A Guide to Implementing the Theory of
Increasing Profitability Through Increased
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
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%.
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
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?
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.
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
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
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).”
aren't companies rushing out to improve their productivity &
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
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
There are a
number of constraint classifications, but in reality there are two main
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."
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;
time mean reduction – 70%
level mean reduction – 49%
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
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
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.
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.
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.
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
(1) Ohno, T.,
(1978) The Toyota production system: beyond large-scale production. English Translation 1988, Productivity
Press, pp 114-115.
E. M., (1990) What is this thing called Theory of Constraints and how should
it be implemented? North River Press,
(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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