EFFECT OF BOTTLENECKS IN PRODUCTION

LINES ON DECISION MAKING IN FINANCE

A PROJECT REPORT

Submitted by
Rahul R. Nakhe
Roll No. 2542

NAME OF THE GUIDE
CA Madhura Ranade
in partial fulfillment for the award of the degree
of
MASTER OF BUSINESS ADMINISTRATION
In
FINANCE MANAGEMENT


DEPARTMENT OF MANAGEMENT SCIENCES
UNIVERSITY OF PUNE
MAY 2012-14

UNIVERSITY OF PUNE
BONAFIDE CERTIFICATE
Certified that this project report EFFECT OF BOTTLENECKS IN
PRODUCTION LINES ON DECISION MAKING IN FINANCE is the
bonafide work of RAHUL R. NAKHE who carried out the project work under
my supervision.




CA Madhura Ranade
PROJECT GUIDE
DEPARTMENT OF MANAGEMENT SCIENCES
UNIVERSITY OF PUNE
GANESHKHIND, PUNE - 411 007



Dr. (Capt.) C. M. Chitale
PROFESSOR & HEAD
DEPARTMENT OF MANAGEMENT SCIENCES
UNIVERSITY OF PUNE
GANESHKHIND, PUNE - 411 007



External Examiner

ACKNOWLEDGEMENT

I have great pleasure in submitting this project report entitled Effect of
Bottlenecks in Production Lines on Decision Making in Finance to the
University of Pune.
I would like to sincerely thank my guide CA Madhura Ranade for her time to
time guidance & inputs that added value to the contents of the project.



Rahul R. Nakhe
Roll No. 2542
Department of Management Sciences
(PUMBA)
University of Pune

i

TABLE OF CONTENTS
CHAPTER
NO.
TITLE PAGE
NO.
ABSTRACT ii
LIST OF TABLES iii
LIST OF FIGURES iv
1 INTRODUCTION 1
1.1 Production Line 1
1.2 Bottleneck 1
1.3 Decision Making by Finance 2
1.4 Challenges 3
2 VIABILITY OF NEW PRODUCTS 4
2.1 Case study 4
2.2 Assumptions and Basic Data 5
2.3 Product Cost calculation with no bottleneck effect 6
2.4 Effect of bottleneck on Product Cost 7
2.5 Efficient way for Product Cost 8
2.6 A word on Batch Size 8
2.7 Profit with Carrying Cost 10
3 CAPITAL INVESTMENTS 12
3.1 Case Study 12
3.2 Case I 13
3.3 Case II 13
4 MAKE OR BUY DECISIONS 15
4.1 Case Study 15
4.2 Case I 16
4.3 Case II 16
5 CONCLUSION 18
REFERENCES 19

ii

ABSTRACT
This project suggests improvements in traditional ways of decision making by
Finance. In firms where products are manufactured on Production Lines (Set of
Sequential Operations), Finance needs to evaluate following types of proposals
to give a decision whether to go ahead or not.
Viability of New Products by calculating product cost.
Investment in Equipment (Capital) by performing cost saving calculations
Make/Buy Decisions by comparing purchase price to internal cost
Suggested approach takes holistic view towards this evaluation and also
recognizes the fact that every Production Line has a bottleneck operation which
limits its production capacity.
iii

LIST OF TABLES
TABLE NO. DESCRIPTION PAGE NO.
TABLE 1 Raw Material Cost 5
TABLE 2 Process Data 5
TABLE 3
Processing cost for individual processes with no
bottleneck effect
6
TABLE 4 Total Cost with no bottleneck effect 6
TABLE 5 Processing cost with bottleneck effect 7
TABLE 6 Total cost with bottleneck effect 7
TABLE 7 Efficient way of calculating Product Cost 8


iv

LIST OF FIGURES
FIG. NO. DESCRIPTION PAGE NO.
FIG 1 Production Line 1
FIG 2 Production capacity of individual processes 1
FIG 3 Production capacity of the Production Line 2
FIG 4 Process Flow for Product P 4
FIG 5
Graph of Product Cost per unit without considering
carrying cost
9
FIG 6
Graph of Product Cost per unit considering carrying
cost
10
FIG 7 Graph of Product Cost per unit and Profit per unit 11
FIG 8 Process Flow and Process Data for Product P 12
FIG 9
Process Flow and Process Data for Product P
(Reproduced)
15


