A Guide to Implementing the Theory of Constraints (TOC)





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Tell Me How You Will Measure Me

It has been said; “Tell me how you will measure me, and I will tell you how I will behave (1).”  The measurements in any organization are the No. 1 formal feedback system in that organization.  So let’s start with measurements in order to better understand our current approach to business, and to help us do that let’s also return to our simple model that we first saw in the introduction.

How would you be measured in such a system?  If you recall it was likely that you were in work up to your eyeballs.  Is that an issue?  It certainly shows that your position is important and necessary and that you have lots of work to get through.  If others have even larger piles of work it might lead you to believe that they are not as efficient as you are.  Is relative efficiency an issue?  It would seem so.

What if it was actually another department or section that wants the work next or that should have provided you with the work by now, rather than someone from your own department.  Somehow the issue is always greater – or at least a great deal more noise is generated when one department is waiting upon another.  Does that every reach a stage from time to time that might be described as frustrating?  Probably around about the time one department is yelling at you to provide something that is still stuck in another department somewhere else.  The matter is essentially beyond your control and yet, somehow, you are apparently responsible none-the-less.

Does this frustration ever look like becoming despair?  Well probably annually if your company has performance reviews.  Maybe even more frequently if you are accountable for departmental performance.  Accountability for departmental performance might be some derived efficiency report, it might be some sort of derived profit or cost report.

Reductionist / Local Optima Approach

The whole internal business performance measurement system is based upon local optimization, either in the form of departmental utilization/efficiency measures or as departmental cost/profit performance measures - or both!  And we don’t need to limit ourselves to departments within a business.  It could equally be businesses within a company, or companies within a corporation.

It takes some conscious effort to realize that the formalization of local efficiency measures through the activities of “scientific” management – Taylorism – is only about 100 years old (2, 3).  Scientific management is such a seductive idea because it legitimizes the actions that we as individuals find so effective in our local settings (family, friends etc) and applies it directly to our work processes.

We assume that the total performance of the system is the sum of all the local performances.  In fact it is so common that we probably don’t even give it much thought.

This approach then is the reductionist/local optima approach; departmental cost or efficiency is just a symptom or an output of this method.

Let’s look at local profit centers a little closer.

Each department has a budget, representing a flow of money into the department (even if it is only a credit in a set of numbers in a management account somewhere).  Money also flows out of the department in the form of expenses (again, even if it is only a debit to those same management accounts).  The difference is the profit for that department.  At the period end if you “make your numbers” there is no problem.  If you don’t make your numbers there is no other problem.  We assume then that the sum of the profits for each department is the same as the total profit for the system as a whole.

However there is condition that must be met in order to sum the local profits as we have just done.  The condition is that there is independence between departments.  Let’s examine that condition.

In order to sum the local profits, indeed the local optima, the inflow of work into each department must be truly independent of the other departments.  An independent input and output has been drawn in.  If I owned a franchise for a no-names fast food shop in several different towns, then I would meet these conditions and I could sum the local profits because my input/output (customers) are geographically isolated from each other.  Does this reflect reality for most process systems?  Probably not.  Let’s have a closer look.

For most systems that we are thinking of there is no real independence of the work flow from department to department.  Oh, we might fool ourselves, and say yes, we have so much work-in-process that the work flow behaves as though it is independent (as we have drawn above) but we all know that when that urgent job needs to move through the system there are dependencies for sure.  So, let’s draw the system as it really is.

This is quite a different diagram to the earlier one.  We have in reality full dependence; we can’t sum the local profits to get the profit of the system because each department is coupled by the work flow.  This is why we suffer frustration, we want to do something, but we can’t because we depend upon someone else doing something else first.  Moreover, the output from this system is always less than we expect that we are capable of given the sum of the local outputs.  Of course we can always fudge this to some extent in our annual budget round by under promising in order to ensure that we perform adequately.  Overall, however, if we are measured against some standard that assumes independence such as efficiencies or cost/profit centers then the frustration will turn to despair.

So, How Do We Measure Success Here?

We typically determine success in several ways.  In absolute terms by net profit, in relative terms by return on investment, or in survival terms by cash flow (4).  But how do we relate our on-going operational decisions – our departmental decisions – to overall system success?  How do we bridge between our operational decisions and system success?  Goldratt and Fox have coined this bridge the “cost” bridge (4).

Let’s draw it.

Any local actions that has a positive effect on cost (reduces it) will increase net profit, increase return on investment, and increase cash flow.  In fact, in the section on the bottom line we essentially accepted this without question.  Remember?  We calculated that a 10% decrease in operating expense at current output would result in a 13% increase in net profit in our example.  The only thing in contention was whether we should be satisfied by such an increase.  Such a cost saving would increase net profit, return on investment, and cash flow.  In fact why stop there?  If we could get our vendors to shave 10% off their prices as well, we could increase these bottom line measures even further.  Clearly decreasing cost always has a positive impact on the bottom line – right?  Let’s investigate this a little further.

