BLENDING THEORY OF CONSTRAINTS, ACTIVITY BASED COSTING, &

STATISTICS TO DETERMINE PRODUCT PRICE AND TO FACILITATE

CONTINUOUS IMPROVEMENT IN SALES AND MANUFACTURING
Brad Miller, Senior Manufacturing Engineer, Medeco Security Locks

Introduction
The Fallacy of Determining “Product Cost”
To survive in today’s transitional marketplace,
manufacturers are forced to offer high quality products at The terms “cost” and “profit margin” are irrelevant for
increasingly competitive prices while maintaining profit a specific product or products produced by a company.
levels to insure organizational growth. Developing a Incorrectly believing there is a specific “cost” of
pricing structure that insures profitability challenges making a product leads management to make incorrect and
managers, who must balance profitability concerns with inappropriate decisions regarding strategic business
the need for negotiation and monetary concessions in practices. For instance, if a certain product “costs” $45.00
competitive sales and marketing environments. The to produce, and the company wishes to make 100 units,
challenge broadens further for manufacturers of custom- expenses should be $4500 (45 x 100). Similarly, if the
engineered products of small batch sizes. Each unique company wishes to make 10,000 units, expenses should be
order must be priced individually, sometimes forcing $450,000 (45 x 10,000). However, certain expenses remain
managers, who have limited historical information about constant regardless of how many units are sold. For
similar products, to make “gut-feel” decisions about when example, mortgage or rental payments and management
a product will contribute positively to company profits. At salaries remain constant whether 100 or 10,000 units are
the same time, manufacturing managers struggle to produced. Therefore, overall expenses do not increase in
accurately predict how process improvement and capital direct proportion to the quantities of units produced, as the
investment affect the company’s profits. These issues are “product cost” concept would lead us to believe.
further confounded by the traditional cost accounting As another example, assume a company has five
paradigm, making accurate prediction of company profits a products they market. For each product, a “product cost”
matter of luck and chance. has been calculated. In comparing the “product cost” to the
To correctly analyze whether the product prices insure selling price, management notices that one of the products
company profitability, we must evaluate past performance, is being sold for less than the “product cost.” The obvious
analyze current markets, strive toward continuous decision (if the market were unwilling to pay more for the
improvement, and predict and analyze future market product) would be to discontinue the product that has a
environments. As a result, a blend of Activity Based negative “profit margin.” However, when this product is
Costing (ABC) and Theory of Constraints (TOC) discontinued, fixed overhead costs such as management
methodology has been formulated to provide a robust salaries, rental expenses, etc. are redistributed among the
product pricing framework, while providing corporate, remaining 4 products, thereby raising their “costs.” It now
marketing, engineering, and manufacturing management appears that the “cost of producing the remaining 4
with an effective tool for evaluating the impact of process products has increased. However, the process to make the
improvements and business strategies on profitability. The products did not change, the material costs did not change,
methodology defines, explores, and intricately describes however we are led to believe that the “cost” to make these
the assumptions, policies, and business practices that products is now higher. In effect, eliminating one product
enable the organization to successfully manufacture redistributed the fixed expenses of the company to the
custom products. Consequently, marketing management remaining products. At this point we may find that another
can accurately predict contributions of market product’s “cost” has risen above the selling price. It can be
developments and develop strategies focused on company seen from this example that the term “product cost” is
profits; manufacturing management can accurately assess valid and useful only for a specific moment in time; an
what capabilities must be enhanced and improved to “instantaneous product cost.” Many companies offer a
impact company profits directly. Finally, the methodology continually changing product mix in a continually
encourages and facilitates collaboration between changing manufacturing and marketing environment. The
Marketing and Manufacturing management to discover proposed methodology attempts to evaluate expenses for
new strategies for continuous improvement and enhanced short and long term strategic decisions that effect the
profitability. profitability of the company as a whole, not a particular
product in an instant of time.