1.1 Production Line:
A lot of products are made on Production Lines all over the world. Production
Lines are characterized by sequence of processes wherein raw material for the
product gets processed in a stepwise manner to make the finished product
shown in Fig. 1. E.g. furniture, automobiles, TVs, washing machines, etc.
Fig 1. Production Line
Every process in this sequence has some rate of production. Some processes are
fast, some are slow as shown in Fig. 2
Fig 2. Production capacity of individual processes
1.2 Bottleneck:
The slowest process in the sequence is called bottleneck process
RED in Fig. 3. The production rate of this bottleneck process
rate at which products are manufactured.
1. Introduction
A lot of products are made on Production Lines all over the world. Production
Lines are characterized by sequence of processes wherein raw material for the
product gets processed in a stepwise manner to make the finished product
furniture, automobiles, TVs, washing machines, etc.
Every process in this sequence has some rate of production. Some processes are
as shown in Fig. 2.
Production capacity of individual processes
The slowest process in the sequence is called bottleneck process
. The production rate of this bottleneck process determines the
rate at which products are manufactured.
1

A lot of products are made on Production Lines all over the world. Production
Lines are characterized by sequence of processes wherein raw material for the
product gets processed in a stepwise manner to make the finished product as
furniture, automobiles, TVs, washing machines, etc.

Every process in this sequence has some rate of production. Some processes are

The slowest process in the sequence is called bottleneck process (highlighted in
determines the
Fig 3. Production capacity of the Production Line
Another aspect of having a bottleneck operation in production line is non
bottleneck operations cannot be utilized to their fullest capacity.
This is in contrast with working at best efficiencies in order to get back
maximum returns. The return on investment will occur earlier when machines
will be used for a maximum amount of time (e.g. 24 x 7). However, i
bottleneck machines are run to their fu
not increase. But, WIP will increase to a large extent locking up money.
illustrated in the examples taken later.
1.3 Decision Making by Finance:
For these kinds of Production Lines,
proposals to give a decision whether to go ahead or not.
Viability of New Products: It is decided by calculating manufacturing
cost of the product and comparing it with its selling price (profitability).
Investment in Equipment (Capital)
by performing cost saving calculations and comparing these cost savings
with price of the equipment.
Make/Buy Decisions
between the price to buy from outside and the cost
internally.
Production capacity of the Production Line
Another aspect of having a bottleneck operation in production line is non
bottleneck operations cannot be utilized to their fullest capacity.
s in contrast with working at best efficiencies in order to get back
The return on investment will occur earlier when machines
will be used for a maximum amount of time (e.g. 24 x 7). However, i
bottleneck machines are run to their fullest efficiency, output of products will
, WIP will increase to a large extent locking up money.
illustrated in the examples taken later.
Decision Making by Finance:
For these kinds of Production Lines, Finance evaluates following types of
proposals to give a decision whether to go ahead or not.
Viability of New Products: It is decided by calculating manufacturing
cost of the product and comparing it with its selling price (profitability).
Investment in Equipment (Capital): This is judged to be profitable or not
by performing cost saving calculations and comparing these cost savings
with price of the equipment.
Make/Buy Decisions: These are based on the output of comparison
between the price to buy from outside and the cost of making the same
2


Another aspect of having a bottleneck operation in production line is non-
bottleneck operations cannot be utilized to their fullest capacity.
s in contrast with working at best efficiencies in order to get back
The return on investment will occur earlier when machines
will be used for a maximum amount of time (e.g. 24 x 7). However, if non-
llest efficiency, output of products will
, WIP will increase to a large extent locking up money. This is
following types of
Viability of New Products: It is decided by calculating manufacturing
cost of the product and comparing it with its selling price (profitability).
: This is judged to be profitable or not
by performing cost saving calculations and comparing these cost savings
: These are based on the output of comparison
of making the same
3

