In a continuation of my series on Constraints Management, I want to discuss some of the tools and methods TOC offers. The Theory of Constraints has several other strategic tools, or maybe a better word is methodologies, aimed at addressing specific problems that I have written about numerous times in this blog. Learning these methods was an important step forward for me as I learned how to manage organizational constraints. Let’s take a look at these critical improvement tools and discuss their implications.
1. Throughput Accounting (TA) - TA was introduced by Goldratt as an alternative to traditional Cost Accounting (CA) for making real time financial decisions. He believed (as I do) that with three simple measurements, the financial impact of the decisions we make could be realized much faster than by waiting for last month’s accounting sheet that many managers don’t really understand anyway. TA is not a replacement for traditional cost accounting simply because GAAP is required by law. But if the goal of a company is to make money now and in the future, TA is the method of choice for me in making real time financial decisions. The three measurements are:
- Throughput (T) – the rate at which the system generates money through sales. The actual calculation for T is sales revenue minus totally variable costs (those things that vary with the sale of products like raw materials, sales commissions, shipping costs, etc.) or
SR – TVC.
- Inventory or Investment ( I ) – all the money the system invests in things it intends to sell. While we typically think of parts or materials needed to produce our product, investment can also include equipment, the plant itself, etc. basically anything that could eventually be sold.
- Operating Expense (OE) – all the money the system spends to turn inventory or investment into Throughput. OE includes things like labor costs, equipment rental charges, etc.
Using TA, daily management decisions became very straight-forward for me in that good decisions moved T higher while I and OE move lower or remain the same. With TA there was no more waiting until the books are balanced to know if a decision I made was a good one or not.
One of the most noteworthy differences between TA and CA is that TA considers labor costs as a fixed operating expense while CA spreads out or allocates the cost of labor across all products, making it variable. Another difference between TA and CA is how each views inventory. Cost Accounting views inventory as an asset on the books whereas Throughput Accounting views inventory as a liability.
There are other financial metrics that are derived from T, I and OE that made decisions much easier for me. Two of the more common ones I use are:
- Net Profit (NP) – Throughput minus Operating Expense or NP = T – OE
- Return on Investment (ROI) – Throughput minus Operating Expense divided by Inventory or ROI = T – OE/I
The significant ramifications of TA, at least for me, is that by driving Throughput higher, Net Profit increases, even if Operating Expense remains constant. Likewise, if OE is reduced, then NP improves provided that T at least remains constant. Finally, if I is reduced, then ROI increases, even if T and OE remain constant. Let's now look at another one of TOC's methods.
2. Dynamic Replenishment – The problem with many part’s distribution models is directly related to the inaccuracy of forecasting models. For example, many companies use a part’s replenishment model referred to as the Minimum-Maximum System of replenishment. This type of system establishes both a minimum and maximum level of parts to hold in place with the minimum representing a re-order point. That is, when the stock of a part (or material) reaches this minimum level, an order is placed to replenish the stock level back up to the maximum level. Because this type of system is based upon a forecast, it is not uncommon for companies to experience a stock-out period until the part arrives, especially if there is a lot of variation in the vendor's replenishment time. In addition, using this replenishment system results in much, much more inventory than is necessary.
TOC offers a different type of replenishment system which is not based upon a forecast of part’s usage, but rather the actual usage of parts. Instead of forecasting the demand and ordering against a reorder point, TOC’s replenishment solution simply replenishes what’s been used on a regular basis (e.g. once per week). Many implementations of this type of replenishment system have typically resulted in a 40 to 50 percent reduction in the amount of inventory carried and the virtual elimination of stock-outs.
In our next posting we'll continue looking at more of the tools and methods that TOC uses to solve some problems common to many companies.