 Other inaccuracies exist in assuming that a “product to determine profitability, not product to product
cost” exists. “Product cost” implies that the more of a fluctuations. After all, products are not profitable,
product with a high “profit margin” is made the higher the companies are.
overall profit of the organization, thereby implying infinite
capacity. However, we know that our organizations are Existing Methodologies
only capable of producing a finite quantity of certain
products, limiting the overall profit of the company. In Both Activity Based Costing and Theory of
order to make additional profit, a company must invest Constraints attempt to correct the inaccuracies of
money in process improvements or technology. However, traditional accounting methods (product cost, profit
such additional expenses change the circumstances in margin). While these methods have benefits and principles
which the “product cost” was initially calculated. The idea that can assist an organization in evaluating potential
of “profit margin” also encourages management to profitability, each has limitations when applied to the
aggressively pursue these “high margin” products, manufacturing and marketing processes of manufacturers
endangering the marketing stability of a broad product of specialized and custom products.
base and reducing the importance of customer focus:
supplying the customer with the specific product they Traditional Accounting Methods
want. These methods attempt to evaluate the profitability of
Many of the current methodologies base “product individual products by allocating overhead expenses of the
cost” on the “value adding” activities used to generate the organization to various product lines in proportion to the
product. The assumption is that as material is processed direct (value adding) labor spent in producing the product.
through an organization, money spent to transform that In the past, direct labor and materials expenses were an
material into a marketable product continually raises the extreme proportion of the expenses of the organization,
value of the material until the product is complete. The and wages were paid by piece (piece-work). With these
problem with this thinking is that until a product is assumptions, these methods required little effort to
complete, any in-process material is worthless to the implement and were quite accurate. However, overhead
company. The company cannot sell the in-process material costs became a larger proportion of the overall expenses of
for the “value” supposedly imposed on the material. In organizations due to expanded management and
fact, until the final product is complete, the original administrative support, increased expense and complexity
material price can often only be recovered partially by of technology, and intensified competition necessitating
selling the in-process material as scrap. Direct Labor is aggressive marketing. As overhead expenses became
often included in the “value” added to in-process material. larger, traditional accounting methods produced less
The standard hours for performing the particular activity accurate and more misleading results.
multiplied by an average wage rate determine the “value
added” to the product via direct labor. This concept also is Activity Based Costing (ABC)
invalid for multiple reasons. For instance, if a particular This method attempts to evaluate the profitability of a
product takes 1 hour to process each, and there are only 7 product by attempting to allocate overhead costs to product
products scheduled, the process operator will stretch out related activities that they support. ABC improves on
his labor to fill the entire 8 hours, thereby incurring traditional accounting methods, making product costing
expenditures not accounted for with “value adding” much more relevant to the way today’s companies are
methodology. Also, what manager will make an operator managed and structured. ABC methods also focus on
clock out to only be paid for, say, 7.83 standard hours? In where expenditures are being spent and why, encouraging
most circumstances, the manufacturing operators will work accurate and Pareto based management decisions. While
a full eight hours and get paid for it regardless of the ABC attempts to make all costs variable, the reality in
quantity of work processed. today’s companies is that there are some truly fixed
Because of the multiple interactions of various expenses. ABC is only capable of supplying and
products, a single “product cost” cannot be determined. As “instantaneous product cost” that is only valid for an
seen above, the “product cost” and therefore the “profit instant in time. It also inaccurately leads management to
margin” of any one particular product, is greatly dependent believe that increasing certain product volume directly
on the quantities and types of different products that are correlates with an increase in fixed expenses. These
being produced at the same time. The resulting product inaccuracies prevent the use of ABC to accurately predict
mix does not remain constant, but is instead constantly long term profitability.
changing. When an organization offers an infinite
combination of products in small production quantities, the Theory of Constraints (TOC)
inaccuracies involved in determining a “product cost” are This method attempts to evaluate the profitability of a
even more exaggerated. This necessitates a method of product by allocating overhead expenses to the proportion
predicting overall expenses and overall revenue generated of the organization’s constraint (or limiting activity) the
product consumes. TOC enables a company to be able to RDirect < EDirect, then RFixed = 0 and P will be negative and
evaluate long term profitability by realizing that the will equal RDirect – EDirect – EFixed.
revenues generated are constrained by 1 (or at the most, 2) Therefore, for a company to be profitable for the year,
operations or policies held by the company. This method
focuses management attention on the operation that has the RDirect = EDirect (4)
potential of making profits for the company in the future.