Generally in large organizations, Engineering helps Finance to arrive at proper
calculations by providing correct technical data. However, in organizations
where no Engineering department is there, the improvements suggested will
help in decision making.
1.4 Challenges:
While taking decisions on these proposals, Finance is posed with the following
challenges.
1. The data on which these calculations are based is not accurate. E.g. setup
time and cycle time for machines and equipments.
2. The calculation process is tedious and slow.
3. The calculations are based on a mix of products which keeps on changing
depending upon the forecast.
Let us consider these scenarios one by one.

2.
2.1 Case study:
Let us consider a factory with following description.
1. Production begins with two raw materials AA and BB.
2. Raw material AA is processed through processes A, B, C and D.
3. Raw material BB is processed through processes E, F, G and H.
4. Then they are assembled together
processes I, J and K to make finished product P.
like Fig. 4 as shown below.
Fig 4. Process Flow for Product P
2. Viability of New Products
consider a factory with following description.
Production begins with two raw materials AA and BB.
Raw material AA is processed through processes A, B, C and D.
Raw material BB is processed through processes E, F, G and H.
Then they are assembled together with bought out parts X and Y through
processes I, J and K to make finished product P. The process flow looks
as shown below.
. Process Flow for Product P
4

Raw material AA is processed through processes A, B, C and D.
Raw material BB is processed through processes E, F, G and H.
with bought out parts X and Y through
process flow looks

5

2.2 Assumptions and Basic Data:
1) All resources work 8 hours a day, 6 days a week.
2) The factory has similar other products to fill its remaining capacity.
3) There is no scrap.
4) The machine hour rates indicated include labor costs, consumables and
overhead costs.
5) Setup time is negligible.
6) Unit for money is Rs unless otherwise stated.
Let us assume following data for Product P to arrive at Product Cost. Raw
material cost is in Table 1 and Process Data is in Table 2.
Cost
Raw Material AA 12
Raw Material BB 15
Part X 3.5
Part Y 4
Table 1. Raw Material Cost
M/c Hr Rate Pcs/Hour
(Rate) (Pcs)
Process A 2000 1200
Process B 3500 720
Process C 3000 850
Process D 2000 900
Process E 2000 1200
Process F 4000 1800
Process G 3500 850
Process H 2500 900
Process I 1500 1000
Process J 1000 1050
Process K 1000 1050
Table 2. Process Data


6

2.3 Product Cost calculation with no bottleneck effect:
With the above data, processing cost looks like the Table 3 shown below.
Processing Cost per unit is calculated as
Proccssing cost pcr unit =
Hocinc Eour Rotc
Picccs pcr Eour

M/c Hr Rate Pcs/Hour Cost/Pc
(Rate) (Pcs) (Rate/Pcs)
Process A 2000 1200 1.67
Process B 3500 720 4.86
Process C 3000 850 3.53
Process D 2000 900 2.22
Process E 2000 1200 1.67
Process F 4000 1800 2.22
Process G 3500 850 4.12
Process H 2500 900 2.78
Process I 1500 1000 1.50
Process J 1000 1050 0.95
Process K 1000 1050 0.95
Table 3. Processing cost for individual processes with no bottleneck effect
Total cost is as shown below in Table 4.
Cost with Theo O/P
Raw Material AA 12
Raw Material BB 15
Process cost AA 12.28
Process cost BB 10.78
Part X 3.5
Part Y 4
Assembly cost 3.41
Total cost 60.97
Table 4. Total Cost with no bottleneck effect
At a Sales Price of 70 Rs/unit, there is 14.8% of Profit. Please note here that in
order to get these outputs from individual processes, a lot of raw material will
have to be introduced on line and it will land into an enormous pile of WIP.
7

