|
A Guide to Implementing the Theory of
Constraints (TOC) |
|||||
|
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.
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. 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.
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.
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.
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 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).
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. 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. 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.
And let’s not leave out not-for-profit. How about a public health system as an
example?
“’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.
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.
Is this too
pecuniary for you? We could rearrange
it a little.
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.
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.
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).
There is a
further useful measure, expressed as a ratio of these fundamental operating
measures (16, 17), it is a measure of productivity;
Let’s draw both of these situations. |
