Synchronous Management Principle 4: The Marginal Value of Supply Chain Disruptions | Operational Excellence Quick Hits

Speaker 1: (00:05)
In today’s session we’re going to continue on the concept of synchronous management. The next principle that we’re going to discuss is principle number four, which talks about the marginal value of constrained material.

Speaker 1: (00:18)
If your organization has trouble getting materials from the suppliers, and that’s the case a lot today with the issues with supply chain, and if that constrained material is what’s limiting your throughput of your organization, what’s that worth to the organization? The statement here is, “The marginal value of the constrained material is equal to the purchase price of the constrained material plus the throughput value of the finished product requiring this material.” Let’s dive into that concept a little bit deeper.

Speaker 1: (00:49)
Again, what is the throughput rate? It’s the rate which the organization generates value added through sales. What is the value added? It’s the selling price minus the totally variable costs. Of course, material makes up one of the totally variable costs so if that becomes a constraint, how do we look at that from an organizational perspective? Again, totally variable costs are not insignificant costs that increase as a result of producing an additional unit. Of course, each additional unit that requires material, especially if it’s constrained material, what’s that worth?

Speaker 1: (01:22)
Again, our four elements of totally variable costs are materials, outsource processes, sales commission, and freight. If we look at a synchronized system, even with a synchronized system that has unbalanced capacity to achieve balanced flow, we have a capacity constrained resource which is the resource with the least amount of capacity in that value stream. In this case, we’re talking about material that is the constraint so coming into the process our raw material becomes a constraint. That becomes the most valuable resource for the organization.

Speaker 1: (02:04)
What is that margin value of constraint material worth? The marginal value looks at the increased amount of the value that can be achieved by providing an additional source of output. To achieve that additional source of output, of course we need an additional source of input of material. In the case of marginal value material, the loss is the sales revenue for the organization for that item that the material goes into, because it’s the purchase price of the constrained material plus the throughput value of that finished product. The throughput value of the product, plus the material cost, makes up the majority of your selling price so that’s what we want to look at here.

Speaker 1: (02:45)
It’s like lost sales for the organization. Where can material loss come from? There’s multiple sources that we can lose material. The first obvious one is if we scrap material. If we scrap a product that has the constrained material in it, we lose the cost of that material plus the sales revenue value of that item that’s scrapped, which is significant. We also can lose material from over productions. If we’re producing more than what we need in the short horizon, then that material, doesn’t do us any good to have that material sitting in finished goods or sitting in whip someplace because that’s what’s limiting our throughput.

Speaker 1: (03:28)
Another place, it can be stealing. I’m not talking about employees taking material home, we allocate the material that’s dedicated for one product and we steal it and we allocate it to another product to increase the bat size, and that contributes to over-production also. Another way would be downgrading a product so we have constrained material, we produce something that doesn’t meet specifications and we downgrade that to a lesser value product. Another one is with substitute for another material so we have the constrained material and we actually substitute that for another product. That material that we substitute is the constrained material, which is another huge loss for the organization. If your organization has issues with any of these, scrap, overproduction, stealing, downgrading, substitutions, then if you have supply chain issues that’s having huge negative effects on your business and your profitability.

Speaker 1: (04:30)
That’s our session for today. When we look at constrained material that has significant impact on the organization, much more than a constrained resource internal to the company. Our next session next week is going to talk about marginal value of sales order in a constrained market, so when we have the constraint in the market, what’s that worth to the organization? In this case, it’s equal to the throughput value of that order.