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Quality, Time and the Theory


of Constraints

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Last Class
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Strategy

Cost leadership
Product differentiation

Balance scorecard

Evaluate strategy implementation


Four perspectives

Financial and non-financial

Analyze changes in operating income to evaluate


strategy

Growth component, price recovery and productivity


component
Adjust for market growth
Cost leadership and product differentiation components
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Learning Objectives
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Explain the four cost categories in a costs-ofquality program.


Develop nonfinancial measures and method
to improve quality.
Combine financial and nonfinancial measures
to make decisions and evaluate quality
performance.
Describe customer-response time and explain
why delays happen and their costs.
Explain how to manage bottlenecks.
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Quality as a Competitive Tool


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Quality: the total features and characteristics of a


product or a service made or performed
according to specifications to satisfy customers
at the time of purchase and during use.

Cisco Systems and Motorola (US)


British Telecom (UK)
Fujitsu and Honda (Japan)
Samsung (South Korea)

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Toyotas Recall
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Between Nov 2009 and Jan 2010, Toyota was


forced to recall 9 million vehicles worldwide
because gas pedals began to stick and were
causing unwanted acceleration on eight Toyota
models
As the crisis unfolded, Toyota was slow to take
responsibility for manufacturing problems. The
company then faced the long and difficult task of
restoring its credibility and assuring owners and
new-car shoppers that it had fixed the problems

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Stock price following Toyota


recalls

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Two Basic Aspects of Quality


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Customer
Satisfacti
on

Design
Specificat
ions
Design Quality:
how closely the
characteristics of
a product or
service meet the
needs and wants
of customer.

Actual
Performa
nce
Conformance
Quality: the
performance of a
product or service
relative to its
design and
product
specifications.

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Two Basic Aspects of Quality:


Illustration

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Quality Management: BSC


Structure

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Explain the four cost categories in


a costs-of-quality program

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Costs of Quality (COQ)


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Costs incurred to
preclude the
production of
products that do
not conform to
specifications

Costs incurred on
defective products
before they are
shipped to
customers

Costs incurred to
detect which of the
individual units of
products do not
conform to
specifications

Costs incurred on
defective products
after they have
been shipped to
customers

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Costs of Quality (COQ):


Illustration

Opportunity
costs

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COQ Reports
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Step 1: identify the Chosen Cost Object


Step 2: Identify the Direct Costs of Quality of the
Product.
Step 3: Select the Activities and Cost-Allocation
Bases to Use for Allocating Indirect Costs of
Quality to the Product.
Step 4: Identify the Indirect Costs of Quality
Associated with Each Cost-Allocation Base.
Step 5: Compute the Rate per Unit of Each CostAllocation Base.
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Costs of Quality (COQ):


Illustration

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Develop nonfinancial measures


and method to improve quality

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Customer Perspective
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Customer satisfaction and preference


Market share
Percentage of highly satisfied customers
Number of defective units shipped
Number of customer complaints
Percentage of products that fail soon after
delivery
Average delivery delays
On-time delivery rate
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Internal-Business-Process
Perspective

Driver of customer satisfaction


Three techniques
Control

charts
Pareto diagrams
Cause-and-effect diagrams

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Control Charts
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Statistical quality control (SQC) is a formal


means of distinguishing between random and
nonrandom variations in an operating process.
What are random and nonrandom variations?
Control charts an important tool in SQC, is a
graph of series of successive observations of a
particular step, procedure, or operation taken at
regular intervals of time.

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Control Charts
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Pareto Diagram
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Observations outside control limits serve


as inputs for Pareto diagrams.
Pareto diagram: a chart that indicates how
frequently each type of defect occurs,
ordered from the most frequent to the
least frequent.

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Pareto Diagram
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Six Sigma Quality


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Upper and lower control limits can be set


at a distance of 6.

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Cause-and-Effect Diagram
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The most frequently recurring and costly


problems identified by the Pareto diagram
are analyzed using cause-and-effect
diagrams
Also called fishbone diagrams because
they resemble the bone structure of a fish

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Cause-and-Effect Diagram
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The Learning-and-Growth
Perspective: Quality
Improvements
What are the drivers of internal-businessprocess quality?
Recruiting outstanding design engineers
Providing more employee training
Lowering employee turnover

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Advantages of Costs of
Quality (COQ)

Focuses managers attention on the costs of


poor quality
Evaluates trade-offs among prevention
costs, appraisal costs, internal failure costs,
and external failure costs
Compares costs and benefits of different
quality-improvement programs and setting
priorities for cost reduction

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Advantages of Nonfinancial
Measures of Quality

Nonfinancial measures of quality are often easy to


quantify and understand
Nonfinancial measures direct attention to physical
processes and hence help managers identify the
precise problem areas that need improvement
Nonfinancial measures, such as number of
defects, provide immediate short-run feedback on
whether quality-improvement efforts are
succeeding
Nonfinancial measures such as measures of
customer satisfaction and employee satisfaction
are useful indicators of long-run performance
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Describe customer-response time


and explain why delays happen
and their costs

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Time as a Competitive Tool


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Companies view time as a driver of strategy.