However, this method assumes the only expense that is So that the revenue generated by manufacturing and
directly correlated with product volume is material costs. marketing will AT LEAST cover the Direct Expenses
Consequently, this method loses some of the detailed incurred, even if very few Fixed Expenses are paid for.
accounting that is evident in the ABC model. Using equations (2), (3), and (4), equation (1) reduces
to:
Formulation of an Expense Structure
P = RFixed – EFixed (5)
The new methodology developed attempts to blend
the detailed expense analysis of the ABC technique with P is the total profit for the company. RFixed is the
the long-term profitability analysis of the TOC technique. portion of the revenue that is NOT spent on Direct
This involves evaluating the profitability of the company Expenses. EFixed is the portion of expenses (Fixed
and the contribution of individual products to that profit, Expenses) that do not change with volume fluctuations.
not attempting to determine the profit of individual From equation (5), the blended methodology now
products. attempts to insure that the revenue (over and above the
revenue that is used to pay for Direct Expenses) generated
P=R–E (1) by the company will sufficiently cover the Fixed Expenses
for the company.
P is overall Profit for an organization; R is all We first define a fair market value for the product.
Revenue received into an organization; E is the total This market value is the price that the market is willing to
Expenses incurred by the organization. Profit may be pay for the product as determined by the marketing
calculated over any specified time: Profit for one day = organization. From the market value, total revenue
Revenue generated that day – Expenses incurred that day; generated for this order is determined by multiplying the
Profit for one year = Revenue generated that year – market value for the product by the order quantity:
Expenses incurred that year.
For a sufficiently long horizon, say one year: (R) for this order = Market Value for 1 wafer x Order
Quantity (6)
E = EDirect + EFixed (2)
The first task in determining the profit of the company
EDirect are any expenses that can be directly correlated with this order in mind is to determine what portion of the
with the volume of production. This includes such items as total revenue (calculated in equation (6)) will be spent on
raw materials, chemicals, and packaging, which increase direct expenses for producing this product. We must first
linearly with an increase in quantities of product produced. evaluate the direct expenses by using ABC techniques to
EFixed are any expenses that are fixed over a period and correlate expenses with activities used to generate those
do not fluctuate with volume of production. This includes expenses.
items such as property taxes, planned capital expenditures,
and advertising, which remain constant for a given year. Calculating Direct (Variable) Expenses
Regardless of how much product is produced, these
expenses are predictable and fixed. The calculation of the Direct Expenses requires an
Similarly for the year, intimate knowledge of the manufacturing process. The
challenge is to determine the relationship between specific
R = RDirect + RFixed (3) engineering specifications and various actual expenses
within the organization.
RDirect is the portion of revenue that is used to pay for Examples of engineering specifications are
the direct expenditures incurred. RFixed is the portion of dimensions, material specifications, machining steps
revenue that is used to pay for the fixed expenditures required, assembly steps required, various manufacturing
incurred. difficulty ratings, surface finish, vendor requirements,
The model assumes the Revenue (R) generated “pays” average scrap rates, etc. These specifications can easily be
first for the Direct Expenses and then “pays” for the Fixed entered into a spreadsheet to make the repetitive
Expenses out of the remainder of the Revenues so that if calculations simpler.
 The calculation of the Direct Expenses begins with the vendor requires minimum order quantities, do not
evaluation of the expense structure of a previous year for necessarily assume that a future customer will require the
which data is available. Keeping in mind the definition of same material.
Direct Expenses as seen in equation (2) (EDirect are any The calculations for Direct Expense for an order can
expenses that can be directly correlated with the volume of be modeled using a spreadsheet program such as Excel. By
production.), tabulate expenses that fall into this category. entering specific engineering specifications, quantity
These expenses may be raw materials, predictable attributes and Direct Expenses can be calculated routinely.
consumable materials or tools, water and electricity In each case, the previous annual expense is divided by a
consumption, preventative maintenance expenses, specific activity attribute that accurately describes how the
packaging, shipping expenses, etc. Labor, either direct or expense category increases. The activity attribute chosen,
indirect, is NOT included as a direct expense. therefore, is a description of the current processes in place
Next, specific, measurable, quantity attributes are at the company.
tabulated to correspond with each of the expenses listed The result is a tabulated list of the expense incurred in
above. This information is available from current every direct expense category for a specific product
accounting and manufacturing process information. Some ordered. The total direct expense for the order is then the
examples may be pounds of material, number of machine sum of the direct expenses for each expense category plus
runs through a specific machine, number of machine hours any itemized additional expenses (such as special vendor
on a specific machine, number of holes drilled, etc. processing, etc) that may be needed. The total Direct
These production-volume-based descriptions are then Expense calculated is EDirect for this order. We now know
used to determine the total direct expenses for a specific the total Revenue (R) for this order from equation (6) and
order. For each expense item, the previous total from equation (4) we know that RDirect = EDirect. We can
expenditure for that item is divided by the previous now determine that for this order:
quantity attribute to determine an “expenditure per
quantity attribute” measure. This measure is then RFixed = R - EDirect (7)
multiplied by the “quantity attribute” required for the
specific order in question to determine the total direct In other words, the portion of the revenue that will be
expense (EDirect) for this order. spent on Fixed Expenses will equal the Total Revenue
generated by the order minus the Direct Expenses incurred
Example 1. in producing the order.
