TOC / Constraint

Management
(Theory of Constraints)

What is
blocking you
from getting
more of
your Goal?
The Current State of Affairs

BUT...

OR...
Cost World Thinking Has Paid
Off for Many…Until Now...

Cut Waste

Identify Waste
 What Now?
Continue to Cut?
Cut
Protective

Capacity?
Cut Waste

Identify Waste
 A New Way of Thinking...

“The significant problems we face today

can not be resolved at the same level
of thinking we were at when we
created them.”
Einstein
 What is the TOC/
Constraint Management?
Organizations are a complex web of
people, equipment, methods, materials
and measures. This detail complexity is
bad enough, then add to it the dynamic
complexity of changing customers,
suppliers, workforce, regulations, etc.
and you have a picture of the challenge
faced by today’s management team.
 What is TOC? (continued)

Traditionally, management has divided

the organization into smaller, more
manageable pieces. The objective is to
maximize the performance of each
part. After all, global improvement is
the sum of the local improvements.
Right?
 What is TOC? (continued)

W rong! TOC claims complex systems

exhibit inherent simplicity!
There are very few points in a system,
perhaps only one, where a significant
improvement in local performance causes
a significant improvement in global
performance.
Such a factor is called a constraint.
 How does TOC help
companies?

If you want more of your goal ,

you must focus on your constraint,
follow through ,
and manage based on feedback .
That is the essence of TOC!
 Finding the Focal Point

• Before a business can properly focus ,

one necessary condition is that they
answer the following question:

W hat is the Goal

of a for profit enterprise?
 The Goal?

• To make money now and in the future!

 The Goal (continued)

Some would argue that the goal of their

company is to...
• To satisfy customers now and in the
future!
Or to..
• Provide a secure and satisfying jobs for
employees now and in the future!
 The Goal (continued)
TOC recognizes that only the “owners” of a
company can choose THE goal. However,
once chosen, the other 2 become conditions
necessary to achieving the goal.
Make money
Goal
now and
in the future.

One necessary A 2nd necessary

condition Provide security and Provide satisfaction to
condition
satisfaction to employees customers
now and in the future. now and in the future.
 The Goal (continued)

That is…
• If your goal is to satisfy customers, it is
absolutely necessary that you make money
and that you provide security and satisfaction
to employees...
• Likewise, if your goal is to provide secure and
satisfying jobs, you also have to make money
and satisfy your customers...
…or you won’t be in business in the future!
 The Goal (continued)

The choice is yours, choose any of the

three as the goal of your organization!
You cannot escape the fact that a
company must make money now and in
the future!

For the duration of this presentation, we

will assume that the goal is:
• To make money now and in the future!
 Measuring Progress

Once the Goal is identified, the next

crucial need for success in achieving
the goal is to identify which
measurements will be used to judge
success.
 What measurements
should we use?
Conventional Wisdom
• Net profit?
• Efficiency?
• Utilization?
• Return On Investment?
• Cash Flow?
“Are you using the right m easurem ents?”
Jonah in The Goal
 What measurements
should we use? (continued)
Generally Accepted Performance Measures
• Net Profit
• Return on Investment/Equity/Assets
• Cash Flow
TOC does not question the validity of these 3
measures; they are vital and must be
satisfied. However, TOC does question their
usefulness as Operational Measures.
 What measurements
should we use? (continued)

• For the average worker it is almost

impossible to see the effect that any of
their actions has on Net Profit (NP) or ROI.
• As a result we have created measures like
efficiency and utilization because we
believe they are linked to NP and ROI.
But are they?
 Utilization

• Suppose more material is released for the

purpose of improving the Utilization of a
certain resource. Further suppose that this
resource can produce faster than the pace
setter resource. This “improvement” in
utilization will not increase shipments but
will increase your investment in inventory.
Does that improve net profit and/or ROI?
 Efficiency
• In a similar fashion, suppose you
spend money to “improve” the
Efficiency of a non-bottleneck
resource. You will not increase
shipments, you will probably increase
WIP, and (depending on the nature of
the expenditure) you will either
increase your investment or operating
expenses. Does that improve NP
and/or ROI?
 What measurements
should we use? (continued)

TOC Measures
• Throughput
• Inventory&Investment
• Operating Expense
 Throughput (“T”)

The rate at which contribution dollars

(m onies ) are entering the organization.
• Only $ generated by your system get counted;
i.e., raw materials and purchased services (like
heat treating) don’t count because those $ pass
through your books to your suppliers.
• “T” = (Selling Price - Unit Variable Costs)/time,
or “T” = “Contribution$”/time
• Building to stock does not generate throughput
 Inventory/Investment (“I&I”)

All the m oney currently tied up inside

the system.
• “I” really is made up of two categories
1. Investment in machinery, buildings, etc. (if
owned)
2. Inventory in the form of raw materials, work in
process (WIP), and finished goods (FG)
 “I&I” (continued)

Is the Inventory portion of “I&I”

a liability or an asset?
• To the extent that it protects against lost
sales it is an asset.
• To the extent that too much (especially
WIP and FG) ties up cash and retards
responsiveness to market preferences
(causing lost sales) it is a liability.
 Operating Expense (“OE”)

