Session 4 B Product Mix with Capacity Constraints,

Theory of Constraints, Linear Programming (Cont’d)

 Learning Objectives
 Understand the usefulness of the linear programming (LP) technique
for business managers (Cont’d)
 Formulate business planning problems as LP models that are
subject to one or multiple constraints
 Understand Opportunity Cost/Shadow Price
 Gain basic concept of Simplex Method
 Perform Sensitivity Analysis in LP
 Understand the basics of the Theory of Constraints
 Understand the fundamental concepts of Throughput Accounting
Continue with the example from Session 4 A

Remember previous example

Maximize C = 14 Y+ 16 Z (Objective function)

For the following period, the availability of resources are expected to be subject
to the following limitations:

Labour 2.880 hours

Material 3,440 units

Machine capacity 2,760 units

The marketing manager estimates that the maximum sales potential for product
B is limited to 420 units. There is no sales limitation for product Z.
Optimal Solution
 Putting all the lines together
 Optimal Output
 What if C = 2,240?

 Y = 160 units ($2,240/$14) at $ 14 contribution per unit

 Or 140 units of Z ($2,240/$16) at a contribution of $ 16 per unit.

 Extend to the right until it touches the last corner of the boundary of ABCDE, i.e. Point C

 Y = 400 units (Contribution of $ 5,600) Plus 60 units of Z (Contribution $ 960) = $ 6,560

Solving the simultaneous equations
 Solving the simultaneous equations for the Optimal point C:

Remember:

 8Y+4Z = 3,440

 6Y+8Z = 2,880

So, 16Y+8Z = 6,880

 6Y+8Z = 2,880

 And 10 Y = $4,000

 Y= 400

 Z=60

 i.e. (16 x 400) + 8Z = 6,880

•
How to calculate the Marginal Contribution
from obtaining extra unit of material in
excess of 3,440?
Work Out the Revised Optimum Output

•
8Y + 4Z = 3,441 (revised material constraint)
•
6Y + 8Z = 2,880 (unchanged labour constraint)

•
Solving the two equations,
Work Out the Revised Optimum Output

•
Solving the two equations,
•
Y = 400.2
•
Z = 59.85
Marginal Contribution from obtaining extra unit of
material

The Change in contribution arising from obtaining an additional unit of material :

400.2 units of Y and 59.85 units of Z vs 400 units of Y and 60 units of Z

$
Increase in Contribution from Y (0.2 x 14) 2.8

Decrease in Contribution of Z (0.15 x 16) -2.4

Increase in Contribution 0.4

•
How to calculate the Marginal Contribution
from obtaining extra Labour hour?
•
(see poll question)
 Revised Optimum Output
•
8Y + 4 Z = 3,440 (unchanged material constraint)
•
6Y + 8Z = 2,881 (revised labour constraint)

•
Solving the equation

•
Y = 399.9 units
•
Z = 60.2 units
Marginal Contribution from obtaining
extra labour hour
The Change in contribution arising from obtaining an additional unit (lobour hour) of labour:
399.9 units of Y and 60.2 labour hours of Z versus 400 units of Y and 60 labour hours of Z

Decrease in Contribution from Y (0.1 x 14) -1.4

Increase in Contribution of Z (0.2 x 16) 3.2

Increase in Contribution 1.8

 Opportunity Cost/Shadow Price
•
In summary,
 the Premium to pay for one extra unit of material is $ 0.4, same as
the marginal increase in contribution by one extra unit of material
 Also called Opportunity Cost or Shadow Price
 So, for material purchased in excess of 3,440 units, the company
can pay up to $ 0.4 over and above the present acquisition cost of
material of $ 4
 Similarly, the increase in contribution by one extra labour hour (in
excess of 2880 hours) is $1.8.
 Thus, the opportunity cost/shadow price for one extra labour hour is
$ 1.8 (in excess of 2880 hours),
 Calculation of Relevant Costs
So, what is the relevant cost for our sales mix decision?
 The relevant cost for a scarce resource is
Acquisition Cost of Resource + Opportunity Cost

 the relevant costs for:

 Material = $ 4.40; ($ 4 (acquisition cost) plus $ 0.4 (opportunity cost) )

 Labour = $ 11.8 ($ 10 acquisition cost plus $ 1.80 opportunity cost)

 Variable overheads = $ 1.00 ($ 1 acquisition cost plus zero opportunity cost)

 Fixed overhead = nil

Opportunity cost/shadow price help us to make decision
How does opportunity cost/shadow price help us to make decision?
 In our example, assume that 100 additional units of materials can be
purchased by overseas supplier at $ 4.2, should you accept the
offer?
 Poll question
 Opportunity cost/shadow price help us to make decision (Cont’d)

Yes, we should. Why?