For the power used in a specific manufacturing
operation, the expense is measured in dollars per machine Calculating Fixed Expenses
hours. Because the power used in this specific operation
increases linearly with the number of hours the machine Fixed Dollars per Unit of the Bottleneck
operates, machine hours are used as the attribute to We now have the information needed to calculate the
describe this expense. Power consumption may be Fixed Dollars per Unit of the Bottleneck. Using TOC, we
determined by using engineering specifications for the have identified one specific operation as the Bottleneck or
machine. If these are not available, you may estimate the limiting operation. No matter how much product is
power consumption as follows. Say the total dollars spent ordered, the plant’s throughput will be constrained by this
on electrical power last year was $83,000. We estimate operation. Because the bottleneck limits the revenue that is
that the specific machine involved used 15% of the power able to be generated by the plant, the orders processed by
consumed by the plant. Therefore, 15% of $83,000 = the bottleneck must pay for the Fixed Expenses. The
$12,450 was spent on power to run that specific machine calculation of Fixed Dollars per Unit gives us a measure of
last year. We also know that this machine ran for 24,000 how much revenue is being generated for every unit
hours last year. Consequently, $12,450 / 24,000 = $0.519 produced by the bottleneck.
per machine hour. If we determine that the specific order The first thing is to define a Unit of production.
in question will consume 4.78 hours of this machine’s Usually, each specific product will consume a different
time, the total direct expense for power used by this proportion of the constraining operation. A Unit is defined
machine for this order will be $0.519 x 4.78 = $2.48. as a standard length of time of actual production time by
the bottleneck operation. Some products will consume less
Example 2. than one unit (easier to make), some will consume more
For the packaging of a particular order, the customer than one unit (more difficult). Regardless, the bottleneck
has requested a special container. Because we know the operation can only produce a limited number of “units” in
expense of each individual container directly, we simply a fixed time period.
calculate the direct expense by multiplying the cost of one
container (say $3.00) by the number of containers that are
needed (say 50) to arrive at $150 for this order. If the
 For the order in question: MEFixed = EFixed / 12 (10)
WEFixed = EFixed / 52 (11)
F$/U = RFixed/U (8) DEFixed = EFixed / D (12)

F$/U is the Fixed Dollars per Unit of Polishing for this MEFixed is the Average Fixed Expenses in an average
order. RFixed is the Revenue generated by this order for the Month. WEFixed is the Average Fixed Expenses in an
Fixed Expenses from equation (7). U is the total Units of average Week. DEFixed is the Average Fixed Expenses in
the Bottleneck operation for this order as determined by an average Day. D is the number of days in a year.
the engineering specifications.
Therefore, for every order placed, the Fixed For Products that Must be Processed by the Bottleneck
Dollars/Unit of the Bottleneck is calculated and tracked. From manufacturing process data, we know the total
We can then determine the Average Fixed Dollars/Unit of capacity (in “Units”) of the Bottleneck operation. We also
the Bottleneck by: know the percent of that capacity that is productively used
continually. From this, we can calculate the total capacity
AF$/U = Sum of F$ / Sum of U (9) of the Bottleneck for the year in “Units.”

AF$/U is the Average Fixed Dollars per Unit of the YC = (WC x %Ut x Y) / W (13)
Bottleneck over a specific period of time. F$ is the Fixed
Revenue Dollars Ordered which equals the Total Revenue YC is the Capacity of the Bottleneck for the year. WC
– Direct Expenses. U is the Units of the Bottleneck is the Capacity of the Bottleneck for the week. %Ut is the
Ordered. percent of the capacity that is productively utilized. Y is
The Average Fixed Dollars per Unit of the Bottleneck the number of working days in the Year. W is the number
must be updated periodically. of working days in a Week.
