 Hello, and welcome to this session. This is Professor Farhad in which we would look at the theory of constraint. This topic is usually covered in cost accounting as well as managerial accounting. As always, I'm going to remind you to connect with me on LinkedIn, YouTube, subscribe to that channel. If you haven't done so, I have 1800 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people and check out my website farhadlectures.com for additional resources for this, as well as your other accounting and finance courses. So the goal of any company is to sell as many products as you can produce. And hopefully this makes sense. And if you can do so, that's your achieving your objective. Sometime you might experience some sort of a bottleneck or some constraint that's going to slow you down, that's going to limit your capacity to produce. Well, think of the, why do we call it bottleneck? Think of this bottle that's upside down and we're trying to get the M&Ms out of these two bottles. Notice this bottleneck is larger than this one. So the M&M, you can fill out this jar faster than this jar because your bottleneck is larger. Here your bottleneck is smaller, therefore you come to a standstill. So something is limiting your production. Same thing as if you have a traffic and you have three lanes that goes into a one lane, this is another bottleneck. So something is slowing down traffic. Otherwise things should be moving fast. So anything that limits your production or the ability to produce is called a constraint or a bottleneck. And that could be labor. You don't have enough specialized labor, time, you don't have enough time, material, machine hours, any other production resource that will limit you. So what are your choices when you have constraint, when you have bottleneck? How should you produce? Well, you should produce, the general rule, you should produce and sell the unit with the highest contribution margin and students forget about the other side of this per constraint resources. So what you have to do first is to identify what is my issue? What is my bottleneck and my production? Then I have to use the contribution margin per the highest constraint resource. And we'll see what that means in a moment in an example. And in this theory, we use the term throughput contribution. Basically throughput contribution is sales minus variable cost, which is contribution margin. The best way to illustrate this is to actually work an example. So let's take a look at this example. We have outdoor luggage, makes high end hard sided luggage for sports equipment, data concerning three of the company's most popular model. And here they are. We have ski guard, we have golf guard, and we have fishing guard. And let's take a look at the selling price per unit, 200, 300, 255, the variable cost per unit, $60, 140, and 55. Now obviously, once you have sales and variable cost, you can always compute the contribution margin. So this is 260 and this is 200. Just basically, that's what you should be thinking about every time you are, you see sales minus variable cost. Now, what do we need to produce those hard sided luggage? We need plastic injection molding machine processing time. And here's what we need, what we know about those plastic injection molding machine hours. The time required on the ski guard, you need two minutes of those. You need two minutes to produce the ski guard. You need five minutes for the golf guard, and you need four minutes for the fishing guards. You also need pounds of plastic pellets per unit. You need seven pounds for the ski guard. You need four pounds for the golf guard, and you need eight pounds for the fishing guard. So this is basically, those are the resources, your factors of production to manufacture those hard sided luggage. So let's take a look at the first scenario. The total time available on the plastic injection molding machine is the constraint in the production process. So what we did is we identified that we don't have unlimited amount of this. Which product would be most profitable, most profitable use of this constraint? So assuming this is the constraint, which one is the most profitable? So what should you produce of the most? And which product will be the least profitable using this constraint? Obviously, because we have three products, we can identify the most profitable as well as the least profitable. So what do we need to do? First, we have to compute the contribution margin per unit. And we already kind of did this. We said the 200 minus 60 is 140. I believe I did this incorrectly. It's 160, not 260. 255 minus 55 is 200. So first you find the contribution margin per unit. Now don't jump and say, well, this is my highest contribution margin because this is what students do on my exams. They would say, well, you told us it's the highest contribution margin per unit. But that's not the answer. You have to find the highest contribution margin per unit of the constraint resource. So what is the constraint resource here is the hours on this, well, the time on this plastic injection molding machine. So let's take a look at this. Again, for the ski guard, you will need two minutes, five minutes, and four minutes. Now what you do is you find this contribution margin per unit per for the of the constraint resource. What you do is you will take the dollar amount unprofit, you'll divide it by two minutes. And you are making seven on minute time, your minute is worth $70. So if you use those minutes to produce ski guard, each minute is technically contributing $70 to your contribution margin. Here, if you'll take 160 divided by five, so 160 divided by five, it's the minute using this machine for the golf card is $32 per minute. And for the fishing guard, we'll do the same thing, 200 divided by five, it's $50 per minute. Now, which one is the most profitable machine? So what should you do if you have limited amount of minutes? What should you do? Should you should you focus on producing fishing guard, golf guard or ski guard? Well, if you have limited amount of minutes, what you should do is you should produce as many as possible of the ski guard. Why? Because every minute spent on the ski guard is contributing $70 to your contribution margin. You have the highest contribution margin per unit of the constraint resource. Now, obviously, if I ask you which one is the least, well, the golf guard is the least. So first produce as many ski guards as you can and sell as many as as much as you can, then produce fishing guards as many as you can until you run out of the resources for this, then you produce the golf guard. If the plastic injection molding machine processing time is your constraint resource. Okay, let's take a look, let's change the scenario a little bit and let's assume we have a severe shortage of the plastic pallets. So remember here, we need those plastic pallets to go into our luggage. And the severe shortage has required the company to cut back its production so much that the plastic injection molding machine is no longer the bottleneck. So this is no longer the bottleneck. The bottleneck now is the pound of plastic pallets per unit. So now we switch the constraint resources to the plastic pallets. Assuming that's the case, which one is the most profitable use of this constraint resource and which product would be least profitable use of this constraint? Well, so the constraint resource here is the pounds of plastic pallets. We're going to do the same thing. We're going to first compute the contribution margin per each product. Then we're going to find the contribution margin per constraint resource. Same thing. We're going to take $170 divided by seven pounds. And it's given us $20 per pound for the golf guard. It's given us $40 per pound. And for the fishing guard, it's given us $25 per pound. So what should you produce the most if you have a limited amount of pallets to make the maximum profit? I would produce the golf guard. Why? Because it's given me the most per the constraint resource. So I'm constraint resource. So if that's my constraint resource, the first thing I do, I produce as much possible of the golf guard, then I'll produce as much as possible of the finished guard, then I'll, whatever's left, I'll produce ski card. So this is how you would use those limited resources in your production facility. Now notice here is the highest contribution margin was $200. Now why we never chose the fishing guard as the first option? Well, it has the largest contribution margin, but it's not the most profitable use of the constraint resource. Well, if you have plenty of resources, then yes, if we have unlimited resources, we should focus on producing and selling as many fishing guards as possible, because it's going to give us the highest margin. But we don't have that option. Our resources are limited, therefore we have to produce the highest contribution margin per constraint resource. So the highest contribution margin in proportion to its contribution than the other two product. In other words, more of the other product can be produced for a given amount of the constrained resources, and this more then makes up for the lower contribution margin. Once we maximize our contribution margin per the constrained resource, then we move on to the second level, then to the third level. And if we don't have any more resources, that's fine. We made the most of our resources. As always, I'm going to ask you to like this recording, share it, put it in a playlist, and don't forget to visit my website farhatlectures.com for additional resources for this course, as well as your other accounting, finance, and CPA exam need. Good luck, study hard, and stay safe.