 $ 4.2 < $ 4.4 (relevant cost of material in excess of 3440 units)
As for extra material:
The revised optimal output becomes:

 Increase Y by 20 units (100 x 0.2 units), i.e. 420 units (400 + 20) of Y used

 Decrease Z by 15 units (100x 0.15 unit), i.e. 45 units (60-15) of Z)

 Increase Y & Decrease Z because of higher contribution

 Note that the line 8y+4z = (3440+100) is now shifted upward

Quick checking:

 Maximize C = 14 Y+ 16 Z (Objective function)

 Contribution based on Initial Optimal output C = 14 * 400 + 16* 60 = $ 6,560

 Contribution based on Revised Optimal Output C = 14*420+16*45 – 100*0.2

(extra price for material) = 6,580
Opportunity cost/shadow price help us to make decision
(Cont’d)
•
What about for labour hours?
•
If the factory manager tells you that the workers are willing to work for extra time of 100
hours for a overtime premium of $ 1, will you allow?
•
Poll Question
•
Yes, because
•
$ 1 < $ 1.8 (the opportunity cost)

Thus, the revised optimal output becomes:

 Decrease Y by 10 units (100 x 0.1 units), i.e. 390 units (400 - 10) of Y used

 Increase Z by 20 units (100x 0.2 unit), i.e. 80 units (60+20) of Z)

Opportunity cost/shadow price help us to make decision
(Cont’d)
What about the contribution based on Revised Optimal Output C?

Quick Checking

 Maximize C = 14 Y+ 16 Z subject to the following constraints:

 Contribution based on Initial Optimal output C = 14 * 400 + 16* 60 = $ 6,560

 Contribution based on Revised Optimal Output C = 14*390+16*80 – 100*1

(overtime premium) = 6,640
 Simplex Method

 Whatabout product mix decision for more than two

products using the scarce resources?
 Use Simplex Method
 A mathematical technique used in linear programming to
solve optimization problems
 Simplex Method
 Formulate a model that does not include any inequalities.
 Introduce slack variables
 A constraint that is unused at the point of optimality
 So, turn the equations from an inequality into an equality
 In our example,
 Maximize C = 14 Y + 16Z

 8Y+4Z+S1 = 3,440 (material constraint)

 6Y + 8 Z + S2 = 2,880 (labour constraint)

 4Y+6Z+S3 = 2,760 (machine capacity constraint)

 1 Y + S4 = 420 (sales constriant from product Y)

 Equations in Tableau form
 Understand the Tableau Form used in Simplex Method

Simplex Method
Equations in Tableau Form (Matrix)

Initial Matrix

Quantity Y Z Note

S1 = 3,440 -8 -4 (1) (Material Constraint

S2 = 2,880 -6 -8 (2) Labour Constraint)

S3 = 2,780 -4 -6 (3) (Machine Hours Constraint)

S4 = 420 -1 0 (4) (Sales constraint)

C=0 14 16 (5) contribution

 Final Matrix
 Interpret the Final Matrix

Equations in Tableau Form (Matrix)

Final Matrix

Quantity S1 S2 Note

Y = 400 -1/5 (0.2) +1/10 (0.1) (1)

Z = 60 +3/20 (0.15) -1/5 (0.2) (2)

S3 = 800 -1/10 (0.1) +4/5 (0.8) (3)

S4 = 20 +1/5 (0.2) -1/10 (0.1) (4)

C = 6,560 -2/5 (0.4) -1 4/5 (1.8) (5)

 Interpret the Final Matrix
• Remember we calculate the Marginal Contribution from obtaining extra unit of material. It
comes up with similar result

The Effect of Removing One Unit of Material from the Optimim Production Programme

S3 (Machine S4 (Sales of Y) S1 (Material) S2 Labour Contribution ($)

Capacity)

Increase product Z by 3/20 -0.9 (0.15*6) none -0.6 (0.15*4) -1.2 (0.15*8) +2.4 (0.15*16)
(0.15) of a unit
Decrease product Y by 1/5 +0.8 (0.2*4) +0.2 +1.6 (0.2*8) +1.2 (0.2 * 6) -2.8 (+.2*14)
(0.2) of a unit

Net Effect -0.1 +0.2 +1 Nil -0.4

 Sensitivity Analysis
 Note that the value of Opportunity costs that we calculate is valid only within
a range of production (or constraints)

How to find out the range that the opportunity cost applies for each
input?
 Note from the final matrix.