All the m oney the system spends to

turn inventory into throughput.
• All expenses are lumped together and usually
considered as one big expense.
• All employee labor expenses are almost
always Operating Expense (direct, indirect,
sick, operating, etc.).
 Operating Expense (“OE”)
(continued)

Allocation of operating expenses often leads to

local decisions that reduce global profit and
ROI. For example:
• Some companies sell all their products at a
price that the fully allocated cost system says
includes some net profit, yet they go bankrupt.
• Others sell some of their products “at a loss”
according to their fully allocated costing
system, yet total net profit goes up.
 A Very Important Question

“Wait a minute,” someone exclaims. “If I

monitor Throughput, Inventory/
Investment, and Operating Expense in
the short term, how can I be sure that
I will have a Profit, with reasonable
Return On Investment in the long
term, and maintain a positive Cash
Flow?”

28
 Financial Links
The following are based on
“The Race” by Goldratt and Fox (North River Press, 1986)

Case 1: If we can increase “T” while

maintaining level “I&I” and level “OE”, what
will the impact be on Net Profit, ROI, and
Cash Flow?
If...
Throughput

Investment

Operating
Expense
T I&I OE
Then...
Investment
Return On

Cash Flow
Net Profit

NP ROI CF
 Financial Links (continued)
Case 2: If “I&I” decreases (by reducing WIP)
while “T” and “OE” remain level, what will
the impact be on Net Profit, ROI, and Cash
Flow?
Throughput

Operating
Investment
If...

Expense
T I&IInvestment
Return On

OE

Cash Flow
Then...
Net Profit

NP ROI CF
 Financial Links (continued)
Case 3: If we can decrease “OE” while
maintaining level “T” and level “I/I”, what
will the impact be on Net Profit, ROI, and
Cash Flow?

If...
Throughput

Investment

Operating
Expense
T I&I OE
Then...
Investment
Return On

Cash Flow
Net Profit

NP ROI CF
 Financial Links (continued)

• So the answers in all 3 cases show

unquestionably that by determining the
impact that an action will have now on
Throughput, Inventory&Investment,
and Operating Expense we can predict
the future impact on Net Profit, ROI,
and Cash Flow.
 Financial Links (continued)

Case 4: What about Inventory&Investment?

Because it has no direct impact on Net
Profit, it seems to be less powerful at
impacting the bottom line. But...

Investment
Even though when... I&I
There is no Direct impact on...
NP
 Financial Links (continued)

However, reducing Inventory&Investment,

especially by reducing the amount of work
in process Inventory (WIP), and finished
goods (FG) does reduce some operating
expenses, known as carrying costs.

If... Then... Carrying

Inventory

I
WIP

Costs
 Financial Links (continued)

And...

If... Carrying
Costs
Then...
Investment

Cash Flow
Return On
Net Profit

NP ROI CF
 Financial Links (continued)

Therefore, there is an indirect link...

If... Then...
Inventory

Net Profit
I NP
WIP

And since we already saw that a reduction

in WIP causes a direct increase in ROI and
Cash Flow, we can see that reducing WIP
has a significant financial impact.
 Financial Links (conclusion)

• Throughput, Inventory&Investment,
and Operating Expense are valuable
operational measures that can be used
to guide our decisions.

• The next question must be: which of

these 3 is the most important -- or do
they all have equal weight?
 Where should a manager
focus?

Decreasing Operating Expense?

Decreasing Inventory&Investment, or
Increasing Throughput?
 The “Cost World”

• Decreasing “OE” is definitely #1 because we

have relatively high control of our expenses.
• Increasing sales is always important, but it
ranks #2 because we are at the mercy of the
marketplace and have less control over sales.
• The Inventory portion of “I” tends to fall into a
“grey area”; it is a “necessary evil” that must be
lived with to protect sales, but too much is
clearly bad.
 The “Throughput World”

• Increasing “T” is unquestionably #1 because

it has the greatest potential impact on the
bottom line.
• Decreasing the Inventory portion of “I&I” is
#2 because excess WIP and finished goods
jeopardize future throughput.
• Decreasing “OE” #3 because significant
reductions (which are usually capacity
reductions) jeopardize future throughput.
 TOC Question...
TOC does not claim to have been the factor that
determined the proper ranking of the 3
operational measures. The vital contribution of
TOC is to answer the following critical question:
How should w e m anage a com pany in a
w orld w here increasing Throughput is the
#1 priority, reducing I nventory is #2, and
reducing Operating Ex pense is a tactic of
last resort to be em ployed only after
com prehensive efforts at #1 and #2?
 Chain Analogy
A company can be compared to a chain. The
activities that constitute business are really a
“chain” of dependent events. That is to say that
we don’t ship parts until they are packaged, and
Marketing
we don’t package parts until
Bidding
they are manufactured, etc.
Procurement

Manufacturing

Packaging

Shipping
 Chain Analogy (continued)

Conventional Wisdom believes

that...
• Improvement of any link
is an improvement to the chain.
• Global improvement is
the sum of the local improvements.
• Primary Measurement: Link Weight
Result: Every link wants/needs more
resources all the time
 Conventional Wisdom
“Take actions that will maximize any/all local
operations.” (i.e. Fight constantly for scarce
resources.)
Maximize

Marketing Maximize Bidding

Maximize
Procurement Manufacturing
Maximize
Maximize
Packaging Shipping
Maximize
 Chain Analogy (continued)

Throughput World Approach believes that...