2.4 Effect of bottleneck on Product Cost:
Let us now consider the effect of Bottleneck. Because of bottleneck, even
though non-bottleneck processes have more outputs individually, the output of
the line will be limited to that of the bottleneck process. In this case, process B
is the bottleneck process with an output of 720 pieces per hour. So line output is
also 720 pieces per hour. With this, processing cost modifies to data as shown
below in Table 5.
M/c Hr
Rate
Pcs/Hour Cost/Pc
Actual
Pcs/Hr
Actual Cost/Pc
(Rate) (Pcs) (Rate/Pcs) (Actual Pcs)
(Rate/Actual
Pcs)
Process A 2000 1200 1.67 720 2.78
Process B 3500 720 4.86 720 4.86
Process C 3000 850 3.53 720 4.17
Process D 2000 900 2.22 720 2.78
Process E 2000 1200 1.67 720 2.78
Process F 4000 1800 2.22 720 5.56
Process G 3500 850 4.12 720 4.86
Process H 2500 900 2.78 720 3.47
Process I 1500 1000 1.50 720 2.08
Process J 1000 1050 0.95 720 1.39
Process K 1000 1050 0.95 720 1.39
Table 5. Processing cost with bottleneck effect
Total cost is as shown below in Table 6.
Cost with
Theo O/P
Cost with
Actual O/P
Raw Material AA 12 12
Raw Material BB 15 15
Process cost AA 12.28 14.58
Process cost BB 10.78 16.67
Part X 3.5 3.5
Part Y 4 4
Assembly cost 3.41 4.86
Total cost 60.97 70.61
Table 6. Total cost with bottleneck effect
8

Now, at a Sales Price of 70 Rs/unit, there is a loss of Rs. 0.61 per Unit.
2.5 Efficient way for Product Cost
There is an efficient way of arriving at this product cost. Since the whole
production line works at the production rate of the bottleneck machine, we can
sum up machine hour rates for all processes. Using bottleneck production rate
we can get the processing cost as shown in Table 7 below.
M/c Hr
Rate
Pcs/Hr Cost/Pc
Actual
Pcs/Hr
Actual
Cost/Pc
(Rate) (Pcs) (Rate/Pcs)
(Actual
Pcs)
(Rate/Actual
Pcs)
Raw Material AA - - 12.00 - 12.00
Raw Material BB - - 15.00 - 15.00
Process A 2000 1200 1.67 720 2.78
Process B 3500 720 4.86 720 4.86
Process C 3000 850 3.53 720 4.17
Process D 2000 900 2.22 720 2.78
Process E 2000 1200 1.67 720 2.78
Process F 4000 1800 2.22 720 5.56
Process G 3500 850 4.12 720 4.86
Process H 2500 900 2.78 720 3.47
Part X - - 3.50 - 3.50
Process I 1500 1000 1.50 720 2.08
Part Y - - 4.00 - 4.00
Process J 1000 1050 0.95 720 1.39
Process K 1000 1050 0.95 720 1.39
Process Cost Sub-Total 26000 - - 720 36.11
Part Cost Sub-Total 34.50
Total Cost 70.61
Table 7. Efficient way of calculating Product Cost
2.6 A word on Batch Size:
In product cost calculation, batch size plays an important role. In production
environments where setup times for change in products are considerably large, a
decision has to be taken on batch size. Since setup is non-productive and setup
cost gets divided on the entire batch, people tend to run large batches to reduce
9

unit product costs. Cost per unit reduces with increasing batch size as shown
below in the graph in Fig 5.

Fig 5. Graph of Product Cost per unit without considering carrying cost
However, this has a negative ramification. As the batch size goes on increasing,
inventory also increases. An inventory larger than optimal size has following ill-
effects.
For products with short shelf life (e.g. medicines, food products), they get
deteriorated or need to be scrapped.
For products with short market life (e.g. consumer electronics),
obsolescence is high as new products are being introduced to the market a
short intervals of time.
Money is locked in this inventory and it reduces cash flow.
Valuable space is occupied for storing this inventory.
Theft and pilferage are other ill-effects.
0.0
50.0
100.0
150.0
200.0
250.0
300.0
350.0
400.0
450.0
500.0
0 200 400 600 800 1000
C
o
s
t

/

u
n
i
t
Batch Size
Cost per unit without considering carrying cost
Setup cost
Mfg cost
Cost/unit
10

So, if we consider costs of carrying inventory, the Cost per Unit will vary with
increasing batch size as shown in graph as in Fig 6 below.

