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Theory of Constraints (Part 3)

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TOC does not concern itself with optimization of a particular portion of the company. It concerns itself with the improvement of the entire system.

*Let me restate here that all these ideas are from the Theory of Constraints of E. M. Goldratt and his books, Goal, Goal II and Critical Chain gives the concepts told here in the form of stories.*

To understand TOC fully, one has to fully understand the goal TOC has envisioned for any business and the underlying measurements by which it measures the success of a business.  TOC does not concern itself with optimization of a particular portion of the company. It concerns itself with the improvement of the entire system.

Coming to the goal of a company, a company's main goal is not creating a quality product or being the best employer or higher productivity or higher market share or higher operating margins or innovations or many of the lines that we hear often from many managers. Rather the goal of any commercial organization is 'To make more money now as well as in the future'.

So what about the other goals which are mentioned? Think about it. All the other goals such as being a good employer or higher productivity are just steps to make money, either now or in the future. The problem comes when people focus on the steps rather than on the ultimate goal.

My personal take on it is that, it is very similar to the goal of a person of making money => the actual motive or goal is to be happy now and in the future but by confusing it with making money, many people lose quite a lot in their lives without realizing it.

Coming back to topic, to achieve the goal of making more money now and in the future, we need to know how to measure ourselves. Ideally such measurements should be such that it can be applied to both the CEO of the organization as well as the driver of the CEO. This will ensure that every decision taken with these measurements will make sure that the company goes closer to the stated goal.

These 3 measurements are: THROUGHPUT, INVENTORY/INVESTMENT and OPERATING EXPENSE

  • THROUGHPUT:  This is the rate at which the system generates money through sales.
  • INVENTORY: This is all the money that the system has invested in purchasing things which it intends to sell.
  • OPERATIONAL EXPENSE: This is all the money the system spends in order to turn inventory into throughput 

 

throughput.pngLet us understand these terms more closely as these TOC terms are a bit different from the popular definitions. When we analyze the "Throughput" of a single process we have to analyze the sales that arise from the cases or widgets that the single process is responsible for. Not the amount of items / service which has gone through the process but what has actually been sold. This will give us the answer as to why many (Not all) six sigma projects do not yield the desired effect. These projects concentrate on speeding up the particular process (thus causing increased inventory down the line) and not increasing the sales in the system as a whole. On analyzing "Inventory / Investment", it is everything that can be sold by the company later for money. This can include even the land and building on which the company is running. "Operating expenses" is anything which is spent to turn the inventory into throughput (Which includes depreciation of machines). Each and every measurement here can be measured in money. The money coming into the system, money locked in the system and money made out from the system.

The beauty of TOC lies in its simplicity. These 3 measurements once measured give us the rest of general measurements which are regularly stated. For example:

  • Profit = Throughput - Operating Expense
  • Return on Investment (ROI) = (Throughput - Operating Expense)/Inventory = Profit / Inventory
  • TA (Throughput Accounting) Productivity = Throughput / Operating Expense
  • Investment turns (IT) = Throughput / Investment

Hence in order for a company to keep improving, it has to concentrate on increasing Throughput while reducing both Inventory and Operating Expense. Any change in one measurement which leads to an adverse impact to the other measurements will only cause more problems.

When one thinks in these terms there will be a paradigm shift in thinking on how to resolve problems at an organization level. One can no longer think on improving only their "silos", rather they have to think how their actions affect the whole system and thus behave accordingly.

Comments

Varghese - Enthused to see your passion on TOC. Good read as always.

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