Module 04 Discussion – Theory of Constraints

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A re you familiar with the Theory of

Constraints (TOC)? Physicist Eliyahu

M. Goldratt introduced this manage-

ment technique in 1986 in the best-

selling novel The Goal. TOC is another

operation improvement technique centered on an innov-

ative decision-making process. Just like ABM, BPR, CI,

and TQM (Activity-Based Management, Business Process

Reengineering, Continuous Improvement, and Total

Quality Management), TOC is founded on its own phi-

losophy and has its own buzzwords. And like the other

operation improvement programs, TOC considers speed,

waste reduction, capacity, direct labor use, and the like

according to its own unique perspective. But its foremost

appeal is its simplicity. TOC is based on three logical,

straightforward premises:

1. The only reason that companies do anything is to

make money.

2. Anything that a company does to speed up the processes

that generate money is appropriate.

3. Each business operation is one big process with many

subprocesses.

According to TOC, companies that keep these three

things in mind will prosper.

T O C TA L K TOC’s basic vocabulary emphasizes its philosophy and its

three performance measures. Throughput equals sales rev-

enue minus direct materials cost—it measures the speed

at which the company makes money. Inventory is the raw

materials value tied up in work in process and finished

goods. Large amounts of inventory are undesirable

because it means that the company has spent money for

production that hasn’t generated revenue yet. Operating

expenses are all of the costs of operations other than

direct materials costs. Under the Theory of Constraints,

operating expenses are fixed and therefore irrelevant to

any TOC decision. Of the three terms, throughput is the

most important. It tells the company that it is achieving

its goal of making money. Moreover, increases in

Business Management

TOCFOR YOU?IS IF YOUR COMPANY IS CONSIDERING

THE THEORY OF CONSTRAINTS, HERE ARE FIVE QUICK THINGS TO REMEMBER.

B Y L I N D A E . H O L M E S , C M A , A N D

A N N B . H E N D R I C K S , C M A , C P A

throughput mean that the rate at which the company is

making money is increasing.

P R O C E S S I M P R O V E M E N T P R O C E D U R E According to Goldratt, there are five basic steps to opera-

tions improvement:

1. Identify the system’s constraint(s), and prioritize them

according to importance.

2. Exploit the system’s most critical constraint.

3. Subordinate everything else to the action taken in Step 2.

4. Elevate the system’s constraint(s).

5. Repeat Steps 1-4, focusing on the new constraint.

(These are paraphrased from The Goal, p. 307.)

What these steps accomplish are incremental improve-

ments in the operation as a whole. In Step 1, an assess-

ment of the entire process identifies the slowest

subprocess. This subprocess is called the constraint or the

bottleneck. Identifying the constraint is very important

because it sets the pace of the whole operation. The Goal

uses Boy Scouts on a hike to illustrate this concept. We

learn that no matter how fast some of the boys walk, the

boy who walks the slowest always sets the pace and deter-

mines when the whole troop will reach its destination.

Faster boys in the front of the line will get far ahead, but

faster boys at the end of the line won’t be able to walk any

faster than the slowest boy. Using this example, we can

easily visualize the constraint in a production operation:

Work in process is piled up in front of (or before) the

constraint, and the processes behind (or after) the con-

straint sit idle waiting for something to do.

In Step 2, the company determines how best to

“exploit” the constraint. Exploiting means finding ways to

get the maximum output possible from the constraint

without overloading it and requires that the whole opera-

tion be slowed down to the pace of the constraint. The

most obvious way to exploit the constraint is by proper

scheduling and control that favors the constraint’s capaci-

ty. It’s also important to improve quality control so that

the constraint will work only on good inputs. Waste of

time and effort incurred when the constraint spends its

valuable time working on output that will eventually have

to be scrapped or reworked should be avoided.

In Step 3, the company subordinates all other opera-

tion improvement opportunities to exploiting the con-

straint. This may cause problems with managers and

workers who have their own ideas about operation

improvement. Glaring problems that everyone can see

and that most know how to correct will always be present

in any operation, but TOC requires that all operation

improvement opportunities other than those dealing with

the constraint be ignored. This may be very difficult for

managers and employees to accept if they don’t under-

stand what’s going on. Therefore, TOC recommends that

the company discuss the Theory of Constraints and its

rules with all employees involved so that they will under-

stand what is going on, support it, and be willing to help.

Step 4 calls for “elevating” the constraint. This means

that the company finds ways to increase the capacity of

the constraint. Ways to increase the output of the con-

straint include:

1. Performing regular maintenance on the constraint to

prevent breakdowns.

2. Running the constraint for extra shifts.

3. Automating the constraint.

Since the constraint sets the pace, making it faster will

speed up the whole operation. This increases the rate of

throughput (i.e., the rate at which it generates money),

which is the company’s overriding objective.

By now you’ve probably guessed that after performing

Steps 1-4 the original constraint is faster and no longer

the constraint. Considering the value of continuous

improvement, Step 5 says to find the new constraint and

start the TOC process again.

