responsibility Centers
A responsibility center is an organization unit for which a manager is held accountable
A responsibility center is like a small business
But it is not completely autonomous
o Its manager is asked to run that small business to achieve the objectives of the larger
organization
The manager and supervisor establish goals for their responsibility center
These goals should:
o Be specific and measurable so as to provide employees with focus
o Promote the long-term interests of the larger organization
o Promote the coordination of each responsibility center’s activities with the efforts of all
the others
Cost Center
A responsibility center in which employees control costs but do not control revenues or
investment level
Organizations evaluate the performance of cost center employees by comparing the center’s
actual costs with budgeted cost levels for the amount and type of work done
Revenue Center
A responsibility center whose members control revenues but do not control either the
manufacturing or acquisition cost of the product or service they sell or the level of investment
made in the responsibility center
Some revenue centers control price, the mix of stock on hand, and promotional activities
Profit Center
A responsibility center where managers and other employees control both the revenues and the
costs of the products or services they deliver
A profit center is like an independent business, except that senior management, not the
responsibility center manager, controls the level of investment in the responsibility center
Most units of chain operations are treated as profit centers
It is doubtful that a unit of a corporate-owned hotel or fast-food restaurant meets the conditions
to be treated as a profit center
These units are sufficiently large that:
o Costs may vary due to differences in controlling labor costs, food waste, and scheduled
hours
o Revenues may also shift significantly based on how well staff manages the property
Although these organizations do not seem to be candidates to be treated as profit centers, local
discretion often affects revenues and costs enough so that they can be
Many organizations evaluate units as profit centers even though the corporate office controls
many facets of their operations
o The profit reported by these units reflects both corporate and local decisions
If unit performance is poor, it may reflect:
o Poor conditions no one in the organization can control
o Poor corporate decisions
o Poor local decisions
Organizations should not rely solely on profit center’s financial results for performance
evaluations
o Detailed performance evaluations should include quality, material use, labor use, and
service measures that the local units can control
Investment Center
A responsibility center in which the manager and other employees control revenues, costs, and
the level of investment in the responsibility center
For example, General Electric has diverse business units
o Including Energy, Technology Infrastructure, GE Capital, Home & Business Solutions, and
NBC Universal
Senior executives at General Electric developed a management system that evaluated these
businesses as independent operations—in effect as investment centers
Transfer Pricing
Transfer pricing is the set of rules an organization uses to allocate jointly earned revenue among
responsibility centers
To understand the issues and problems associated with allocating revenues in a simple
organization, consider the activities that occur when a customer purchases a new car at a
dealership:
o The new car department sells the new car and takes in a used car as a trade
o The used car is transferred to the used car department
o There, it may undergo repairs and service to make it ready for sale, or may be sold
externally on the wholesale market
The value placed on the used car transferred between the new and used car departments is
critical in determining the profits of both departments:
o The new car department would like the value assigned to the used car to be as high as
possible to increase revenue
o The used car department would like the value to be as low as possible because that
makes its reported costs lower
The same considerations apply for any product or service transfer between any two departments
in the same organization