Page 113 - The Handbook for Quality Management a Complete Guide to Operational Excellence

100 I n t e g r a t e d P l a n n i n g S t r a t e g i c P l a n n i n g 101

Inventory/Investment certainly includes the materials that the company
will turn into finished products or services. But it also includes the assets
of a com pany, which are eventually sold off at depreciated or scrap value
and replaced with new assets. This is even true of factory buildings them-
selves. However, for day-to-day decisions, most managers consider “I” to
represent the con sumable inventory of materials that will be used to
produce finished products or services.
Operating Expense (OE) is defined as all the money the system spends
turning Inventory into Throughput. (Goldratt, 1990, p. 29). Notice that
overhead is not included in the Throughput formula (or the definition).
Overhead, and most other kinds of fixed costs, are included in Operating
Expense. Constraint management measurements delib erately segregate
fixed costs from the Throughput calculation for a valid reason: allocating
fixed costs to units of product sold produces a distorted concept of actual
product costs in most day-to-day situations.
For example, let’s say you’re a small manufacturer of precision-
machined parts. You’re working on an order for 100 units of a particular
part for an orig inal equipment manufacturer. In the middle of this run, the
customer calls and asks you to add 10 more units to the order. This will
increase your pro duction time by 53 minutes. How much more have these
additional 10 units cost you? As long as you’re not backlogged with work,
the cost of the extra units is the value of the raw materials alone! You
didn’t pay any more in salary to the machine operator (he or she works by
the hour, not by the piece). In most cases you wouldn’t pay any more in
electricity costs. You have to turn the lights on for business for the whole
day anyway. And the cost of the general manager’s company car didn’t
change just because you produced 10 addition al units of the product. The
real cost of the increase in production volume is limited primarily to the
cost of materials alone.
Labor costs are also considered an Operating Expense, because in
almost all cases they are paid by some fixed unit of time, not by the indi-
vidual unit of product produced. We pay people by the hour, week,
month, or year, whether they are actively producing a product for sale or
not. Moreover, the capacity to produce a product or service (the resources:
people, facilities, equipment, etc.) is obtained in “chunks.” It’s really dif-
ficult to hire six-tenths of a person, or to buy three-quarters of a machine.
So the expenditure of cost for capacity usually comes in sizeable incre-
ments—a step function. Products, on the other hand, are normally priced
and sold by the unit—smaller steps, perhaps, but closer to a continuous
function. All this makes it difficult to attach an accurate allocation of fixed
costs to a unit of product. Which means that those who do so obtain a dis-
torted impres sion of product costs—not a good basis from which to form
operating deci sions.

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