Question

(Theory of Constrainst)
Remember: effectively managing restricted resources in the production area of a company is key to increasing profits. When there is a limited resource production, you can increase profit by producing the article having the highest margin of contribution of the restricted resource or can be increased in different ways the operational capacity of the constrained resource (changes in work shifts, work overtime, etc.)
He argues with an example of a restricted resource in the production of some product and at least one alternative to manage the restricted resource that generates an increase in the profits of the company.

Answer 1

Let us consider an example of a company producing two products say Horlicks and Boost.

Particulars	Horlicks($ per unit)	Boost($ per unit)
Selling price	100	80
Material(Flour) @$.2 per Kg	20(i.e.,10kgs to make 1unit)	10(i.e.,5kgs to make 1unit)
Labour @$.3 per hour	15	30
Variable overheads @$.4 per machine hour	40	16

Here Flour is a common material used for the production of both Horlicks and Boost.

Considering a situation of shortage in the supply of aw material (Flour) which being a common resource. Now the profitability of the company depends upon how efficiently the company utilizes this raw material (Flour) for the production of its products in such a way that the contribution per raw material gets maximized.

Considering the above example,

Let us first ascertain the contribution per raw material in both the cases.

{Here contribution being the difference between selling price and all the variable cost incurred for the production of a product and

Fixed cost remains the same irrespective of any level of output, so it can be ignored in our analysis.}

Particulars	Horlicks($ per unit)	Boost($ per unit)
Selling price	100	80
(Less) Material	(20)	(10)
(Less) Labour	(15)	(30)
(Less) Variable overheads	(40)	(16)
Contribution per unit	25	24

Here prima facie we will rush into a conclusion that it will be profitable for the company to produce more of horlicks than boost since its contribution per unit of final product (horlicks) is more than Boost.

By continuing the above example let us consider that the company has limited stock of flour of 1000kgs for producing both the products.

Let us make an analysis if the company gets engaged in the production of wholly

1. Horlicks
2. Boost

Particulars	Horlicks	Boost
A. Total raw material available for production	1000kgs	1000kgs
B. Raw material required per unit of final product (as per the above table)	10kgs	5kgs
C. Total units that can be produced (A/B)	100 units	200 units
D. Contribution per unit	Rs.25	Rs.24
E. Total contribution ( C*D)	$ 2500	$ 4800

Even though the contribution per unit of horlicks is greater than that of Boost, the overall contribution gets maximized only with the production of Boost rather than horlicks.

The erroneous conclusion reached in the first case is because of ignoring the fact that there is a resource constraint (Raw material - Flour), To reach at a wise, logical decision we should also consider the effect of the shortage of the raw material. This can be done by taking Contribution per unit of raw material as base instead of contribution per unit of final product.

                                                                            Horlicks                        Boost

Contribution per unit of raw material               $ 2.5(25/10kgs)           $4.8 (24/5kgs)

Thus when there is a limiting factor in the production process, the profitability of the company can be maximized by producing the article having the highest margin of contribution of the restricted resource (i.e., Flour in our case).

[Here we have assumed flexibility in terms of availability of the other factors of production]