A Guide to Implementing the Theory of
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!
Does that seem a little far-fetched? Let’s go through the mechanics so that we are sure that we all understand. Firstly we have a 20% overall increase in sales. Some of this is used to pay for the increase in raw materials. The increase in raw materials is 20% of 30% or 6%. So now we have an overall increase in income of 20% - 6% = 14%. Let’s see what the relative increase in profitability is. It must be 14% / 30% = 46.66%. We rounded that to 46½%.
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.
Now we have a choice, a 13% increase in profit due to a significant cost-cut, or a 46½% increase in profit due to a significant productivity gain. Which would you prefer?
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.
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