The theory of constraints can bring purchasing operations into a strategic role in manufacturing. The availability and price of raw materials that the purchasing department is able to acquire can force new approaches to assessing total production costs and profits and may be determining factors in product mix.

Take a hypothetical company called Gooey Hues, Inc. Its two main products — green goo and orange goo — are made on the same machines, staffed by the same workers, at a weekly price tag of $3,000 in operating expense, exclusive of raw materials. Market demand is 100 units a week for green goo and 80 units a week for orange goo.

Costs

Green goo requires one part each of blue goo and yellow goo per finished unit and orange goo takes two parts of yellow goo and one part red goo per unit. Blue goo costs $20 per unit, yellow goo costs $5, and red goo costs $10, but supplies are limited for the yellow goo. Only 120 units of yellow goo are available each week — not enough to meet the total demand for both products. The constraining element is yellow goo, required for both products.

Green goo sells at $60 a unit, so filling the market demand of 100 units would bring in $6,000. Subtracting the $2,500 cost of raw materials — the only cost that constraint theory deducts from revenue to determine throughput — shows a return of $3,500, or $500 over operating expenses.

Orange goo sells at $65 per unit, the demand is 20 units less, and it uses more of the raw material that is in short supply. But the cost of raw materials needed for a unit of orange goo is less than the cost of raw materials for green goo. Filling the market demand of 80 units would bring in $5,200 in revenue, and subtracting the $1,600 in raw material costs would leave a throughput of $3,600 for orange goo — $100 more than for green goo.

Shortage

Orange goo sounds like the more profitable product choice for Gooey Hues — until you remember the shortage of yellow goo. Only enough is available to produce 60 units of orange goo. And the throughput for 60 units of orange goo would be $2,700, or $300 less than operating expenses.

A better outcome would result from changing the product mix to meet the market demand for 100 units of green goo and using the remaining 20 units of yellow goo for production of 10 units of orange goo. The throughput would be $3,500 for green goo and $450 for orange goo, for a total throughput of $3,950, or $950 above operating expenses.

And if the purchasing department at Gooey Hues were able to find additional supplies of the scarce yellow goo at a higher price — say $15 a unit instead of $5 — the formula would need to be reexamined. In determining what product mix made sense, the company would analyze the new supply conditions in light of other resources to identify potential new constraining factors, such as equipment or labor.

Chart:

Gooey Hues Throughput Choices

Green Goo

Unit selling price                               $60

Unit raw material costs

            1 part blue goo          @                   $20

    *1 part yellow goo             @  5

                                                                         $25

Orange Goo

Unit selling price                               $65

Unit raw material costs

*2 parts yellow goo                          @ $5

             1 part red goo                                 @ 10

                                                                  $20

Green Goo

Cost to fill demand

            100 units x $25             $2,500

Orange Goo

Cost to fill demand

            80 units x $20            $1,600

Green Goo

Product Mix Choices:          

            OPTION 1

            100 units          @$60 =  $6,000  

           Less cost of materials    - 2,500

            Throughput                 $3,500

            OPTION 2

            100 units          @$60 =  $6,000  

           Less cost of materials          - 2,500

            Throughput                 $3,500

            Total throughput

            with Option 2: $3,950

Orange Goo

            OPTION 1

(Or)

*60 units        @$65 =    $3,900  

                                                                       - 1,200

                                                             $2,700

OPTION 2

(Plus)

            *10 units          @$65 =   $650  

                                                                       - 200

                                                             $450