W H AT A B O U T P E R F O R M A N C E M E A S U R E S ? So far, we’ve discussed increasing speed and output and

improving quality, but we haven’t mentioned any of the

conventional management accounting performance mea-

sures (i.e., productivity, cost per unit, etc.). TOC won’t

suggest using any of them, either. Moreover, according to

TOC, not only are conventional management accounting

performance measures unnecessary, but focusing on

them can make things worse. Of course, we still need

management accounting—we just have to be very careful

about what we believe is important, the measures we

take, and how we use them.

Here are five “truths” about management accounting to

think about as they relate to TOC.

Management Accounting Truth #1: Process improvements work together to speed up the whole operation. We know that in Total Quality Man- agement and Continuous Improvement the objective is to

eliminate waste and speed up every process. The Theory of

Constraints takes almost the opposite view. It requires that

we focus on the constraint while leaving all other people,

processes, and machines alone. Consider what would hap-

pen to TOC’s inventory (i.e., work in process) if a process

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located before the constraint were sped up. This process

would produce even more work in process that the already

overloaded constraint couldn’t handle. Likewise, if the

newly improved, more efficient process were located after

the constraint, it would still be sitting idle, waiting for the

constraint to send it work. Remember, increasing the speed

of nonconstraint processes will only make things worse. Extra

costs will be incurred with no increase in throughput.

Management Accounting Truth #2: You have to spend money to make money. Under other operation improvement programs like Business Process

Reengineering, a company is required to make radical

process changes, usually by purchasing expensive

machines, equipment, and/or technology. For example, in

the landmark book Re-Engineering the Corporation,

Michael Hammer and James Champy talk about the way

that IBM Credit Corporation turned its step-by-step

paper-based credit approval process into a one-step com-

puterized process. Credit approval time went from seven

days to four hours—an amazing improvement. But TOC

discourages large expenditures for process improvements.

It presumes that companies are already working at capac-

ity and that all resources are running as efficiently as pos-

sible. According to TOC, all that a company needs to do

is slow things down and work to the capacity of the con-

straint. Expensive improvements can be made, but only

on the constraint. Remember, be very careful that all

money spent on new equipment, hardware, or software goes

toward maximizing the capacity of the constraint.

Management Accounting Truth #3: Operations can be made more efficient by improving labor efficiency variances. Who doesn’t believe that keeping workers busy earning their pay benefits the firm?

Well, TOC, for one. Just like any other nonconstraint, fully

utilized labor will produce more work in process than the

constraint can handle. This causes the same problems that

happen when any other nonconstraint process becomes

more efficient. Think what would happen if idle workers

from processes located after the constraint were moved to

processes located before the constraint to keep them busy.

Let the workers spend their free time on machine mainte-

nance, on learning new skills, or just having a rest. They

will be happier, and the company will eventually have

more money to spend. Remember, increasing labor efficien-

cy when labor isn’t the constraint will only increase work-in-

process inventory and tie up money that could be used more

effectively somewhere else.

Management Accounting Truth #4: Large pro- duction runs are desirable because they are an efficient use of setup time and fixed costs. Moreover, large production runs reduce per- unit costs, which will increase profit. Actually, the opposite is true for TOC. Large production runs overload

the constraint and increase work in process without

increasing throughput. Moreover, TOC views all costs oth-

er than direct materials as irrelevant fixed costs. It doesn’t

matter how they are arbitrarily allocated among individual

products. Remember, making production decisions based on

reducing per-unit costs works against the objectives of TOC.

Management Accounting Truth #5: Product mix should be determined based on maximiz- ing total contribution margin. Traditional product mix decisions consider individual product profitability

measured by contribution margin per unit. This makes

sense in an operation with no constraint. But in opera-

tions with a constraint it’s better to select among products

based on the benefit (i.e., throughput) received per unit of

capacity of the constraint. This is the same analysis used

in traditional management accounting when the system is

bound by a scarce resource. With TOC, the constraint is

the scarce resource, so the benefit obtained from it should

be maximized. Remember, wise use of time at the constraint

is the thing to consider in TOC product mix decisions.

The simplicity and logic of the Theory of Constraints

make it very appealing. All that it requires is a thorough

knowledge and understanding of the processes that are

already in place. In addition, except for slowing things

down (which can have its own benefits to work atmos-

phere and morale on all levels), no expensive or demor-

alizing changes will be needed. Finally, remember, you

should adapt your performance measurement to your

new understanding of processes and outcomes so that

you can correctly gauge your performance and make

effective decisions. Our five suggestions should help. n

Linda E. Holmes, CMA, Ph.D., is assistant professor of

accounting at the University of Wisconsin-Whitewater in

Whitewater, Wis. You can reach her at (262) 472-5451 or

[email protected].

Ann B. Hendricks, CMA, CPA, Ph.D., is assistant professor

of accounting at the University of Wisconsin-La Crosse in

La Crosse, Wis. You can reach her at (608) 782-0220 or

[email protected].

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