A Quick Guide to Theory of Constraints

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The number one duty of a manager is to ensure that processes take place efficiently and smoothly. This involves decision making and the implementation of the decisions and it is the difference between good managers and okay managers.

Every manager has his way of doing things. Although the goal of all these methods is to ensure smooth operation, some have higher chances of success than others.

Management is a very broad discipline. This partly explains why managers – even within the same industry – have different approaches towards the achievement of goals, whether organizational or personal. It can easily get confusing, especially when concepts start overlapping each other.

However, there are several management concepts and paradigms that persist to this day, no matter how many other, newer, concepts are introduced. Right off the top of your head, you can probably name more than a few of them. Six Sigma. MRP or Manufacturing Resource Planning. JIT or Just-in-Time Manufacturing. TOC or Theory of Constraints.

In this article, we will be focusing on the last one mentioned, the Theory of Constraints and what it can do to your business.

THE CORE CONCEPTS OF THEORY OF CONSTRAINTS

The TOC Institute provides what seems to be the most straightforward definition for the Theory of Constraints (TOC). The theory involves identification of constraints, and simply managing them in order to continuously improve the effectiveness and efficiency of a system.

When Dr. Eliyahu M. Goldratt first introduced the TOC concept in his bestselling book “The Goal” in 1984, it was seen as an organizational and management paradigm that would help you as a manager to make decisions about “changes”, and how these changes can provide solutions to various business problems or issues that arose in the course of business operations. Goldratt’s presentation of the concepts was written in such a way that it was told like a story, which added a practical and reality-based touch, allowing readers to connect with the topic and understand it better and easier.

TOC, which is sometimes referred to as “constraints management”, has one ultimate goal, and that is profit improvement. The final goal is clear-cut enough. The confusion comes when you try to achieve this goal through the application of TOC.

Essentially, the TOC holds that every organization has at least one constraint that stands on the path, blocking it from reaching its final goal of improved profitability. By definition, a “constraint” is any limiting factor that restricts one from achieving a goal. In the context of business and management, a constraint is any element or factor that serves as a bottleneck that limits the organization from improving profits.

Therefore, it is the TOC’s view that every process, system, or organization has a constraint that must be identified and managed in order to clear up the path towards improved profitability. It works under the premise that even a single bottleneck will have a negative effect on performance and subsequently the results of operations.

Therefore, the theory then provides a suite of tools and techniques that help in managing these constraints to improve performance. This is done until the constraints cease to become limiting factors, and the company can go on its way towards reaping higher profits.

The TOC has a holistic view, looking at the big picture, rather than the small details. Instead of managing separate resources, assets, or procedures to optimize their productivity, the TOC focuses on the interconnections and links among these separate components, specifically on the barriers that impede them from working as a single unit. The result is an entire system that flows and operates smoothly, free of any bottleneck.

THE BENEFITS OF TOC

To find out if the theory of constraints is worth implementing, we have to first verify that the implementation has benefits to the companies.

This is a no-brainer, really, but it has to be said: businesses and profit-oriented organizations have one ultimate goal, and that is – obviously – to earn more profits. Despite how overwhelming it might look on the managers, even investors expect their investments to bring in more profit every period. Making more money and earning a higher profit involves several components and the TOC postulates that its implementation is one method towards higher profit margins.

Through successful implementation of the TOC, an organization may reap the following benefits:

  • Reduced inventories. Improvement of processes by managing and eliminating bottlenecks will reduce cycle times in the production process, which means there will be lower inventory of materials, in process, and finished goods. It will also reduce lead times in the supply chain, as well as the distribution chain.
  • Reduced operating costs and expenses. There are many ways that management of constraints can reduce costs of operations. For example, reduced cycle times mean lower overhead costs. Reduced inventories, on the other hand, mean lower warehousing and storage costs. Stock-outs across the supply chain will also be eliminated, and this will translate to more cost savings for the company.
  • Increased throughput. A business will enjoy increased productivity of a business process, procedure, machine or system through the application of the TOC. If cycle times are reduced, the company can actually take this as an opportunity to increase the production process throughput. Elimination of a constraint is likely to reveal idle resources and free up additional production capacity, which is definitely to the advantage of the company. It is essentially handed an opportunity to produce more, without having to make any additional investment.
  • Improved workplace synergy. Often, employees have conflicts that are work-related. Application of the TOC will help in minimizing these conflicts and sometimes even eliminating them fully. The result is more time spent on actual productive duties.
  • Improved operational control. Most of the time, the reason that managers lose control of operations is the lack of a fixed guide that will point them in the right direction. The TOC provides this guidance, so that managers can focus on what needs to be prioritized.
  • Improved business reputation and branding. The company’s branding will also benefit. Improved processes can mean that products and services will be delivered to customers on time, in full, and with no defects, thereby improving the company’s relationship with the customers. This will eventually trickle to its relationship with the other key players in the market, improving the company’s standing in the industry. Better reputation will lead to more sales revenues and, ultimately, higher profits.

THE TOC TOOLS

As mentioned earlier, the TOC offers a set of tools that managers and other change agents may employ in constraints management. We will take a look at three of these tools, and how they are applied.

The sets of tools include:

  1. The Five Focusing Steps
  2. The Thinking Processes
  3. Throughput Accounting

I. The Five Focusing Steps of TOC

In order to manage constraints (and drive and improve systems performance), a manager must have an inquisitive mind, asking questions and actively seeking their answers. If your company is focused on its goal of earning higher profits, it also has to be focused on the impediments in order to get them out of the way.

Goldratt identified five focusing steps that must be followed for the identification and elimination of constraints. (Take note that there may be more than one constraint. However, for purposes of simplifying this discussion, we will be using a scenario with only one constraint.)

Step 1. Identify the systems constraint.

This goes without saying because you really can’t fix a problem you don’t know exists.

You will be looking for the “weakest link” in the system. Which part of the production process yields the highest amount of bottlenecks? Where are you experiencing the largest number of unnecessary delays? Which unit or branch are you experiencing resource hemorrhage?

A constraint can either be a physical constraint, or a matter of policy. The most common types of physical constraints may include:

  • Capacity constraint. This exists when your company’s operations expose a lack of capacity to satisfy demand for its products and services in the market. If this constraint is present, the priority is to eliminate it so that more capacity will be freed up to offer more earning power.
  • Market constraint. There is a market constraint if the company has more than enough capacity (to the point that it has idle time and resources), but there is not enough demand in the market to translate into sales and, eventually, profit.
  • Material constraint. Your company’s operations will definitely encounter problems if it experiences trouble obtaining the materials and supplies needed to make and sell products to meet market demand.
  • Cash constraint. Difficulties in cash flow are also considered a constraint, since they could mean an inability on the part of your company to meet its working capital requirements and continue making and selling its products and services.

As an example, let us consider a bottleneck in capacity arising from machine inefficiencies, such as when a specific machine requires a downtime period for maintenance and recovery. This will result in a stall in the production process, slowing it down. It is also likely to result in the overstock of supplies and raw materials that are input into the production process. Employees in processes that require input from the faulty machine will be left idle. In short, operations (and its corresponding costs) will still continue even with the stall in production. This is referred to as bottleneck operations.

Physical constraints are relatively easy to identify. Policy constraints, on the other hand, are not as obvious, and sometimes pose more challenges for change agents. This is because the cause of impediment to performance lies in a rule, behavior or policy within the organization.

For example, a company may follow a policy on batch production, opting to make products in large batches in order to keep production overhead costs low. However, this also means high costs in storing of work-in-process inventories and warehousing of finished goods. Customer satisfaction can also be affected if the distribution process causes delays in delivery of finished products.

The most obvious way to identify constraints is through the use of existing information regarding the current state of operations in your business. By taking a look and reviewing the current flow of processes within your organization, (e.g. determining activities that incur the highest costs, aspects of customer service that gets the most negative feedback) you can immediately spot the constraint that must be dealt with swiftly and accordingly.

