Chapter 2
“Theory of Constraints”
“If you want “real” performance you reach it by many, many little improvements everywhere. This is one philosophy. There is another one…the silver bullet”
Dr Eli Goldratt1
The “Theory of Constraints” is put forward as that silver bullet: the identification and elevation of the biggest constraint a company has. In doing so, it purports to point out why many organisations fail to achieve the expected results through more incremental quality or continuous improvement processes. Whilst elements of the Theory may complement Cost Accounting, Total Quality Management, Activity Based Costing or Just In Time processes, it is very much based on the belief that if you identify the key issue, the seemingly impossible becomes possible:
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“Give me a place to stand and I will move the earth.”
Archimedes, On the lever in Pappus Synagoge 2
According to Goldratt, he used the novel format for “The Goal” (1993) to allow the reader to work through the scenarios as they read them, and come to the same conclusions (hopefully) as the author4. This Socratic approach is continued in the sequel “It’s Not Luck” (1994)5, indicating that the lessons learned at the branch-plant level also work at the global level. “Necessary But Not Sufficient” (2000) continues this theme and style when applying it to today’s rapidly changing software industry6.
In the latter two books, the constraint exists primarily outside the company in the form of existing market constraints and future perceived constraints. “What is this thing called the ‘Theory of Constraints’ and how should it be implemented?” (1990) deals specifically with the Theory though it is written more as a discussion paper than either as an academic paper or as a novel. His two other books offer self-help via the “toolbox” element “Thinking Processes”.
The Theory centres on three key measures: Throughput, Inventory and Operating Expense. By using these metrics, and concentrating on the identification and elevation of either internal or external constraints (aptly identified through the bottleneck metaphor), Goldratt believes that companies can better identify:
What to change?
What to change to?
How to create change? 7
The measures
To be profitable, a company needs to produce products that customers want, and to sell these at above cost. How you define profit, cost and indeed the time frame clearly define whether or not you achieve the goal. Go ask an accountant how difficult it is to agree how profitable a business really is!
The “Theory of Constraints” concentrates very much on elevating constraints to increase Throughput. The results will then reduce Inventory. Operating Expense is the last of the worries. By dealing with the three measures in this order the Theory presents a different focus – one that reverses ‘common practice’ where Operating Expense dominates:
“You are right,” Stacey agrees. “The entire bottleneck concept is not geared to decrease operating expense, it’s focussed on increasing Throughput”.
The Goal, p294
The definitions, and the metrics themselves are deliberately simple:
• “Throughput: the rate at which the system generates money through sales
• Inventory: the money that the system invests in purchasing things, which it intends to sell
• Operating Expense: all the money the system spends in order to turn Inventory into Throughput.”8
In concentrating on the identification and elevation of the constraint, or “bottleneck”, arguments are put forward that this bottleneck controls the profitability of the whole company. Using the familiar hourglass to illustrate, the Theory argues that one can tinker with the hour-glass’ colour, shape, material and dimensions both before and after the bottleneck and it will make absolutely no difference to the time taken for the sand to run out. Only improvements at the bottleneck deliver results. And if you think about it, he’s right.
In “The Goal”, these constraints – and solutions – are first uncovered whilst trying to get a line of Boy Scouts to walk and stay together. The only way this could be achieved was by placing the slowest person, Herbie, at the front. In this Boy Scout example, Herbie was easy to identify; there was a queue right behind him. Once Herbie governed the speed, it was vital that he travelled as fast as he could. So the contents of his day-sac were redistributed around the other non-constraining Boy Scouts. This elevated the constraint. If the bottleneck is so critical, there are significant ramifications for how managers work, the way they measure, how costs are allocated, and how staff are deployed.
“It’s only a novel”, I hear you say. Where’s the evidence? Where’s the proof that it works? How certain can I be that it adds value? Read on….
The primary source of analysis or overview in this area comes from Victoria J. Mabin and Steven J. Balderstone, both academics at the Victoria University of Wellington, New Zealand. In 2000 they published The World of the Theory of Constraints: A Review of the International Literature. In reading nearly 400 abstracts on the topic it becomes apparent that almost all academic study and practical examples come from the U.S. manufacturing arena. Whilst not unexpected, it is perhaps surprising that non-manufacturing and service sector examples make up only 5% of the available evidence. Equally it is surprising to find that there are very few examples of research resulting in negative benefits 9.
Mabin & Balderstone revisited their research in 2003 providing a wider, up-to-date analysis. Based on in depth of analysis of 81 cases, their findings were that ToC does appear to have measurable benefits. Many of these case studies used large national or multinational companies. Proctor & Gamble, Ford (electronics division), Avery Dennison Labels, Pratt & Whitney, G.E., Lucas Varity, United Airlines and Boeing have all reported combinations of increased revenue / Throughput, improved due-date delivery, reduced Inventory and/or lead-time. Out of a total of 82 case studies, only one reported a negative response (4% increase in Inventory)11. Even in this example, all other metrics were positive and the authors concluded that ToC had been beneficial.
Warrender Financial plc
”Warrender Financial”, like any company, is shaped by past decisions. Whilst this makes Warrender Financial unique, it should be able to be viewed in Throughput (T), Inventory (I) and Operating Expense (OE) terms. The research at Warrender Financial proved a valuable test-bed for the concepts, almost all of which worked well without adaptation. Using the ToC definitions and couching them in terms familiar to finance people, we end up with the following:
Inventory (I) has two elements:
A: Inventory to be Invested – money coming in expecting a return
B: Inventory Invested – money received and invested to generate a return
Throughput (T) is generating revenue from converting A into B (difference between interest rates charged and paid, plus related services) and
Operating Expense (OE) is the cost incurred in this process. Profit (loss) is the result. The incentive for a bank therefore is to maximise Throughput by matching money coming in to investment opportunities. If it is out of balance the following reduces Throughput:
1) If not enough investment opportunities, some money can only invest at the risk free/base rate (i.e. on deposit), reducing Throughput
2) If there are more investment opportunities than cash coming in, Throughput is limited by the company’s ability to attract the cash.
As a result of (1) and (2) there is an incentive to minimise cash sitting around doing “nothing”: the quicker you convert the incoming cash into loans the better.
Within the ToC environment (1) and (2) are couched in terms of “market constraints”: the bank needs to grow the market. The ability to convert quickly represents an internal constraint, with process re-engineering required.
Having two types of Inventory is not part of ToC Theory. In this example, the first one fits with the ToC ideal (minimise Inventory) whilst the second would suggest that the bank wants to have an ever-increasing Inventory. I believe that new money awaiting investment (A) can be classed as Throughput. However, existing money invested (B) is more correctly termed an asset (indeed the investment industry often uses the measure “assets under management”).
The definitions therefore broadly hold:
• Throughput: the rate at which the system generates money through sales
• Inventory: the money that the system invests in purchasing things, which it intends to sell.
• Operating Expense: all the money the system spends in order to turn Inventory into Throughput
• Assets: all the client money or – more generally – clients you have
Using these definitions, maximising Throughput dictates that the company seeks to attract new money, whilst retaining as much of the existing as possible. OE includes Sales & Marketing, IT costs, and setting up the contracts. Throughput should be a net figure, reflecting losses as money goes out. Throughput as a net figure means that good on-going customer service plays a role in encouraging further investments whilst minimising the amount leaving the company.
So, how can we use this knowledge to run businesses better, more efficiently, and more profitably? And how can we run our own lives using ToC terms to guide us?
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