Similarly, we can calculate the total capacity of the
Determination of Fixed Expenses Bottleneck for a month, week, or day in Units of the
Looking at equation (5), P = RFixed – EFixed, in order to Bottleneck using similar formulas:
calculate the company’s profit (P), having RFixed from
equation (7), we only need to find EFixed. Begin by listing MC = (WC x %Ut x M) / W (14)
each of the company’s planned, fixed expenses. These do WC = (WC x %Ut x W) / W (15)
not increase or decrease with volume of production or DC = (WC x %Ut) / W (16)
product mix and they remain constant throughout the year.
Examples might be specific capital improvement projects, MC is the Capacity of the Bottleneck for the Month.
marketing and advertising, fixed supply expenses, property WC is the Capacity of the Bottleneck for the Week. DC is
taxes, direct and indirect labor, etc. the Capacity of the Bottleneck for a Day. M is the number
Included as a fixed expense is direct labor, This is a of working days in the Month. W is the number of working
diversion from both Traditional Accounting and Activity days in the Week.
Based Costing methods that treat direct labor as a direct By combining the results of Equations (10), (11), and
expense. The reality at most companies is that direct labor (12) with Equations (13), (14), (15), and (16), we can now
is a fixed expense. It does not usually vary with volume or calculate the Percent of the Utilized Capacity that is
product mix for a wide capacity range. This is especially captured by the single order in question for the year,
true for companies with “no layoff” and “no overtime” month, week, or a day.
policies. If an individual employee is idle due to a process
improvement or a product mix that bypasses one or more %TY = U / YC (17)
processes, that employee will still receive a full, 40-hour %TM = U / YM (18)
workweek of pay. Most likely, they will be moved to a %TW = U / YW (19)
different area to help out there. If for some reason, work %TD = U / YD (20)
hours are decreased for everyone because of a decrease in
available market, this needs to be reflected in the Fixed %TY is the Percent of the utilized capacity that is
Expense of labor. Likewise, if the hours are increased or captured by this order in a Year. %TM is the Percent of the
employees are added to meet increased available market, utilized capacity that is captured by this order in a Month.
the Fixed Expense of labor should be adjusted. Direct %TW is the Percent of the utilized capacity that is
labor should be calculated as a true Fixed Expense. captured by this order in a Week. %TD is the Percent of
Each Fixed Expense listed may be summed together to the utilized capacity that is captured by this order in a Day.
arrive at the Total Fixed Expense (EFixed) for the year. We U is the total Units of the Bottleneck spent on this order.
can also derive an average Fixed Expense for a month, We do not allow the Percent of the utilized capacity to
week, and day: exceed one (1.0) because the plant does have a defined
finite capacity. The revenue generated by a single order, profitable. To give an idea of how much of the total Fixed
across a period of time, cannot exceed the finite capacity Expenses should be paid by a specific order (on average),
of the organization to produce product in that period of we use the proportion of the annual Capacity of the
time. Bottleneck that the order consumes. However, the market
We may now calculate the new Average Dollars per may dictate that we accept more or less revenue for a
Unit of the Bottleneck by taking into consideration the specific order. The company must determine the selling
orders placed in the past along with the proposed order at a price of the product by looking at the demands of the
specific market value (refer to results from Equations (17), marketplace. By estimating the proportion of Fixed
(18), (19), (8), (9)): Expenses for this order (from equation (29)), and by
evaluating the Revenue generated by this order for Fixed
YF$/U = (%TY x F$/U) + ((1 - %TY) x AF$/U) (21) Expenses (from Equation (7), we get an idea of how this
MF$/U = (%TM x F$/U) + ((1 - %TM) x AF$/U) (22) order will influence the overall annual profit for the
WF$/U = (%TW x F$/U) + ((1 - %TW) x AF$/U) (23) company.
DF$/U = (%TD x F$/U) + ((1 - %TD) x AF$/U) (24) For this particular order, the estimated annual profit
may be calculated by:
YF$/U is the Fixed Dollars per Unit of the Bottleneck
averaged over a year. MF$/U is the Fixed Dollars per Unit Estimate of Profit = RFixed – EFixed (estimated) for this
of the Bottleneck averaged over a Month. WF$/U is the order (30)
Fixed Dollars per Unit of the Bottleneck averaged over a
Day. For Products NOT Processed by the Bottleneck
By multiplying equations (21) and (13) for a year, (22) To this point, calculations have been based on product
and (14) for a month, (23) and (15) for a week, and (24) that goes through the Bottleneck operation. However, there
and (16) for a day, we determine the anticipated RFixed are special ways of dealing with product that does not go
(Fixed Revenue) for a year, month, week, and day through the bottleneck. Because product that does not go
respectfully: through the bottleneck operation does not take up any of
the Bottleneck’s capacity, the additional capacity of other
For a Year: RFixed = YF$/U x YC (25) areas of the plant may be utilized.