Fig 6. Graph of Product Cost per unit considering carrying cost
2.7 Profit with Carrying Cost
A little consideration will show that profit will vary with increasing batch size
as shown in graph in fig 7 below. It is assumed that Sales Price does not change
with volume.
0.0
100.0
200.0
300.0
400.0
500.0
600.0
0 200 400 600 800 1000
C
o
s
t

/

u
n
i
t
Batch Size
Cost per unit considering carrying cost
Setup cost
Mfg cost
Carrying cost
Cost/unit
11


Fig 7. Graph of Product Cost per unit and Profit per unit
With above discussion it is clear that there is an optimum batch size which
needs to be calculated by taking into account the inventory costs.

0.0
100.0
200.0
300.0
400.0
500.0
600.0
0 200 400 600 800 1000
R
s
.
Batch Size
Cost per unit and Profit per unit
Cost/unit
rofit/unit
!pti"u" #atc$ Si%e
3.1 Case Study:
Conventionally judgment on Capital investment proposals
saving calculations. We saw the effect of bottleneck on product cost
calculations. Let us see the effect of bottleneck on Capital Investment.
We will consider the same line we considered for product costing.
flow is reproduced below.
Fig 8. Process Flow and Process Data for Product P
3. Capital Investment
judgment on Capital investment proposals is done through cost
saving calculations. We saw the effect of bottleneck on product cost
calculations. Let us see the effect of bottleneck on Capital Investment.
We will consider the same line we considered for product costing.
flow is reproduced below. Bottleneck (Process B) is highlighted in RED.
Process Data for Product P
12

is done through cost
saving calculations. We saw the effect of bottleneck on product cost
calculations. Let us see the effect of bottleneck on Capital Investment.
We will consider the same line we considered for product costing. Its process
(Process B) is highlighted in RED.

13

Let us consider that a machine is to be brought at Rs. 10,00,000/-.
3.2 Case I:
Machine replaces a non-bottleneck machine D. Following assumptions are
made.
1. The operator who is operating the machine to be replaced can operate this
machine after training.
2. Cost per hour for labor and overhead is Rs. 1000.
3. Machine processes parts at faster rate and saves 10% time per part.
4. Factory works 8 hours/day for 300 days in a year.
5. Standard Return on Investment = 5 years
With above assumptions, cost saving works out as shown below.
Money saved per year = Time Saved x Cost per hour for labor and overhead
= (10% of (300 x 8)) x 1000
= 2,40,000 Rs.
Return on Investment = Machine Price / Money saved per year
= 10,00,000 / 2,40,000
= 4.2 years
So investment is justified.
However, since the machine is non-bottleneck, these savings will not
materialize as bottleneck machine controls line output, so the new machine has
to work at the same rate as that of bottleneck as it is downstream (after
bottleneck machine). If it would have been upstream (before bottleneck
machine), inventory will have to be increased drastically.
3.3 Case II:
Machine replaces bottleneck machine B. The same assumptions are made as in
Case I. So Return on Investment calculated is 4.2 years as in the above case.
So investment is justified.
However, since the machine is bottleneck, justification should be done by
considering additional sales. Let us further assume that annual sales from this
14

line is Rs. 1,00,00,000/- (Rs. 1 Crore). Then additional sales of Rs. 10 Lakh
(10% increase in production) will happen. Since the company already has rest of
the resources, only Raw Material and consumables will be required additionally.
The calculation works out as shown below.
Assuming unit sales price of 80 Rs.,
Additional units produced = 10,00,000 / 80
= 12,500
Raw material cost = 12,500 x (12 + 15 + 3.5 + 4)
= 4,31,250 Rs.
Profit = 10,00,000 4,31,250 (assuming consumable cost as nil)
= 5,68,750 Rs.
Return on investment is 1.76 years.
Here, please note that additional output will be limited to that of the next would-
be bottleneck process i.e. processes C & G in this case.