The P & Q Analysis

In the Haystack Syndrome, Goldratt presented a small thought experiment, known as the P & Q problem (5).  It is named after the two products it produces – “P’s” and “Q’s.”  This elegant little example, strictly educational, seems to have taken on a life of it’s own as it turns up in various examples to illustrate concepts as broad as total preventative maintenance.  Often the numbers and the story have mutated somewhat in the process, but at the heart is the P & Q problem.

Because the example is educational, I have split it out here into separate pages (you wouldn’t cheat but you might accidentally see the answer before you see the question).  The P & Q question is here.  Try to work through it first.  The first part of the answer is here.  Check the answer after your first attempt.

The P & Q is important.  Please try to do it before you go any further.

What happen in the P & Q when you worked through it based upon your experience?  You probably tried to optimize it following some fairly rational arguments, you probably also got a less than desirable answer.  What went wrong?

Saving Cost Alone Is Not Enough

Saving cost is synonymous with local optimization.  However, we have seen from the example above that saving cost alone is not a sufficient bridge between local actions and the bottom line measures of; net profit, return on investment, and cash flow.  In fact neither is maximizing labor utilization nor any other of the local optimizations.

Maybe the P&Q was an exceptional example?  However if you want to believe this, then please read Debra Smith’s war stories in “Unbelievable decisions by companies you would know if I could name them (6).”  In fact to do justice, please don’t stop at the end of the first chapter of that book, read the whole book.

What then if you were to observe the financial manager of a large business or the owner/manager of a small business over a period of time?  Then, I think that you will see that decisions based upon cost are indeed undertaken – up to a point.  That point is where the person’s intuition takes over and the cost based decision is overturned or moderated (moderated by common sense as it happens).  The important point is that intuition should at some point take over.  The danger is that non-operational people, or financial people who “believe” the numbers but don’t have access to their composition, may make erroneous decisions as a consequence.  Cost-based decisions often give rise to the wrong answers.

Thus the bridge between local actions and the bottom line results of net profit, return on investment, and cash flow must be based on cost + intuition, and not on cost alone (4).

Is this satisfactory?  Well I don’t think so, but we can save that for the section on accounting for change.  Let’s leave the last word at the moment to Schragenheim and Dettmer “Operational decisions based on traditional cost concepts can be confidently considered unreliable (7).”

How Did We Get Into This Mess?

Well human endeavor sort of “grew” into this mess.  Think about it for a moment.  It’s not all that long ago that there were no process-based businesses.  Certainly the industrial revolution – the steam powered one that is – is only about 200 years old.  And the earlier phase of the industrial revolution – that waterwheel powered one – extends that time frame back about another 100 years.  Before the industrial revolution there were no process industries only cottage industries.

In a cottage industry – even where whole towns were involved, there were many small parallel systems of few parts – fulling, spinning, dyeing, and weaving wool spring to mind.  In fact they are rather like the first profit/cost system diagram that we drew with totally independent inputs and outputs in each department.  With the onset of the industrial revolution there was a move from many small parallel systems to a smaller number of larger serial systems of many parts.  The first processes industries grew out of linen milling and similar agricultural based processing.  The rest, as they say, is history.

Of course a large number of parallel systems in a loose network is an extremely robust form of process (8).  However, as we will learn in later pages, there are also ways to create very robust serial systems as well.

In all pre-industrial history local optimization equaled global optimization – they were one and the same.  However, as a process becomes more serial in nature it is less likely that local optimization can equal global optimization.  We outgrew local optimization in serial (industrial) processes, but we forgot to replace local optimization with something else.

What To Do – Rules Of Engagement

Let’s turn to natural systems for a moment for some guidance, “Living systems have integrity.  Their character depends on the whole.  The same is true for organizations; to understand the most challenging managerial issues requires seeing the whole system that generates issues (9).”

Let’s start again from scratch then – or if we want to be more proper – first principles.  It seems that we need to know what the system is that we are dealing with, where does it start, and where does it end.  We need to know what the system exists for, and we need to know how to measure progress towards the reason for its existence.

Scheinkopf expresses this as (10);

(1)  Define the system and its purpose.

(2)  Determine the system’s fundamental measurements.