• Most improvement of most links
do not improve the chain.
• Global improvement is NOT
the sum of the local improvements.
• Primary Measurement: Chain Strength
Result: Resources are channeled to the weakest
link (aka: Herbie, the constraint, “CCR”).
 TOC/Global Wisdom: FOCUS

“Think Globally. Take only those local actions that

will strengthen the chain.” (i.e. Focus scarce
resources on the constraint.)
Marketing

Bidding
Management &
Procurement
Scarce Resources
Manufacturing

Packaging

Shipping
 A Process for Follow
Through
The Process Of On Going Improvement
1. Identify the constraint
2. Decide how to Exploit the constraint
3. Subordinate all other decisions to the necessity
to exploit the constraint
4. If after #2 and #3 more capacity is needed to
meet market demand, Elevate the constraint.
5. Go back to #1, but don’t let inertia becom e
the system ’s constraint.
 Follow Through: Step 1
Identify the constraint
– The effect of the true constraint can be
“visible” internally (i.e. you can’t supply
fast enough) or externally (i.e. there is not
enough demand).
– Don’t confuse factors that limit your ability
to exploit the constraint with the constraint
itself. For example, bad policies are never
the constraint, though they frequently limit
your ability to exploit the actual constraint.
 Follow Through: Step 2
Decide how to Exploit the constraint
– What is it going to take to get the most that
is reasonably possible out of the capacity
constrained resource (CCR)?
– Utilization and efficiency are crucial at the
CCR.
– This step is often treated as
indistinguishable from step 4, but it is
usually beneficial to Exploit before
Elevating.
 Follow Through: Step 3
Subordinate all other decisions to the necessity
to exploit the constraint
• The focus is on being a high quality, reliable
supplier to, or customer of the constraint.
• Utilization and efficiency are not factors to
emphasize at the non-constraint
resources.
• This step is often skipped, and thereby the
majority of financial benefit of TOC is lost!
• This is the toughest step because you must
change your measurements/culture.
 Follow Through: Step 4
If after #2 and #3 more capacity is needed to
meet market demand, then Elevate the
constraint.
• Add more capacity through capital
investment or outsourcing, or off-load the
constraint by defining alternative routings,
process or product redesign, etc.
• Often times, Exploitation and Subordination
are sufficient to reach the needed output; do
not increase investment too soon!
 Follow Through: Step 5
Go back to #1, but don’t let inertia becom e
the system ’s constraint.
• Often times, when a new constraint is
identified, it is necessary to change your focus
(and many of the policies you just made)!
• CAUTION! The long term strategic application
of TOC does not call for the continuous
removal of the constraint; rather, in order to
best exploit business opportunities, the idea is
to choose strategically which resource should
be designated as the “Drum” (or pace setter)
and then keep that “constraint” stationary!
Management based on Feedback

• TOC solutions are robust because they

provide not only a means for creating
a plan, but also a powerful means for
executing the plan. (Many other
methods rely on frequently changing
the plan – usually causing chaos.)
 Feedback (continued)

• ‘Buffer management’ provides dynamic

feedback for short term (expediting)
and long term (adjusting buffer sizes).
• ‘Buffer management’ works differently
in different applications
• Poorly implemented ‘buffer
management’ means wasted profit.
 Three “f-words” of TOC

The Theory of Constraints provides

proven methodology for three vital
needs in any organization:
• Focus
• Follow Through
• Feedback
 TOC Summary: Focus

• A company must first know its Goal

and the necessary conditions for
achievement.
• Then it must identify the correct set of
measures that can be used to judge
their efforts to achieve the goal.
TOC Summary: Follow Through

The Process Of On Going Improvement

1. Identify the constraint
2. Decide how to Exploit it
3. Subordinate all other operations to the necessity
to exploit the constraint
4. If after #2 and #3 more capacity is needed to
meet market demand, Elevate the constraint.
5. Go back to #1, but don’t let inertia become the
system’s constraint.
 TOC Summary: Feedback
• Buffer management
– Know if you need to expedite before the
order is late
– Know when you should reduce or increase
the size of the buffer(s)
 About the Author
Tim Sullivan has retired as a Industrial Specialist for
Iowa State University's Center for Industrial
Research and Service. He specialized in constraint
management and assisted manufacturers in the
successful implementation of TOC. He has a
Master of Science in Industrial Relations from
Iowa State University, and has completed the
“Jonah”, and “Jonah’s Jonah” training at the
Goldratt Institute.
For more information on TOC contact Mike Willett:
phone: 319-234-6811
email: [email protected]
www.ciras.iastate.edu/toc