The opportunity cost of operations

When there is a constraint in the operations of a business, the logical question to ask is how much it costs the company to not have that constraint operational at all times. That is, what is the opportunity cost of not maximizing the constraint?

The Opportunity Cost in Traditional Accounting

Under an old-style cost accounting system, the answer to the preceding question would be that the business is not earning a gross margin on any goods that would otherwise have been produced if the constrained resource had been operational. For example, an employee lunch break results in a constrained resource being stopped for one hour. During that hour, the employee would normally have produced an additional 50 units, each of which would have earned an additional $2 of gross margin. Under this interpretation, the opportunity cost would be a total of $100. Given the small size of the gross margin not earned, the production manager might not elect to have another person operate the machine during the first employee's lunch break.

The Opportunity Cost in Throughput Accounting

When viewed from the perspective of throughput foregone, the answer to the same scenario is somewhat different. Throughput is revenues minus all variable expenses. The constrained resource impacts the ability of the entire production system to earn any throughput, so the opportunity cost is instead considered to be the grand total operating cost of the production facility, divided by the number of hours that the constrained resource is in use. To use the same example, the weekly operating expense for the facility is $336,000, and the constrained resource is operated for all 168 hours of that period, resulting in a cost per hour of $2,000. In light of this much higher cost associated with not running the bottleneck operation, it is considerably more likely that the production manager will assign someone to run it during the first employee's lunch break.

A related question is how to derive the cost of not operating any other resource that is not the bottleneck operation. As long as the amount of downtime involved does not impact the operation of the bottleneck operation, there is a zero opportunity cost associated with the downtime. In fact, if the downtime is not impacting the constrained resources, that means the downtime is avoiding the creation of inventory that is not even needed, so the downtime is actually beneficial in that there is a reduced investment in inventory.

Clearly, there are significant differences in the way the opportunity cost of operations can be calculated, which can result in vastly different treatments of a constrained resource.

Related Courses

Constraint Management