4.
4.1 Case Study:
While outsourcing certain part, the cost to produce this part internally is
calculated. This internal cost is compared with the price quoted by vendor.
this case study, lets consider the same production line in earlier example.
Fig 9. Process Flow and Process Data for Product P

4. Make or Buy Decisions
While outsourcing certain part, the cost to produce this part internally is
calculated. This internal cost is compared with the price quoted by vendor.
this case study, lets consider the same production line in earlier example.
Process Flow and Process Data for Product P (Reproduced)
15

While outsourcing certain part, the cost to produce this part internally is
calculated. This internal cost is compared with the price quoted by vendor. For
this case study, lets consider the same production line in earlier example.

16

4.2 Case I:
Lets assume that process A is to be outsourced along with material. This is a
non-bottleneck process. The internal cost of this will be worked out as shown
below.
Cost of raw material AA = Rs. 12
Cycle time = 12 s (including setup)
Processing cost = Rs. 3.33 (assuming Rs 1000/hr labor + overhead rate)
Total cost = 12 + 3.33
= Rs. 15.33
If vendor asks a price of Rs 13.5/piece, probably decision will be made to buy
with saving of Rs. 1.83/piece.
However in this case, we need to understand that outsourcing an operation will
not reduce any overheads. It may not reduce any direct labor especially if the
operator is transferred elsewhere or in fear of unrest, he/she is not removed. So
the only expense reduces is raw material cost (Rs. 12 in this case). And the cost
increased by Rs 1.5 per piece.
4.3 Case II:
Now, lets assume that processes A and B are to be outsourced along with
material. B is a bottleneck process. With involvement of bottleneck process,
justification should be done by taking into account the additional sales.
Let us further assume that annual sales from this line is Rs. 1,00,00,000/- (Rs. 1
Crore). An additional sales of Rs. 10 Lakh (10% increase in production) will
happen because of outsourcing. Since the company already has rest of the
resources, additional output will be generated. The calculation works out as
shown below.
Assuming unit sales price of 80 Rs.,
Additional units produced = 10,00,000 / 80
= 12,500
Raw material cost = 12,500 x (15 + 3.5 + 4) {excluding outsourced part)
17

= 2,81,250 Rs.
Cost of outsourcing = 20 x 12,500 (assuming Rs 20 / piece outsourced)
= 2,50,000
Saving due to outsourcing = 12 x 12500
= 1,50,000
Net cost of outsourcing = 2,50,000 1,50,000
= 1,00,000
Profit = 10,00,000 2,81,250 1,00,000
= 6,18,750 Rs.
So additional profit of 6,18,750 Rs will be made per year.
Here, please note that additional output will be limited to that of the next would-
be bottleneck process i.e. processes C & G in this case.

18

5. Conclusion
Bottleneck and batch size in a production line environment have significant
effect on the output, product costs and inventory. As such while deciding on
product viability, capital purchases and make/buy decisions, real outputs and
inventory optimization should be considered. A holistic view will ensure that
decisions taken are beneficial for the firm. Following points should be noted in
decision making.
1. While calculating product cost, real output is to be considered taking into
effect of bottleneck process.
2. Batch size is another important consideration to optimize product costs
and inventory.
3. Capital investment is also affected by bottlenecks. Hence first bottleneck
process needs to be improvised through productive machines.
4. Make/Buy decisions should be taken such that bottleneck process can be
augmented.

19

References
1. Goldratt, E. M. and Cox, J. 2004. The Goal: A Process of Ongoing
Improvement. 3rd rev. ed. Productivity & Quality Publishing Pvt. Ltd.,
Madras.