For a Month: RFixed = MF$/U x MC (26) In considering the fixed Revenue that is contributed
For a Week: RFixed = WF$/U x WC (27) by this order, it is important to evaluate the vacant
For a Day: RFixed = DF$/U x DC (28) capacities of the other areas in manufacturing. We must be
careful not to assume that the capacities in other areas are
Now that we have calculated RFixed (Equations (25), infinite, and we do not want to create additional
(26), (27), (28)) and EFixed (Equations (10), (11), (12)) for a Bottlenecks by straining another operation. We must first
year, month, week, and day, we can easily calculate the calculate the total capacity of each other area in the plant.
profit encountered by VSI for product that must go through We then determine the percent of the capacity that is
the bottleneck on a Daily, Weekly, Monthly, and Annual actively utilized (using a Theory of Constraints
basis using equation (5), P = RFixed – EFixed. The results of perspective). We add 10% to the capacity utilized so we
these short and long term profitability calculations may be can make certain that we do not load the capacity of a non-
determined using a spreadsheet such as Excel. bottleneck operation over 90%. The reason is that for
We can now estimate the proportion of the Fixed manufacturing to continuously supply the Bottleneck
Expenses that should be paid for by this product order for operation with material, all other operations must have
the company to remain profitable. This is simply the excess capacity to feed the polishing operation in an
proportion of the Annual Capacity used by the order emergency.
multiplied by the Annual Fixed Expenses: Using equation (6) to determine the total Revenue
generated by the order, and having calculated the Direct
Estimate: EFixed Paid by this Order = %TY x EFixed for the Expenses (EDirect) for this order, we use equation (7) to
Year (29) calculate the Fixed Revenue (RFixed) contributed by this
order.
This is an estimate because it is fully negotiable. This Estimated Annual Profit may then be calculated by:
is not a Direct Expense incurred in the making of the
product; the Direct Expenses have been paid for as a part P = (AF$/U x YC x %Ut) – EFixed +RFixed (31)
of the Total Revenue produced by the product (Equations
(3) and (4)). However, VSI does have Fixed Expenses that P is the estimated Profit for the year. AF$/U is the
must be paid for somehow in the course of a year. Every Average Fixed Dollars per Unit of the Bottleneck ordered.
order placed should contribute toward the complete YC is the Annual Capacity of the Bottleneck. %Ut is the
payment of the fixed expenses for the company to be Percent of the Bottleneck’s capacity that is constantly
utilized. EFixed is the Total Fixed Expenses for the Year. surplus revenue (net revenue after paying direct expenses),
RFixed is the Fixed Revenue that is generated by this order. at least covers the Fixed Expenses planned by the
In effect, if the Bottleneck operation effectively absorbs organization. In this case, a desirable interval can be
the Fixed Expenses of the organization, excess capacity in created around the average Fixed Expense (Equation (29))
other areas of the plant can be utilized. After subtracting to insure the company receives a profit. The marketing
off the Direct Expenses incurred by these orders, the representative can quickly evaluate the desirability of the
revenues generated by this excess capacity go directly to market value for the product by evaluating how far above
the bottom line profits of the organization. or below the average Fixed Expense is being paid by this
This methodology, accurately predicts both short and order. This desirability measure can be determined by
long term profitability by taking into account management to include a sliding profitability scale, which
requires smaller order quantities to contribute more profit
The process specifications for a specific order than larger order quantities. This sliding scale will give the
The characteristics of the “average” order customer incentive to order larger order quantities as a
The manufacturing performance capabilities method of filling manufacturing capacity.
The capacity and yield in each manufacturing area Each of these methods give marketing flexibility in
The monetary performance of the plant in the past quoting customers a price for the product. There is not a
The predicted fixed expenses for the next year fixed price determined by a fictitious “product cost.”
