Friday, June 13, 2014

Focus and Leverage Part 351


In this posting, I am going to reproduce part of Appendix 1 from Epiphanized, written by my co-author, Bruce Nelson.  I selected this topic because I had received an email from a follower that was very interested in TLS.

Over the past century there have been abundant attempts to improve the quality of both products and services throughout the world, and many different people have contributed to this improvement move­ment and the body of knowledge associated with it. If you take a mo­ment and look back through the years, the list of improvement ideas and acronyms would fill several pages. If it is true that the past helps predict the future, then there will be many more new ideas come into existence.

Currently, three principal improvement methodologies—the The­ory of Constraints (TOC), Lean, and Six Sigma—appear to dominate the subject matter of the improvement world, and each brings its own unique perspective to the improvement playing field. Each also has its own following of zealots and believers. And each proclaims that their single method is the way forward, providing the light and the truth, so to speak. It’s almost as if each methodology is a religious experience of sorts. But does it really have to be this way? Is there a benefit in keeping these methods separate and apart from each other? Does each methodology have to exist in isolation from the others? Let’s look at each methodology in a bit more detail to see if we can answer this question.

Theory of Constraints (TOC)
In the early 1980’s Dr. Eliyahu Goldratt introduced the world to a new way of looking at profitability through his now famous Theory of Constraints (TOC), which was presented in his book The Goal. In principle, Goldratt’s argued that instead of trying to save money through cost reductions, companies would be much more profitable if they focused instead on making money. But aren’t the two ideas synonymous? The answer is—absolutely not! These two ideas represent very different and divergent approaches. Saving money is not the same as making money. And the management strategy you choose to employ to make money is very different than the one you employ to save money.

Goldratt’s emphasis is that the goal of for-profit companies is to make money now and in the future. Goldratt analogized this concept using a chain. He stated that the weakest link in a chain controls the overall strength of the chain, and that any attempt to strengthen any link other than the weakest one will do nothing to improve the total strength of the chain. Organizationally this means that every action or decision taken by the organization must be judged by its impact on the organization’s overall goal of making money. If the decision does not get you closer to that goal, then the decision is probably ineffective.

Goldratt defined a system constraint as anything that limits the system from achieving higher performance relative to its goal. So if the goal of the organization is to make money, then the systems con­straint must be identified first. Goldratt explained that in order to determine whether an organization is moving toward its goal and not away from it, three simple questions must be asked and answered.

1. How much money does your organization generate?

2. How much money does your organization invest?

3. How much money does your organization spend to make it operate?

From his research Goldratt developed his own simplified system of accounting that he referred to as Throughput Accounting (TA). The basis for Goldratt’s accounting system were three financially based, performance metrics:

Throughput (T): This is the rate that the organization generates “new” money primarily through sales. Goldratt further defined T as the money collected through the sale of a unit of product minus what it pays to its suppliers and others—or Totally Vari­able Costs (TVC). Therefore, T = Selling price minus Totally Variable Costs, or T = SP – TVC. The bulk of the TVC would be raw materials, but could include any sales commissions and shipping costs associated with products.

Investment (I): The money an organization invests in items that it intends to sell. This category would include inventory, both raw materials and finished goods.

Operating Expense (OE): All the money an organization spends to operate, including labor costs, office supplies, employee benefits, phone bill, and electric bill and so on. All the money spent to support the organization.

What distinguishes Goldratt’s definition of throughput from the traditional definition is that throughput is not considered to be valuable until money exchanges hands between the organization and its customers. At any point in time before the sale the product is still considered Inventory, even in a finished goods status. Basically, any product that is produced and not sold to a customer is simply termed Inventory or Investment and it has a cost associated with it. This is a major departure from the traditional definition of throughput, and its overall implications are far reaching.

Goldratt expanded his TA definitions still further by defining net profit and return on investment as follows:

Net Profit (NP) = Throughput minus Operating Expense or NP = T – OE

Return on Investment (ROI) = (Throughput minus Operating Expense divided by Investment or ROI = (T – OE)/I

With these three simple measurements (T, I and OE), organizations are able to determine the immediate impact of their actions and decisions on the financial performance of their organization. Does it make sense that the superlative actions upon the system are those that increase T, while simultaneously reducing I and OE? You might wonder why a discussion of TOC started first with a financial definition. The relevance should become obvious shortly.

The Theory of Constraints operates under what Goldratt refers to as his Five Focusing Steps:

Step 1: Identify the system constraint. The constraint is commonly considered anything within a system that limits the system from achieving higher performance relative to its goal.

Step 2: Decide how to exploit the System Constraint. Exploitation implies getting more from what you already have. It requires that you understand why you are currently getting what you are get­ting, and what steps are necessary to maximize the throughput of the constraint. How do you get more from this constraining operation?

Step 3: Subordinate everything else to the System Constraint. The subordination implies that all other nonconstraint processes ac­tivate to the same level as the constraint. It seems contrary to popular belief, but sometimes in order to go faster, you have to go slower.

Step 4: If necessary, elevate the system constraint. Elevation implies more constraint capacity or resources, if the market demand on the system still exceeds current capacity. At this point, it may be required to spend some money to increase throughput—but only during Step 4 and not during Step 2.

Step 5: Return to step 1. When the constraint has rolled (moved) to a new location in the system, then go back to Step 1 and follow the sequence again.

So, you may be wondering why these Five Focusing Steps are im­portant to someone who uses Lean, Six Sigma or the hybrid, Lean-Sigma. The facts are simple— without the understanding of the glob­al system focus provided by TOC, many of the Lean and Six Sigma initiatives will fail to deliver significant bottom line improvement. The fundamental key to impacting the bottom line is directly propor­tional to the company’s ability to drive throughput to higher levels, while at the same time reducing Inventory and Operating Expense. The concept here is driving the system to make money, rather than saving money. Think about it, if your financial model is based upon how much cost you can remove from a process (reducing OE) then, your ROI has a mathematical limit. Likewise, if your focus is only on reducing Inventory, it too has a functional and mathematical lower limit. Throughput, on the other hand, is devoid of a theoretical upper limit. Ponder, just for a moment, the overall impact of simultaneously increasing T while reducing OE and I. The crucial focus of increasing T is what drives NP and ROI!
 
In my next posting I'll continue with more from Appendix 1 of Epiphanized written by Bruce Nelson.
Bob Sproull

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