 Take materials as an example:

 Y = 400 /(-1/5) = - 2000

 S3 = 800/(-1/10) = -8,000

 The number closest to zero (namely −2000) indicates by how much material
can be reduced in the model
 Thus, the lower limit of the range is 1440 units (3440 − 2000).
 Sensitivity Analysis
Similarly, to determine the upper limit

We divide the positive items in column into the quantity column as follows:
 Z = 60/0.15 = 400

 S4 = 20 / 0.2 = 100

 The lower number in the calculation (namely 100) indicates by how

much the materials can be increased.
 Upper Limit = 3,440 + 100 = 3,540

 Thus, Range that the opportunity values of material applies: 1,440 to

3,540 units
 Be careful to interpret what is said in sensitivity analysis in Appendix
 Managing Constraints
 When the scare resources fully utilised, this will give rise to
Bottleneck activities
 Bottleneck - where constraints apply arising from demand exceeding
available capacity
 Theory of Constraints focuses on managing bottleneck operations

•
 Theory of Constraints (TOC)
 TOC describes methods to maximize operating income when faced with
some bottleneck and some nonbottleneck operations.
 3 important measures in TOC
 Throughput margin (revenues minus the direct material costs of the
goods sold)
 Investments (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.)
 Operating costs (all costs of operations (other than direct materials) incurred to
earn throughput margin, including salaries and wages, rent, utilities, and
depreciation).

 Objective
 increase throughput margin while decreasing investments and
operating costs.
 Theory of Constraints (TOC)
Steps to manage bottleneck operations:

1. Recognize that bottleneck operations determine the contribution

margin of the entire system
2. Identify the bottleneck operations.
3. Keep the bottleneck operation busy and subordinate all
nonbottleneck operations to the bottleneck operation.
4. Take actions to increase the efficiency and capacity of the bottleneck
operation
Theory of Constraints (TOC)
 Use variable cost for decision making
 Focus on the short-run maximization of throughput contribution
 Thus, the TOC normally assumes only direct material is variable and
consider all other operating expenses (including direct labour) as fixed.
 Labour not a truly variable cost unless their pay is 100% tied to the no of
units made.
 For our purpose, we’ll consider labour cost or any other operating cost as
variable costs, only if they are truly variable cost.
 Thus, Throughput accounting and Contribution accounting use the same
concepts to maximize profit in the short-run;
 Difference: definition of variable costs could be different.
 Exercise – 3 Different Methods

Throughput accounting.

A Speedy Inc makes and sells two products A and B, each of which
passes through the same automated production operations. The
following estimated information is available for period 1:

(i)
Product unit data A B

Direct material cost $ 2 40

Variable production overhead cost $ 28 4

Overall hours per product unit (hours) 0.25 0.15

(ii) Production/sales of products A and B are 120 000 units and 45000
units respectively. The selling prices per unit for A and B are $60 and $70
respectively.

(iii) Maximum demand for each product is 20 per cent above the
estimated sales levels.
(iv) Total fixed production overhead cost is $1 470 000. This is absorbed
by products A and B at an average rate per hour based on the estimated
production levels.

Required:
Using net profit as the decision measure, show why the management of
Speedy Inc argues that it is indifferent on financial grounds as to the mix of
products A and B which should be produced and sold, and calculate the
total net profit for period 1. (6 marks)
 Example (Cont’d) – Profit per Unit (Full unit
cost) Approach

Required:
 Using net profit as the decision measure, show why the
management of Speedy Inc argues that it is indifferent on financial
grounds as to the mix of products A and B which should be produced
and sold, and calculate the total net profit for period 1
 Pre-determined Fixed Overhead Rate

 Pre-determined Fixed Overhead Rate = Expected Overhead Cost /

Expected Level of Activity
 Total fixed Production Overhead is $ 1,470,000, what is the
expected Level of Activity in hours?
 What is the fixed overhead rate per hour?
the expected Level of Activity in hours?

What is estimated total number of hours

Product A Product B Total

Usage per unit

Planned production of No
of units

Total Hours ?
the expected Level of Activity in hours?