AT&T,

Wal-Mart, and GE

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Customer-Response Time
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Customer-Response Time
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Some companies evaluate their response


time improvement efforts using
manufacturing cycle efficiency (MCE)

Value - added Manufacturing Time


MCE
Manufacturing Cycle Time

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Time Drivers
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Time driver is any factor in which a


change in the factor causes a change in
the speed of an activity.
Two time drivers:

Uncertainty about when customers will


order products and services.
Bottlenecks due to limited capacity. A
bottleneck occurs in an operation when the
work to be performed approaches or
exceeds the capacity available to do it.
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Time Management
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When demand uncertainty is high, some


unused capacity is desirable
Increasing the capacity of a bottleneck
resource reduces manufacturing lead times
and delays
Reduce the time for setups and processing
Invest in new equipment to increase
capacity
Careful scheduling of production
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Falcon Works (FW)


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FW uses one turning machine to convert steel


bars into a special gear for planes.

It makes its sole product only after customers have


ordered it.
Receipt time and delivery time are minimal
Its strategy is to differentiate itself from
competitors by offering faster delivery.

Step 1: Whether to introduce a second


product, a piston for pumps?

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Step 2: Obtain information


Numbers of orders for gears FW has received
Typically

30, but can be 30, 10, 50

Time it takes to manufacture gears


1000

units/order
100 hrs of manufacturing (8 hrs of setup, 92 hrs of
processing)

Available capacity
Annual

4,000 hrs

Queues and delays will occur because of


uncertainty

Average

manufacturing cycle time


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Average waiting time: the average amount of time that an order


waits in line before the machine is set up and the order is
processed

Average manufacturing time

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30*(1002)/2*(4000- 30*100)=150 hours


(waiting time)

100 hours (manufacturing time)

Manufacturing cycle time= 250 hours

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Step 3: Make predictions about the future

Producing both gears and pistons

FW expects to receive 10 orders for pistons, each order


for 800 units. Each order will take 50 hours of
manufacturing time
Expected demand of for gears will be unaffected by the
introduction of pistons
Average waiting time?

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[30*(1002)+10*(502)]/(4000-30*100-10*50)=325
hours (waiting time)
Manufacturing time cycle for gears= 325+100=
425 hours
Manufacturing time cycle for pistons= 325
+50=375 hours

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Step 4: Make decisions by choosing among


alternatives

Should FWs manager introduce pistons?


Relevant revenues and relevant costs of
adding the piston product
Product

Gears
Pistons

Annual
Average
Number of
Orders

30
10

Average Selling Price per


Order if Average
Manufacturing Cycle Time
per Order Is
Less Than
More Than
300 Hours
300 Hours

$22,000
10,000

$21,500
9,600

Direct
Material Cost
per Order

Inventory
Carrying
Cost per
Order per
Hour

$16,000
8,000

$1.00
0.50

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Costs of time
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Product

Effect of Increasing Average


Manufacturing Cycle time
Expected Loss in
Expected Increase
Revenues for Gears in Carrying Costs
for All Products

(1)
Gears
Pistons
Total

(22,00021,500)*30=15,000
--

Expected Loss in
Revenues Plus
Expected Increases
in Carrying Costs
of Introducing
pistons

(2)
(425 250)*$1*30=5,250
(3750)*$0.5*10=1,875
$7,125

(1)+(2)
20,250
1,875
22,125

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Alternative 1:
Introduce Pistons

Relevant Items

(1)

Expected revenues

22,000*30=660,000

Expected inventory carrying


costs

21,500*30+9,600*10=$7
41,000
16,000*30+8,000*10=56
0,000
425*$1*30+375*$0.5*10
= 14,625

Expected total costs

574,625

487,500

Expected revenues minus


expected costs

166,375

172,500

Expected variable costs

Alternative 2:
Do Not Introduce
Pistons
(2)

16,000*30=480,000
250*$1*30= 7,500

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Difference

(3)=(1)-(2)

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Explain how to manage


bottlenecks

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Overcoming Wireless Data Bottlenecks


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Too many users try to transfer mobile data at


the same time in a given area
Amazon. Com Kindle owners cannot download
new e-books
Mobile brokerage users cannot buy and sell stocks

Wireless providers are working on more


efficient mobile broadband networks (LTE)
In U.S., current holders of spectrum (e.g., radio
stations) sell excess capacity to wireless
providers for profits
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Theory of Constraints and ThroughputContribution Analysis


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The theory of constraints (TOC) describes methods to


maximize operating income when faced with bottleneck
and nonbottleneck operations.

TOC focuses on a short-run time horizon and assumes


that operating costs are fixed costs.

