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A Guide to Implementing the Theory of Constraints (TOC) |
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Increasing
Profitability Through Increased Productivity Everyone understands the benefit of increasing production;
we invest more money, buy more manpower, buy more machinery, and make even
more money. Right? Unfortunately not nearly right as often as
we would like it to be. In fact,
sometimes the increase in total profit is marginal at best. A more attractive alternative is to increase
productivity. That is to increase
output at constant investment, manpower, and machinery. Variable costs such as raw material will
increase in proportion to output, but operating expenses should remain the
same. Therefore the contribution to
the total profit from each additional sale is leverage against the previous
unit allocation for operating expense. A 20% increase in the productivity of a typical
manufacturing company with 30% raw material cost, 40% operating expense (all
labor and all fixed expenses) and 30% profit will produce a 46½% increase in
operating profit! A 20%
increase in productivity results in a 46½% increase in profitability!
Let’s
examine the popular alternative for raising profit – cost reduction. What is the effect of a 10%
across-the-board reduction in operating expense at the current output of
100%? Attaining 10% across-the-board
would be a significant cost saving – correct?
Operating expense is 40% of the total, 10% of 40% is 4%. Therefore we save 4% of our costs and the
profit increase is therefore 4% / 30% = 13%.
Let’s draw that also.
Of
course if we chose the cost reduction way, we would have to be quite sure
that our reduction didn’t actually harm some critical function of the system
in some way. Preferences
aside, which offers greater potential for continuous improvement? Sure we can continue to cut costs, but how
much next time, another 10%? That’s
unlikely. Maybe 5%. Within a round or two the potential for
further improvement is essentially nil. And what if sales pick up after a couple of
cost-cutting rounds? In
contrast what is the potential for increasing productivity more that
once? Extremely good, in fact it is
open-ended, a true pathway to continuous improvement. Thus increasing productivity is both
profitable and open-ended. One
last consideration. Many companies
grow at times by acquisition; they raise equity in the markets and acquire
other businesses in order to increase overall value through “synergies.” What we have proposed above is real organic
growth, generating robust cash inflows from which to grow the business even
more. In many
places around the world today, high growth rates are a fond memory. Indeed in some places deflation has set
in. How do we accommodate this
situation? Well,
Taiichi Ohno, the inventor of Toyota's just-in-time, once said; "In a high-growth period, productivity can
be raised by anyone. But how many can
attain it during more difficult circumstances induced by low-growth
rate? This is the deciding factor in
the success or failure of an enterprise (1).” Why,
then, aren't companies rushing out to improve their productivity &
profitability? Simply,
companies are always constrained from such growth by one of two
constraints. Either they can’t make
enough – in which case they are production constrained. Or they can’t sell enough – in which case
they are market constrained. “Few people in the world can raise productivity
when production quantities decrease. With
even one such person, the character of a business operation will be that much
stronger (1)." We have
to remove the constraints. The more
people who know how to do this, then the more companies and organizations
that can be made much stronger. Ohno was
writing about low-growth rate periods in 1978 but it is every bit as
applicable today. There
are a number of constraint classifications, but in reality there are two main
types; (1)
Physical Constraints (2)
Policy Constraints A physical
constraint, might be a resource, either a person or a machine, or a material
of some kind, time or quality, or supply issues. A policy constraint is almost everything
else that is non-tangible. Be careful, don’t be mislead into believing that most
constraints are physical – the bottlenecks that everyone seems to know
about. Physical constraints merely
become the expression of deeper underlying policy constraints. Goldratt considers that (2); "We very rarely find a company with a real
market constraint, but rather, with devastating marketing policy
constraints. We very rarely find a
true bottleneck on the shop floor, we usually find production policy
constraints. We almost never find a
vendor constraint, but we do find purchasing policy constraints. And in all cases the policies were very
logical at the time they were instituted.
Their original reasons have since long gone, but the old policies
still remain with us." If most
constraints are, in reality, policy then this should be incredibly powerful. It means capacity in reality already
exists, we are simply holding ourselves back based upon some internally held
assumptions or convictions. It should
be possible for an organization to change its own policies, and difficult for
others to imitate. Such conditions
give rise to powerful strategic advantages which we will address in the
strategy section. In a
recent major literature survey by Mabin and Balderstone, published
quantitative results for 82 organizations were presented (3). From this, mean values for improvement
could be derived for between 30 and 32 companies. The results are summarized as follows; Lead time mean reduction – 70% Inventory level mean reduction – 49% Revenue/throughput/profit mean increase – 76% It is
clear that with the Theory of Constraints we get results. You can do the same. How quickly you obtain results depends upon
where the company is prior to starting the implementation and the company’s
ability to consistently implement the concepts, but it really does not matter
what the industry is (4). And of
course “quickly” is a relative term, and here it means several months not
several years. The revenue, or throughput, or profit increase is
uniformly large because we are using the constraint (physical or policy) to
leverage against the sunk operating expense of the organization. The greater the proportion of operating
expense, then the greater the multiplier effect of increased productivity. Think of this as a type of amplifier, the
signal – physical output for sale – is amplified by the sunk operating
expense to generate a much greater throughput and hence profit. Well if
you don’t sell anything to generate income for disbursement then the
multiplier effect on gross profit from operating expense won’t be there. But the potential for increase in output
will be the same none-the-less. If you
do sell something to generate a not-for-profit income – a charitable trust
for instance – then the multiplier effect will be there. For governmental agencies and similar
organizations working from funding it becomes more difficult because income
(funding) is usually capped. The
challenge still remains in these organizations, however, of how to best
increase output within existing funding. Well
replace the thought “we aren’t in manufacturing” with “we aren’t in a
process.” Can you honestly say
that? Most probably not. You are creating a block in your mind to excuse
yourself from drawing a synthesis from manufacturing experience into your own
non-manufacturing process. Don’t let
that happen. What
about service organizations? Think
about it, services must react quickly, so in fact there is often a lot of
physical capacity – but often it is not fully utilized. You can’t store the customers, so if they
are not there you can’t utilize the capacity.
If a service organization is constrained – it is very likely that the
constraint(s) are policy in nature and not physical. Theory
of Constraints enables for-profit organizations to substantially increase
their profitability through increases in productivity. Theory of Constraints also enables
not-for-profit organizations to substantially increase their output using
existing resources through increases in productivity. Organizations are currently blocked from
increasing output by constraints and therefore knowledge of how to surmount
such constraints is a powerful improvement methodology that has been
demonstrated to deliver substantial results. In the
next section we will take a good look at measurements and how such
measurements contribute to the current situation of poor productivity and how
we can overcome this. (1)
Ohno, T., (1978) The Toyota production system: beyond large-scale
production. English Translation 1988,
Productivity Press, pp 114-115. (2)
Goldratt, E. M., (1990) What is this thing called Theory of Constraints and
how should it be implemented? North
River Press, 162 pp. (3) Mabin,
V. J., and Balderstone S. J., (2000) The world of the theory of constraints:
a review of the international literature.
St. Lucie Press, pp 11-12. (4) Stein, R. E., (1994) The next phase of
total quality management: TQM II and the focus on profitability. Marcel Dekker, pg ix. This Webpage Copyright © 2003-2009
by Dr K. J. Youngman |