What is estimated total number of hours

Product A Product B Total

Usage per unit 0.25 0.15

Planned production of No 120,000 45,000
Total Hours 30,000 6,750 36,750
fixed overhead rate per hour

Fixed OH Per Hour $

Total OH 1,470,000.00
No of Hours 36,750.00

Fixed OH Per Hour 40.00

 Profit Per Unit

Profit Per unit

Product A ($) Product B ($)
Direct materials 2 40
Variable production overhead 28 4
Fixed production overhead ? ?
Total cost 40 50
Selling price ? ?
Profit ? ?
 Profit Per Unit

Profit Per Unit Product A ($) Product B ($)

Direct materials 2 40
Variable production overhead 28 4
Fixed production overhead 10 (0.25X $40) 6 (0.15 X 40)
Total cost 40 50
Selling price 60 70
Profit per unit 20 20
 (Full unit cost) Approach

(a)
Total hours = 36 750 (120 000 X 0.25) + (45 000X 0.15)
Fixed overhead rate per hour = $40 ($1470 000/36 750 hours)

Product A ($) Product B ($)

Direct materials 2 40
Variable production overhead 28 4
Fixed production overhead 10 (0.25X $40) 6 (0.15 X 40)
Total cost 40 50
Selling price 60 70
Profi t 20 20

Assuming that the company focuses on profi ts per unit it will be indifferent between
the 2 products.
Total net profi t = $3 300 000 (120 000X $20) + (45 000 X $20)
 Example – Contribution per bottleneck hour Approach
(b) One of the production operations has a maximum capacity of 3,075
hours which has been identified as a bottleneck that limits the overall
production/sales of products A and B. The bottleneck hours required per
product unit for products A and B are 0.02 and 0.015 respectively.
All other information detailed in (a) still applies.

Required:
Calculate the mix (units) of products A and B which will maximize net
profit and the value ($) of the maximum net profit
What is Contribution per Bottleneck Hour

Copntribution Per Unit Product A ($) Product B ($)

Selling Price 60 70

Direct materials 2 40
Variable production overhead 28 30 4 44
Contribution Per Unit 30 26
Bottleneck Hour ? ?
Contribution Per Bottleneck Hour ? ?
Contribution per Bottleneck Hour

Product A Product B
Contribution per unit 30 (60-30) 26 (70-44)
Bottleneck hours $0.020 $0.015
Contribution per bottleneck hour $1,500 $1,733
 How many units of B should be produced?

• As many as possible?
 How many units of B should be produced?

As many as possible? Yes, there is a constraint (sales demand):

45,000 * 120% = 54,000

How many units of A should be produced?

Units to be produced for A

No of bottleneck hours available ?

No of units of B produced 54,000

Usage per unit 0.015
No of bottleneck hours used by B 810

No of bottleneck hours avaialbe for A #VALUE!

Usage per unit of A 0.02

No of units of A produced #VALUE!

How many units of A should be produced?

Units to be produced for A & B

No of bottleneck hours available 3,075

No of units of B produced 54,000

Usage per unit 0.015
No of bottleneck hours used by B 810

No of bottleneck hours avaialbe for A 2,265

Usage per unit of A 0.02

No of units of A produced 113,250

Contribution per bottleneck hour Approach (Summary)

(b)
Product A Product B
Contribution per unit $30 (60-30) $26 (70-44)
Bottleneck hours 0.02 0.015
Contribution per bottleneck hour $1 500 $1 733

Based on the contribution per bottleneck hour the maximum demand of product
B should be produced. The maximum demand of product B requires 810 hours
(54 000 X 0.015) leaving 2,265 hours (3,075 – 810) to be allocated to product A.
This will result in the production of 113,250 units (2,265 hours/0.02) of A.
The maximum profit is calculated as follows:
$
Contribution from product A (113,250 X $30) 3,397,500
Contribution from product B (54,000 X $26) 1,404,000
4,801,500
Less Fixed overhead cost 1,470,000
Net profit 3,331,500
 Throughput accounting
C ) The bottleneck situation detailed in (b) still applies. Speedy Inc has
decided to determine the profit maximizing mix of products A and B
based on the throughput accounting principle of maximizing the
throughput return per production hour of the bottleneck resource. This
may be measured as:
Throughput return per production hour
= (Selling price – material cost) / bottle neck hours per unit
All other information detailed in (a) and (b) still applies, except that the
variable overhead cost as per (a) is now considered to be fixed for the
short/intermediate term, based on the value ($) which applied to the
product mix in (a).
 Throughput accounting
Required:

(i) Calculate the mix (units) of products A and B which will maximize net profit and the
value of that net profit.