TOC objective: increase throughput margin while


decreasing investments and operating costs
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Theory of Constraints and ThroughputContribution Analysis: Illustration


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CI manufactures car doors in two operations

Stamping and Pressing

Each door sells for $100 and has a direct material cost
of $40

Variable costs in other functions of the value chain are


negligible

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Theory of Constraints and ThroughputContribution Analysis: Illustration


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Eliminate idle time at the bottleneck operation: CIs manager is


evaluating permanently positioning two workers at the pressing
operation to unload finished units as soon as one batch of units is
processed and to set up the machine to begin processing the next batch.
This action will cost $48,000 and bottleneck output will increase by 1,000
doors per year.

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Theory of Constraints and ThroughputContribution Analysis: Illustration


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Shift products that do not have to be made on


the bottleneck machine: suppose S corporation, an
outside contractor, offers to press 1,500 doors at
$15 per door from stamped parts that CI supplies.

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Theory of Constraints and ThroughputContribution Analysis: Illustration


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Suppose Gemini Industries, another outside


contractor, offers to stamp 2,000 doors from
direct materials that CI supplies at $6 per door.

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Theory of Constraints and ThroughputContribution Analysis: Illustration


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Reduce setup time and processing time at


bottleneck operations: suppose CI can press
2,500 more doors at a cost of $55,000 a year by
reducing setup time at the pressing operation.

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Theory of Constraints and ThroughputContribution Analysis: Illustration


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Improve the quality of parts or products


manufactured at the bottleneck operation:

Parts 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 the bottleneck machines.
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In-class exercise
Aardee Industries manufactures pharmaceutical products in two
departments: mixing and tablet making. Additional information on
the two departments follows. Each tablet contains 0.5 gram of direct
materials.
Mixing

Tablet Making
(bottleneck)

Capacity per hour

150 grams

200 tablets

Monthly capacity (2,000 hours available


in each department)

300,000 grams

400,000
tablets

Monthly production

200,000 grams

390,000
tables
(instead of
400,000
tables)

Fixed operating costs (excluding direct


materials )

$16,000

$390,000

Fixed operating cost per unit


($16,000/200,000 grams;
39,000/390,000 tablets)

$0.08 per gram

$0.10 per tablet

The mixing department makes 200,000 grams of direct


materials mixture (enough to make 400,000 tables) because
the tablet-making department has only enough capacity to
process 400,000 tablets. All direct material costs of $156,000
are incurred in the mixing department. The tablet-making
department manufactures only 390,000 tablets from the
200,000 grams of mixture processed; 2.5% of the direct
materials mixture is lost in the tablet-making process. Each
tablet sells for $1.
All costs other than direct material costs are fixed costs. The
following requirements refer only to the preceding data. There
is no connection between the requirements

Q1 An outsider contractor makes the following offer: If Aardee


will supply the contractor with 10,000 grams of mixture, the
contractor will manufacture 19,500 tablets for Aardee
(allowing for the normal 2.5% loss of the mixture during the
tablet-making process) at $0.12 per tablet. Should Aardee
accept the contractor's offer? Show your calculations.
$156,000/390,000=$0.4/tablet ; Selling price per tablet
= $1.00; Unit throughput margin=$1.00 $0.40 = $0.60 per
tablet
Increase in operating income:
($0.60 $0.12)*19,500 = $9,360

Q2 Another company offers to prepare 20,000 grams of


mixture a month from direct materials Aardee supplies. The
company will charge $0.07 per gram of mixture. Should
Aardee accept the contractors offer? Show your calculations.
Answer: Operating costs for the mixing department are a fixed
cost. Contracting out the mixing activity will not reduce mixing
department costs but will cost an additional $0.07 per gram of
mixture. Mixing more direct materials will have no effect on
throughput margin, since tablet making is the bottleneck
operation. Therefore, Aardee should reject the company's
offer.

Q3 Aardees engineers have devised a method that would


improve quality in the tablet-making department. They
estimate that the 10,000 tablets currently being lost would be
saved. The modification would cost $7,000 a month. Should
Aardee implement the new method? Show your calculations.
Additional revenue from selling 10,000 extra tablets ($1
10,000) $10,000
Incremental costs to improve quality 7,000
Increase in operating income $ 3,000
Aardee should implement the new method.

Q4 Suppose that Aardee also loses 10,000 grams of mixture in its


mixing department. These losses can be reduced to zero if the
company is willing to spend $9,000 per month in quality-improvement
methods. Should Aardee adopt the quality-improvement method? Show
your calculations.

Cost per gram of mixture =$156,000/200,000 grams = $0.78 per gram


Cost of 10,000 grams of mixture = $0.78 10,000 = $7,800
Benefit from better mixing quality $ 7,800
Cost of improving the mixing operation 9,000
Increase/(Decrease) in operating income $ (1,200)

Q5 What are the benefits of improving quality in the mixing


department compared with improving quality in the tabletmaking department?

Compare the answers to requirements 3 and 4. The benefit of


improving quality at the mixing operation is the savings in
materials costs. The benefit of improving quality of the tablet
making department (the bottleneck operation) is the savings
in materials costs plus the additional throughput margin
from higher sales equal to the total revenues that result from
relieving the bottleneck constraint.

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The End
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