Improve, or buy in?

Two proposals, money for one

Back to the busy market: demand is 100 P and 50 Q, worker B is the constraint, and you run the best plan, 100 P and 30 Q, for ₹300 a week. You have ₹5,000 to invest and two proposals:

• Proposal 1. A fixture for worker D cuts P’s assembly from 15 minutes to 7. Eight minutes saved on every P.
• Proposal 2. A new method for the middle part used by both products. Worker B’s time drops from 15 to 13 minutes, but some of the work moves to worker C, whose time rises from 5 to 9 minutes. Each product now takes two minutes more in total.

The CFO runs them through the cost report. Proposal 1 saves 8 × ₹0.625 = ₹5 on every P: ₹500 a week, paid back in 10 weeks. Proposal 2 adds 2 minutes to each product, so it makes both products dearer. Approve 1. Proposal 2 is a waste of money.

What the cost report missed

Proposal 1 saves minutes on worker D, who already had 750 spare minutes a week. After the fixture, D has 1,550 spare minutes. Worker B is still the constraint, so the plant makes exactly what it made before. Throughput doesn’t change, operating expense doesn’t change. The ₹500 a week of “savings” is a number on the cost report and nowhere else. Payback: never.

Proposal 2 frees 2 minutes of worker B on every middle part. With 100 P made first, B has 2,400 − 1,300 = 1,100 minutes left, enough for 39 Q instead of 30. Nine more Q add 9 × ₹60 = ₹540 a week, and the ₹5,000 pays back in about 9 weeks. Worker C now carries 2,251 minutes, close to its limit, but still within 2,400.

Actions to “improve” margins can reduce the company’s profit. An improvement anywhere except the constraint is a mirage.

Make or buy?

Now the slow market again: 90 P and 25 Q, a loss of ₹450 a week. A new segment wants 10 more P at ₹82. A reliable supplier offers to make P for you at ₹75 a unit, quality guaranteed.

The cost report: P costs ₹82.50 to make. Selling at ₹82 loses 50 paise a unit; buying in at ₹75 and selling at ₹82 earns ₹7 a unit. Outsource.

How to judge outsourcing

Ask what changes, at the level of the whole company:

• Buy in: throughput rises by ₹82 − ₹75 = ₹7 a unit, ₹70 for ten. Operating expense: unchanged.
• Make: throughput rises by ₹82 − ₹45 = ₹37 a unit, ₹370 for ten. Operating expense: unchanged, because B has 300 spare minutes and the ten P need 150.

The supplier’s ₹75 is a truly variable cost. Your “₹82.50” was not: ₹37.50 of it is overhead you pay either way.

Outsourcing can be the right answer, but for a different reason: when it frees the constraint. Suppose the market wants more of everything and B is full. Buying in a part that uses B’s minutes costs some throughput on that part, but every freed B minute can make another product worth ₹2 to ₹3. Then the sum is: change in throughput on the bought-in part, plus the throughput of the extra output the constraint can now produce.

Throughput per constraint unit

All of these decisions follow one rule, which the cost report can’t see:

1. Find the constraint. Is it a resource inside (worker B in the busy market), or the market itself (the slow market)?
2. If a resource is the constraint, judge products, orders and improvements by throughput per unit of the constraint: ₹ per B minute.
3. If the market is the constraint, any order priced above truly variable cost that fits in the spare capacity adds throughput; judge by throughput per unit.
4. Improvements count only if they let the constraint produce more, or cut operating expense or investment.

Check your understanding

Answer all five. Get four right to complete the lesson.

1. Why does Proposal 1 earn nothing?

• The fixture is too expensive
• P sells for too little
• It slows worker B down
• It saves minutes on worker D, who already had spare time; B still limits output

Saving time on a non-constraint changes neither throughput nor expense.

2. Proposal 2 adds 9 Q a week. What is the weekly gain?

• ₹540
• ₹900
• ₹360
• ₹5,000

9 × (₹100 − ₹40) = ₹540, so the ₹5,000 pays back in about 9 weeks.

3. In the make-or-buy case, making the 10 P in-house adds…

• ₹70
• −₹5
• ₹370
• ₹820

10 × (₹82 − ₹45) = ₹370, with no change in operating expense.

4. When can outsourcing raise profit?

• Whenever the supplier’s price is below product cost
• When it frees the constraint to make more of what the market wants
• Never
• When it reduces the number of suppliers

Then the gain includes the throughput of the extra output from the constraint.

5. When the market, not a resource, is the constraint, a product or order should be judged by…

• Throughput per unit
• Throughput per constraint minute
• Product cost
• Total minutes per unit

With spare capacity everywhere, minutes cost nothing extra.