Why do we have this particular order?  Well, the organization in fact defines the measurements rather than the other way around – the measurements define the organization.  Margaret Wheatley is more articulate.  She argues that in too many organizations “… the measures define what is meaningful rather than letting the greater meaning of the work define the measures.  As the focus narrows, people disconnect from any larger purpose, and only do what is required of them (11).”  We can’t afford to have people disconnect from the larger purpose, we are not going to let that happen here.

So, let’s expand this expression out a little more to get the following;

(1)  Define the system.

(2)  Define the goal of the system.

(3)  Define the necessary conditions.

(4)  Define the fundamental measurements.

This is going to be our basis, our rules of engagement.  Let’s look at each facet in turn.

Define The System

Let’s return to our simple model of a system again.  It seems that we are defining our systems as something like the beginning + middle + near-the-end + end.  We will call it “our system” for short.

Our system could, for instance, be a process within a business.

It might be a business stream within a company.

It might be a company within a division, or it might be a division with a corporation.  All that we need to know is that they are bound together by some commonality of process.  Consider a car manufacturer as the ultimate version of our simple system.

And let’s not leave out not-for-profit.  How about a public health system as an example?

And what ties the dependencies in this system together?  Us, the general public, the patients.  Public health systems have tremendous WIP – waiting lists.   Equally, they have lots of ways for pretending that they don’t have waiting lists, such as sending referrals back to their General Practitioners until they are really very ill.

Define The Goal Of The System

“’The owners have the sole right to determine the goal.’  If we are dealing with a privately held company, no outsider can predict its goal.  We must directly ask the owners (12).”  For a company whose shares are traded in the open market “a company’s goal is to make more money now as well as in the future.”

I underlined the word “open” because in some instances publicly held companies are not traded in the open market.  Consider Japan for instance.  Many publicly listed companies in Japan have tightly held multiple cross-shareholdings (and often considerable debt finance).  In instances like this we might expect that these companies will behave more like a private company would in other parts of the world.  It is not enough to assume that making money is the goal of these organizations.

Returning to our definition of the goal in openly traded companies; most often we find that the “more money” has been dropped from the definition, and that is what we will adopt here.  However, the word “more” indicates that the goal is in fact open-ended.  This highlights that fact that in contrast to a “necessary condition” you can’t have enough of the goal.  Maybe in the context of money therefore, the word “more” is redundant.  You can test this, ask someone, anyone, whether they wouldn’t like to make more money now and in the future or whether they are contented with what they currently receive.

Let’s write the goal for a public company traded on the open stock exchange.

We must make sufficient money to reward the owners of the capital after meeting all of our expenses, and we must make sufficient money to continue to profitably reinvest in the business.

Define The Necessary Conditions

Once we have defined the goal, we must define any necessary conditions.  Necessary conditions are minimum levels of other entities that must be present in order to satisfy the goal.  In this respect necessary conditions can be viewed as having limits.  Once a necessary condition is satisfied, additional levels of input will not result in an increased attainment of the goal.

The two most generic necessary conditions are (12);

(1)  Provide employees with a secure and satisfying workplace now and in the future.

(2)  Satisfy customers now and in the future.

Let’s add these to our goal.

How do we read this?  As follows.  In order to make money now and in the future we must provide employees with a secure and satisfying workplace now and in the future.  Also, in order to make money now and in the future we must satisfy customers now and in the future.  They key word is we must, we have to do it in order to make money.  Another way to look at this is; in order to make money we must have an appropriate process (employees) and an appropriate product or service for an appropriate market (satisfied customers).

Is this too pecuniary for you?  We could rearrange it a little.

Now it has really taken on a strategic flavor – a statement of the conditions that are absolutely necessary to ensure that the enterprise will be around both today, and in the future (13).  Thinking about it further, this is really a succinct statement of the loyalty effect – investor, customer, and employee loyalty.  The benefits are well documented (14).

But what if we are a not-for-profit?  Such as a government health provider.  “Necessary conditions are important to identify, especially for not-for-profit organizations.  Sufficient cash is usually a necessary condition.  Expenses might constitute a necessary condition if, for example, funding levels are fixed (15).”  That is to say, some not-for-profit organizations, charitable trusts for instance, might carry out some trading activity that is used to raise sufficient cash to carry out their goal.  Others that rely upon fixed funding must watch their outgoings with utmost care.

Let’s rewrite this diagram for a not-for-profit.

That’s interesting.  Do you see that the only necessary condition entity that didn’t change, regardless of whether we were dealing with for-profit, not-for-profit, or voluntary/government service was the entity that deals with secure and satisfied employees?  This is so important for success that it is difficult to stress it sufficiently.  It has important ramifications in the basic assumptions of management accounting for Theory of Constraints.  We will return to this theme in the section on accounting for change, and also in the section on strategic advantage.

