Prepared by Debby Bloom- Hill CMA, CFM
Jan 19, 2016
Prepared by Debby Bloom-Hill CMA, CFM
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CHAPTER 7CHAPTER 7
The Use of Cost Information in Management
Decision Making
The Use of Cost Information in Management
Decision Making
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Incremental AnalysisIncremental Analysis
Incremental analysis All decisions involve a choice among
alternative courses of action The solution to business problems
involves incremental analysis Incremental analysis is the analysis of the
incremental revenue and incremental costs incurred when one alternative is chosen over another
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Incremental AnalysisIncremental Analysis
Incremental Revenue Additional revenue received by selecting
one alternative over another Incremental Cost
Additional cost incurred by selecting one alternative over another
Incremental Profit Difference between incremental revenue
and incremental cost
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Incremental AnalysisIncremental Analysis
An alternative that yields an incremental profit should be selected
Incremental costs are referred to as relevant costs
Also called differential costs because they are the costs that differ between decision alternatives
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Incremental Analysis ExampleIncremental Analysis Example
Jensen’s Rapid Copy is considering extending its hours Alternative 1 is the status quo Alternative 2 involved the company
extending their hours from 8 pm to midnight The next slide shows the incremental
costs and revenues associated with choosing one alternative over another
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Incremental Analysis ExampleIncremental Analysis Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Incremental AnalysisIncremental Analysis
Incremental Analysis can be extended to more than two alternatives Calculate profit for each alternative The alternative with the highest profit is
the best alternative Difference between the profit for this
alternative and the profit of any other alternative is the incremental profit
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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“What Does This Product Cost?”“What Does This Product Cost?”
Answer: Why do you want to know? No single cost number is relevant for all
decisions Must find incremental information that is
applicable to the decision Some costs will change due to the
decision, some will not Only costs that change are relevant
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
Which of the following is likely to be an incremental cost associated with increasing planned production run of 1,000 units to 1,010 units?
a. Set-up costsb. Depreciation of equipmentc. Inspection costsd. Material costs
Answer: dMaterial costs are variable costs and usually incremental
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Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Analysis of Decisions Faced by Managers
Analysis of Decisions Faced by Managers
Three decisions that managers frequently face:
1. The decision to engage in additional processing of a product
2. The decision to make or buy a product
3. The decision to drop a product line
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Additional Processing DecisionAdditional Processing Decision
Manufacturers must occasionally decide whether to: Sell a product in a partially completed
stage, or Incur additional processing costs required
to complete the product Costs incurred to date of decision on
partially complete product are not relevant, i.e sunk costs.
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Additional Processing Decision – Bridge Computer Example
Additional Processing Decision – Bridge Computer Example
Summary of cost information
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Additional Processing Decision – Bridge Computer Example
Additional Processing Decision – Bridge Computer Example
Incremental analysis summary Incremental revenues are $500 Incremental costs are $400 Would you spend $400 to generate an
additional $500?
Answer: Yes, incremental profit is $100
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Additional Processing Decision – Bridge Computer Example
Additional Processing Decision – Bridge Computer Example
Incremental analysis summary
Sell Partially
CompleteSell Fully Complete Incremental
Revenue $500 $1,000 $500 aPrior Production Costs (800) (800) 0Additional Processing Costs 0 (400) (400) bGain (loss) per unit ($300) ($200) $100 c
a. Incremental revenue associated with alternative 2b. Incremental cost associated with alternative 2c. Incremental profit associated with alternative 2
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Additional Processing DecisionAdditional Processing Decision
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Make or Buy DecisionsMake or Buy Decisions
Most manufactured goods are made up of numerous components In some cases, a company may purchase
one or more of these components from another company or manufacture them themselves
The analysis of this decision concentrates solely on incremental costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Additional information: If purchased, cost
savings include $390,000 in supervisory salaries and all variable costs.
Market value of production machinery is zero
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A key issue is to determine which of the above costs are incremental None of the $15 million of variable
manufacturing costs will be incurred if the part is purchased
The fixed costs associated with depreciation will not be saved Note that not all fixed costs are irrelevant
sunk costs
Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Some fixed costs are avoidable costs Avoidable costs can be avoided if a
particular action is undertaken If the parts are purchased from an outside
vendor, the salaries of 5 supervisors will be saved The savings total $390,000 of avoidable
fixed costs It will cost the company an additional
$110,000 to purchase the part
Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Incremental cost analysis – 3 column format
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Incremental cost analysis - single column format
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
Which of the following is not likely to be an incremental cost for a make-or-buy decision?
a. Materials costb. Direct labor costc. Variable manufacturing costd. Depreciation of building
Answer: dDepreciation of building is not likely to change no matter which alternative is chosen in a make-or-buy decision
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Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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An opportunity cost is the value of benefits foregone by selecting one decision alternative over another For example, if you spend $1,000 instead
of investing in a certificate of deposit, the interest that could have been earned is an opportunity cost
Since opportunity costs differ depending on the option selected, they are incremental costs
Opportunity CostsOpportunity Costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
Which of the following is true?