Instead, there is a price range, within which the desired
When given the above information, a spreadsheet such market price should fall for the product to contribute
as Excel can be created to accurately evaluate the positively to profits. Management defines a desired profit
individual product for their contribution to company profit threshold while allowing marketing the flexibility of
and then predict the company’s resulting daily, monthly, offering prices that meet minimum, but acceptable
and annual profit. The approach has been adapted for profitability. In this way, marketing has the flexibility to
standard as well as non-standard product configurations. offer prices at just at or above the Direct Expenses
The spreadsheet can determine the estimated proportion of incurred by the product, in order to gain market presence,
Fixed Expenses that should be compensated in the while keeping in mind that other products must cover the
manufacture and sale of this order. Finally, the creation of Fixed Expenses for the organization.
such a spreadsheet enables quick tabulation of individual This methodology also allows for aggressive
expenses incurred in every expense outlet of the company, competitive pricing on products that do not go through the
allowing for a detailed Pareto analysis of expenditures. bottleneck operation. Excess capacity can be sold cheaply
to gain market share in specialty markets while large
Using the Profit Calculation portions of the revenues generated contribute directly to
the bottom line profits of the organization (Equation (31)).
There are a couple of ways to approach the Profit
calculations found in equations (30) and (31). One is, Application Examples
based on the predicted expenses for the company, establish
a goal for the profit in dollars. By updating the average Virginia Semiconductor (VSI), a manufacturer of
Fixed Revenue for incoming orders regularly as well as custom silicon products for the microelectronics industry,
maintaining current process performance data, the uses this methodology to make strategic marketing, sales,
predicted Revenue should be fairly accurate. The goal for engineering, and production decisions. VSI uses an Excel
both marketing and manufacturing would then be to spreadsheet to perform the calculations presented in this
maintain a predicted Profit of greater than or equal to the paper. Custom-engineered specifications are entered into
target value. the spreadsheet by marketing, sales, and engineering
The other method for approaching Profit calculations associates. The Excel spreadsheet then calculates specific
is to evaluate the acceptability of each individual order by data regarding revenue, expenses, profitability, lead times,
establishing rules and guidelines for acceptable Fixed and engineering data. Sales, engineering, and production
Revenue. The Fixed Revenue for a particular order is managers manipulate these calculations, based on current
found in equation (7). Using equation (29), we find the process parameters determined by the use of statistical
average Fixed Expenses that must be paid for such orders. tools, to evaluate the effectiveness of proposed decisions
On average, the Fixed Revenue generated during the year and to pinpoint areas of continuous improvement. Through
must more than offset the annual Fixed Expenses for the the use of this spreadsheet tool, several strategic business
company to report a profit. For this particular order, the strategies have been developed.
only requirement is that the Revenue generated by the One of the first strategic initiatives involved a
order cover the direct expenses. Marketing has the streamlining of the sales process. Because VSI’s product
flexibility of offering a product price that is higher than the involves custom specifications, foreign distributors needed
direct expenses, as long as, over the course of the year, the to obtain a quotation for price and delivery on a specific
product order from a marketing manager located at the The methodology and resulting spreadsheet
Virginia, USA manufacturing location. This quotation calculation tool allows marketing management to asses the
would then be sent to the end user for final approval. Any current market price for a specific product for a
negotiation on price or delivery needed to go through both contribution to company profitability; either short or long
the foreign distributor and the marketing manager in term. The approach calculates expected profitability based
Virginia. To streamline the sales process, each distributor on volume and the custom specifications requested by the
was e-mailed a copy of the spreadsheet tool. Now, within customer. Marketing management can evaluate the effect
predetermined limits, a distributor can quote and negotiate of marketing expenses on immediate short-term
directly with the end customer with full confidence that the profitability, while having the flexibility of allowing price
price that is determined for the custom product will be concessions designed to break into markets with long-term
acceptable by VSI. Consequently, the selling process time potential. Marketing is given the flexibility to accept a
has been shortened and the distributors feel they have more market price for a particular product as long as the
control over the negotiation process. Revenue generated by the order covers the Direct
Marketing was then able to evaluate the consequences Expenses, keeping in mind that Fixed Expenses must be
of aggressively pricing certain product configurations. By compensated in the long term.
evaluating various scenarios using the spreadsheet tool, a The approach also allows manufacturing management
strategic plan was developed to price certain products at to assess the current manufacturing practices as they relate
just above the direct expense involved in making the to business expenses. Using the resulting spreadsheet,
product. These extremely competitive prices are used to manufacturing management can easily see the impact of
break into difficult markets and to gain market advantage individual improvements in capabilities, performance, and
within certain market segments. After gaining the quality (yield) on company profit by adjusting process
confidence of new customers, other products can be formulas and values to fit various hypothetical scenarios.