(ii) Calculate the throughput accounting ratio for product B which is calculated as:

Throughput return per hour of bottleneck resource for product B

overall total overhead cost per hour of bottleneck resource

(iii) Comment on the interpretation of throughput accounting ratios and their use as a
control device. You should refer to the ratio for product B in your answer
c 1 Throughput Return per production Hour

Throughput Return per production Hour

Product A B
Selling price ? ?
Direct Material Cost ? ?
Contribution ? ?
Time on Bottleneck hour 0.02 0.015

Throughput Return per

production Hour ? ?
c 1 Throughput Return per production Hour

Throughput Return per production Hour

Product A B

Selling price 60 70

Direct Material Cost 2 40

Contribution 58 30

Time on Bottleneck hour

0.02 0.015

Throughput Return per production Hour

2,900 2,000
 How many units of A to Sell
• As many as possible?
 How many units of A to Sell
• As many as the Co can sell in the market?

• 120,000*1.2 = 144,000
 No of units of B to be produced

Units to be produced for B

No of bottleneck hours available 3,075

No of units of A produced 144,000

Usage per unit 0.02
No of bottleneck hours used by A 2880

No of bottleneck hours avaialbe for B 195

Usage per unit of B 0.015

No of units of B produced 13,000

How to calculate the Profit under Throughput

Total Profit

$
Throughput return from product A (144 000 x $58) 8,352,000.00
Contribution from product B (13 000X $30) 390,000.00
8,742,000.00
Less: variable overheads ?
fi xed overhead cost ?
Net profi t ?
 What is Other Overhead

What is the Other Overhead?

We Assume that the variable overheads (e.g. direct labour) are fi xed in the short-term.

Variable production overhead cost $ [(120 000 X $28) + (45 000 X $4)]

$3,540,000
Profit under ThroughPut Accounting

$
Throughput return from product A (144 000 x $58) 8,352,000.00
Contribution from product B (13 000X $30) 390,000.00
8,742,000.00
Less: variable overheadsa 3,540,000.00
fi xed overhead cost 1470000
Net profi t 3732000

Note:
It is assumed that the variable overheads (e.g. direct labour) are fi xed in the short-term.
They are derived from part (a) – [(120 000 X $28) + (45 000 X $4)]
 Throughput accounting (Summary)

(c) (i)
Return per bottleneck hour = (Selling price – material cost)/(Time on bottleneck resource)
Product A = $2 900 [($60-$2)/0.02 hours]
Product B = $2 000 [($70 - $40)/0.015 hours]

Product A should be sold up to its maximum capacity of utilizing 2,880 bottleneck

hours (144,000 units X 0.02 hours). This will leave 195 hours for product B thus
enabling 13,000 units (195/0.015) to be produced. The maximum profi t is calculated
as follows:

$
Throughput return from product A (144 000 x $58) 8,352,000.00
Contribution from product B (13 000X $30) 390,000.00
8,742,000.00
Less: variable overheadsa 3,540,000.00
fi xed overhead cost 1470000
Net profi t 3732000

Note:
It is assumed that the variable overheads (e.g. direct labour) are fi xed in the short-term.
They are derived from part (a) – [(120 000 X $28) + (45 000 X $4)]
 Throughput accounting – Product B

(c) (ii)

Total overhead cost ($3,540 000 + $1,470 000) = $5 010 000

Overhead cost per bottleneck hour = $1 629.27 ($5 010 000/3,075* hours)
*2,880+195-3,075

Throughput return per bottleneck hour = $2 000 (see c(i))

Throughput accounting ratio = 1.2275 ($2 000/$1 629.27)

 Throughput accounting
(c) (iii)

With throughput accounting a product should be sold if the throughput return per bottleneck
hour is greater than the production cost (excluding direct materials) per throughput hour. In
other words, the throughput accounting ratio should exceed 1.00.

Increasing a product’s throughput ratio can increase profits. The throughput ratio can be
increased by:

1. Increasing the selling price or reducing material costs (note that product B has a very
high material cost).

2. Reducing the time required on the bottleneck resource.

3. Creating more capacity of the bottleneck resource and if possible increase the capacity
so that the bottleneck can be removed (subject to any additional financial outlays being
justified).

Note that product B should be sold because its throughput ratio exceeds 1 but product A
has the higher ranking because it has a higher throughput ratio.
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