Standard Costing – the P-Q Experiment Part 1

The P-Q thought experiment was developed by Eli Goldratt in order to demonstrate the importance of the correct thinking in a business system. The correct thinking being to recognise the system’s constraint, how best to use it, how the rest of the organisation should operate in relation to the decision how best to use the constraint. We will use standard costing to determine which of the two products is the more attractive to sell.

Here is my little business. We sell two products produced according to the routing shown below with my 4 resources. I have 1 of each resource. Note that raw material 2 (RM 2) is used in both products and that only P consumes a purchased part. 

If you check, you will see that we cannot sell all 150 units of P & Q. There is a bottleneck in the system somewhere.

One way to evaluate which of the 2 products should be sold preferentially is to determine the standard cost of the 2 products.

Fixed cost is 6000€ per week and we have 2400 minutes of production time on each machine for a total of 9600 minutes. The cost of a minute is therefore 0.625€. (You could split the 6000$ fixed cost differently – the result will be the same!)

It takes 60 minutes to make one unit of P. So P standard cost is 37.5€ plus 45€ of materials (don’t forget the purchased part) for a total of: 82.50€. Profit margin is 6.50€.

It takes 50 minutes to make 1 unit of Q. The Q standard cost is therefore 31.25€ plus 40€ of materials (there is no purchased part involved) for a total of: 71.25€. Profit margin is 25.75€. That is almost 4 times the profit margin of P.

Clearly the Q product is by far the more preferable. 

NB. The calculation may not consume all of the 6000€ because some of the resources may not be required for the production of whatever can be sold in a week. What does standard costing do with this ‘cost’? Do accountants add a fudge factor so that all costs are theoretically consumed? Or do they simply live with a variance?

My question: how much money can you make with this business using standard cost as your decision criterion. Might you be able to make more within the given parameters, by ignoring what standrad costs tell you?

Keep on improving!