a. Opportunity costs are never incremental costs
b. Opportunity costs are always incremental costs
Answer: bOpportunity costs are always incremental costs because they differ depending upon the outcome selected
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Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Suppose the Tennessee plant is currently spending $500,000 per year to rent space for manufacturing shelving used in the refrigeration units
If production of compressors is discontinued, the company will not need to rent the space In the incremental analysis on the next slide,
the rent savings is shown along with the other cost savings
Opportunity Costs – General Refrigeration Example
Opportunity Costs – General Refrigeration Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Incremental analysis with opportunity costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Dropping a Product LineDropping a Product Line
Analysis involves calculating the change in income that will result from dropping the product line If income increases, the product line
should be dropped If income decreases, the product line
should not be dropped This amounts to comparing the incremental
revenues and costs that result from dropping the product line
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Dropping a Product Line – Mercer Hardware
Dropping a Product Line – Mercer Hardware
Mercer Hardware sells 3 product lines, tools, hardware and garden Direct fixed costs are directly traceable to
each product line Allocated fixed costs are not directly
traceable to a product line Allocated fixed costs are generally not
avoidable, thus no common fixed costs will be saved if the product line is dropped
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Dropping a Product Line – Mercer Hardware Example
Dropping a Product Line – Mercer Hardware Example
Profit calculation with three product lines
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Dropping a Product Line – Mercer Hardware Example
Dropping a Product Line – Mercer Hardware Example
Profit calculation with two product lines
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Dropping a Product Line – Mercer Hardware Example
Dropping a Product Line – Mercer Hardware Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Beware of the Cost Allocation Death Spiral
Beware of the Cost Allocation Death Spiral
When dropping a product line Common fixed costs are not incremental Common fixed cost allocation is spread
among remaining product lines Management must understand and
remember this impact when making decisions
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Avoidable costs
Costs that can be avoided by taking a particular course of action
Always incremental costs, and therefore relevant to a decision
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Sunk costs
Already occurred and not reversible Are not incremental because they do not
differ among alternatives Are not relevant in decision making
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Many students assume that fixed costs
are equivalent to sunk costs This is not always the case Fixed costs can be sunk, not sunk and
irrelevant, or possibly relevant
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Opportunity costs
Represent the benefit foregone by selecting a particular alternative
They are always incremental and relevant to a decision
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Which of the following costs should not be taken into consideration when making a decision?
a. Opportunity costsb. Sunk costsc. Relevant costsd. Differential costs
Answer: bSunk costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
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Classify each of the following as sunk and irrelevant, not sunk but still irrelevant, or not sunk and relevant
Depreciation on equipment already purchasedSunk and irrelevant (not incremental)
President’s salary, which will not change for both action A and action B
Not sunk and irrelevant (not incremental)Salary of supervisory who will be retained for action A and fired for action B
Not sunk and relevant (incremental)
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.
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Decisions Involving Joint CostsDecisions Involving Joint Costs
Joint Products When two or more products always result
from common inputs Joint Costs
Costs of the common inputs Split-Off Point
Stage of production in which individual products are identified
Product may undergo further processing and may incur additional costs
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Allocation of Joint CostsAllocation of Joint Costs
For financial reporting, the cost of common inputs must be allocated to the joint products The total joint cost will be incurred no matter
what the company does with the joint products beyond the split-off point
The joint cost is not incremental to production of an individual joint product and irrelevant to decisions regarding an individual joint product
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.
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Joint Products ExampleJoint Products Example
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.
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Joint Cost Allocation Methods Joint Cost Allocation Methods
Physical quantity of output
Joint costs allocated to product A =
Joint costs allocated to product B =
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Joint Cost Allocation Example Joint Cost Allocation Example
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Joint Cost Allocation Methods Joint Cost Allocation Methods
Relative sales value
Joint costs allocated to product A =
Joint costs allocated to product B =
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Joint Cost Allocation Example Joint Cost Allocation Example
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Additional Processing Decisions and Joint Costs
Additional Processing Decisions and Joint Costs
Joint costs not relevant to decisions made after the split-off point because they are not incremental
Joint costs incurred prior to the split-off point are sunk costs and have no effect on what happens after the split-off point
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.
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The joint costs incurred in a joint product situation:
a. Are incurred before the split-off pointb. Are incurred after the split-off pointc. Should only be allocated based on
physical attributesd. Should never be allocated
Answer: aAre incurred before the split-off point
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.
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Qualitative Considerations in Decision Analysis
Qualitative Considerations in Decision Analysis
Many decisions have one or more features that are difficult to quantify but should be given careful consideration
Examples include, but are not limited to Swings in the economy Loss of control Quality of the product Quality of service Company morale
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Qualitative Considerations in Decision Analysis
Qualitative Considerations in Decision Analysis
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Qualitative FactorsQualitative Factors
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
The Theory of Constraints is an approach to production and constraint management developed by Eli Goldratt Five step process Large increases in profit can be achieved
by elimination of bottlenecks in production processes
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
1. Identify the Binding ConstraintThe binding constraint is the process that limits throughput
2. Optimize Use of the ConstraintProduce products with the highest contribution margin per unit of the constraint
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
3. Subordinate Everything Else to the ConstraintManagers should focus their attention on trying to loosen the constraint and not on process improvements
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
4. Break the ConstraintThis can be done many ways including cross training workers, outsourcing, purchasing additional equipment or hiring new workers
5. Identify a New Binding ConstraintIdentify the additional bottlenecks. If there are no bottlenecks and excess capacity, focus on building demand
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).
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Implications of The Theory of Constraints
Implications of The Theory of Constraints
Inspections Should take place before work is transferred to a
constrained department Batch sizes
When a production process is a binding constraint, it may be better to have large batch sizes The time of the constrained department is not
wasted setting up equipment for numerous batches Across the board cuts
Cuts in bottleneck departments may make sense, but across the board cuts can have a serious negative impact on profits
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).
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You Get What You Measure and The Theory of Constraints
You Get What You Measure and The Theory of Constraints
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