Define The Fundamental Measurements – T I OE

We need to determine the fundamental measures for our system and then ensure that our performance measures are subordinated to these fundamental measures.  “Not just any measurements, but measurements that will enable us to judge the impact of a local decision on the global goal (16).”

“Measurements are a direct result of the chosen goal.  There is no way that we can select a set of measurements before the goal is defined.”  The measurements should enable us to judge whether a local decision has an impact of the global goal (16).

In a commercial organization the fundamental measures are defined by the following questions (16);

(1)  How much money is generated by our company?

(2)  How much money is captured by our company?

(3)  How much money do we have to spend to operate it?

Essentially we are asking; what is the flow of money into the system, what is the flow of money out of the system, and how much is kept in the system?  Goldratt calls these 3 measures; Throughput, Inventory, and Operating Expense.  These are often shortened to T, I, and OE and are defined as follows (16);

(1)  Throughput is the rate at which the system generates money through sales.

(2)  Inventory is all the money that the system invests in purchasing things which it intends to sell.

(3)  Operating expense is all the money the system spends in order to turn inventory into throughput.

Throughput can be considered to be revenue less totally variable costs (17).  A totally variable cost is anything that varies in a direct 1:1 relationship with sales; for instance transportation charges, or commission charges, might be totally variable costs.  If the company produces and sells another unit of product it will incur this cost, and if it produces one unit less it will not incur this cost (18).  Direct labor therefore is not included as a totally variable cost.  We need to be clear; variable costs are variable per unit sale.

Throughput is the financial value of an organizations output and must be measured in monetary units.  Output is the volume of product or service produced by the organization and is measured in physical units of some sort (19).

The next major measure, inventory, includes not only the traditional classes of; raw material, work-in-process, and finished goods inventory, but all other money invested in the organization such as in buildings, machinery, and other capital items – in other words the total investment.  More recently the term investment has been used synonymously with inventory.

Operating expense is the on-going cost of running the business including both direct and indirect labor.  You might like to consider these as the unavoidable costs of doing business.  In an example that I like to use, I ask people to imagine for instance what would happen if we were to close a ward in a public service hospital to patients for one week.  This has certainly happened in the name of saving costs.  How much cost do you think is saved?  In all honesty?  Probably not very much at all.  The unsaved portion is the unavoidable operating expense.

Of the saved portion in this example – the avoidable cost; some may be directly variable cost, and some may indeed be operating expense.  Although changes in operating expenses are not directly variable with volume this certainly doesn’t mean that they are not variable over time (20).  As production increases or decreases over time, so too might the operating expense.  Although as we shall soon see, we should strive to hold operating costs constant while increasing throughput.

It seems that accountants are more familiar with the term “period costs” or period expenses rather than operating expense (21).  This more clearly accommodates changes over time.  Thus another way to consider operating expense is that if an expense is incurred by unit of time – be that; hourly, daily, weekly, monthly, or whatever – then it is an operating expense.  It isn’t considered to vary in any direct relationship with the number of units processed.

We can now see that considering all labor as an operating expense is consistent with this definition.  “Labor is normally purchased in units of time – by compensating people for hours per week or month, or, in the case of salaried employees, for a year (22).”

Let’s attach these new labels to the bar graph that we used in the previous section on the bottom line.

And let’s also summarize the definitions of these key concepts that we have been talking about in these last few paragraphs (16, 17).

Throughput = Sales - Totally Variable Costs

Net Profit = Throughput - Operating Expense

Using period expenses rather than operating expense may make matter clearer (21).

Net Profit = Sales - Totally Variable Costs - Period Expenses

Net profit is the bottom line measure that we use the most.  But we must also consider return on investment (16, 17).

We can also integrate these fundamental operating measures into our simple system.

We can see that sales, less totally variable costs, produces the throughput that enters the system.  Some of this will cover our operating expense, the remainder is operating profit.  There is also a flow of material or work through the system at the same time that will produce new sales in the (hopefully) near future, if not immediately.

There is a further useful measure, expressed as a ratio of these fundamental operating measures (16, 17), it is a measure of productivity;

Productivity is the most important of these definitions to my mind.  Why is it so important?  Because it decouples costs from revenue and thus drives profitability up (21).  In order for productivity to increase we must increase throughput while holding operating expense constant or with minimal increase.  Really the relationship looks more like this;

Let’s illustrate this with the case that we developed in the previous section on the bottom line.  In the example we had 40% operating expense, 30% totally variable costs and 30% profit.  A 20% increase in sales at constant operating expense yielded a 46% increase in profit.  In comparison if we were to allow operating expense to increase at the same rate – the normal situation – then of course the increase in profit would be only 20%.

Let’s draw both of these situations.