marketed that will cover both the direct and fixed By determining the largest contributors to profitable
expenses. manufacturing, opportunities and expense reductions will
Manufacturing also used the spreadsheet tool to effect company profitability. Projected improvements to
improve performance. By adjusting various process the manufacturing process can be properly assessed while
outcomes within the spreadsheet, management determined evaluating the long-term profitability of the company.
that currently capacity improvements affect profits more The approach (especially in a spreadsheet format)
important than yield and scrap improvements (due to the proves to be flexible, allowing for adaptation to business
high quality yield and low scrap). By evaluating high and market changes. As the business and market matures
demand product configurations using the spreadsheet tool, and develops, the corresponding economic changes can be
critical areas to improve the bottleneck capacity were reflected in the numerical data input to the spreadsheet.
determined. Strategic improvement teams were assigned Assumptions and realities of business practices are simply
various performance initiatives, resulting in a 30% changed by adjusting the process calculation formulas, and
improvement in organizational capacity. the corresponding profitability outcome is quickly and
Currently, efforts are being made to reduce expenses accurately described. Short-term changes in process
across the organization to improve the competitive position capabilities and performance are made as often as weekly,
of VSI. To measure and track progress toward this while long term changes in large budgetary items are made
mission, several representative product types are being on an annual basis.
tracked using the spreadsheet tool. The fixed and variable By formulating this new methodology in the format of
expenses attached to these wafer types are tracked a spreadsheet, the approach is designed to facilitate the
periodically. Changes to the expected expenses are evident cooperation of manufacturing and marketing to
as important process parameters are improved and updated strategically work toward the profitability of the company.
in the spreadsheet tool. The matrix of direct expenses gives As revenue and expenditure information is assessed on the
a Pareto evaluation of the main contributors to the expense product level, the developed approach will motivate
involved in producing the product, which is used to target marketing to exploit the appropriate market opportunities.
areas of improvement. Marketing will be able to informatively take full advantage
of products that contribute greatly to the profitability of the
Discussion and Conclusions company while confidently negotiating for valuable Fixed
Revenue to offset the company’s Fixed Expenses.
A new, comprehensive methodology has been Likewise, with the motivation of the profitability of the
developed using applicable principles from Activity Based company at stake, manufacturing will exploit the
Costing and Theory of Constraints, customized for a efficiency, quality, and productivity of the manufacturing
specialty market and manufacturing niche and intended to system. Manufacturing will accurately evaluate the major
assist in the evaluation of current market prices and contributors to both profit and loss, and can target
production capabilities to insure long term profitability. continuous improvement toward gaining the greatest
benefits. The marketing and manufacturing functions can
now more clearly see how the complex interaction
between the two groups works together toward making the
company profitable. Together, marketing and
manufacturing functions will be motivated to develop new
technology, capabilities, and markets to enhance
profitability. The development of this hybrid approach to
profitability assessment will strategically be used as a tool
for continuous improvement efforts.

Bibliography and Suggested Reading

Canada, John R., et al. Capital Investment Analysis for
Engineering and Management. NJ, Prentice Hall, Inc.,
1996.
Goldratt, Eliyahu M. The Haystack Syndrome, Sifting
Information Out of the Data Ocean. NY, North River
Press, 1990.
Goldratt, Eliyahu M. Theory of Constraints. MA, North
River Press, 1990.
Harrison, David S., William G. Sullivan “Activity-Based
Accounting for Improved Product Costing.” Engineering
Valuation and Cost Analysis. Volume I, pp. 55-64.

Biographical Sketch
Brad Miller is currently the senior manufacturing
engineer for Medeco Security Locks, a manufacturer of
high security locks for the retail and business industries.
He has 7 years experience in managing, improving, and
streamlining both manufacturing and business processes.
His areas of experience include metals fabrication, plastics,
assembly, chemical processes, machining, sales, and
engineering. He has effectively utilized plant layout and
process redesign techniques to double productivity. His
strategic implementation of Theory of Constraints
methodology resulted in reduction of work in process by
90%, reduction in cycle time by 77%, improvements in on-
time delivery from 70% to 99%, and a 23% increase in
manufacturing capacity. His experiences in strategic
business planning and statistical methods enhance
continuous improvement on both the corporate level and
the shop floor.
Mr. Miller received a BS in Mechanical Engineering
from Virginia Tech and the Master of Engineering
Administration degree from the Industrial and Systems
Engineering Department at Virginia Tech. He is a member
of the Institute of Industrial Engineers and the American
Society for Quality. Brad may be contacted at
bradmiller_ie@hotmail.com.