Here is very cool video on compraing different systems using the theory of contraints.

Step 2. Decide how to exploit this constraint.

Making use of the resources that are currently available, apply quick improvements to the throughput of the constraint. By ‘quick improvements’, we mean actions that can be performed as fast as possible, without spending or investing too much the changes and upgrades. Usually, the corrective actions are free, since they involve the use of resources that are already available to the company.

What can you as the change agent do to quickly address the issue? What capabilities can you acquire or obtain from the constraining component?

In the example, one way to exploit the constraint will be to reduce the downtime of the bottleneck operation, perhaps by coming up with a machine maintenance and setup schedule that will cut the downtimes into shorter intervals. Another exploit action would be to assign mechanics and other appropriate personnel to keep close tabs on the machine’s preventative maintenance.

Step 3. Subordinate everything else to exploit this constraint.

There is a need to ensure that all the other activities, steps and elements that are not constraints remain in alignment with the decisions made in Steps 1 and 2 with respect to the identified constraint.

This will require that you take a look at all the other activities and steps for a thorough review. You have identified the constraint, and you already have a plan on how to exploit them to increase and maximize profit. Now you have to make sure that the plan is actually put into motion, with everything else falling in line.

Let’s take a look at an example. A machine specialist is assigned on the major machine where capacity constraint is identified is a non-constraint. In the process of ensuring that the machine does not cause stalls in production, the specialist may be tasked to focus solely on that machine. However, this has a potential of leading to an inefficient use of the non-constraint, which is the skill and capabilities of the machine specialist.

Subordinating the non-constraint may entail tasking the machine specialist to also focus his efforts on the other machines in the production process. This will, after all, translate to the benefit of the entire process, and your company, since it will ensure that all the other machines are well-maintained, while keeping the costs of operation at the same level. You see, you’ll still be paying the same salary or wage to the machine specialist whether he spent his work hours on that one machine alone, or if he also performed preventative maintenance on the other equipment and machinery.

If, in this step, the constraint has been eliminated, you may proceed directly to Step 5.

Step 4. Elevate the system’s constraint.

If, at this point, the constraint still remains and has not budged despite the quick improvements you applied, it is time to take another look at the other possible actions that you can do in order to eliminate the constraint.

In actual practice, to “elevate” usually means that it will cost a lot more money than when you are simply “exploiting”. In the example, if the current mechanic or machine operator is unable to fix things, you may have to seek services of a specialist. Or simply purchase a new machine to replace it.

It is not a surprise if this step will last for quite a while, since it may involve the performance of several actions until such time that the constraint has been “broken”.

Step 5. If, in any of the previous 4 steps, the constraint has been “broken”, repeat Step 1 on the next constraint.

A “broken” constraint means the problem has been resolved. Is that the end? Of course not. There is still the next constraint to deal with and, for that, you have to go back to Step 1 and do the whole thing all over again. What used to be the weakest link will be strengthened, but that also means that another link has earned that spot.

But wait! You have to take caution in the last step. See to it that inertia does not become the next constraint. Application of the Five Focusing Steps is a cycle. It is, after all, geared for continuous improvement. As long as there are constraints, the steps have to be performed in a cyclical manner, eliminating one constraint at a time.

The downfall of most businesses is due to their loss of focus. Just because they succeeded in doing away with one constraint, they think they can afford to be complacent about it. Well, you should not. Business landscapes are volatile, changing every second, which means constraints are bound to arise even when you least expect it. In fact, constraints will mostly come up when you least expect them.

II. The Thinking Processes

The Thinking Processes are put in place to provide tools specifically designed for analysis of problems and coming up with their solutions. They are usually applied more than the Five Focusing Steps when dealing with policy constraints which, as we’ve already established earlier, are much harder to identify and manage.

As tools, the Thinking Processes are designed to be scientific in their approach, identifying the root causes and their negative effects, and removing these effects by coming up with solutions to effect changes. They are the preferred tools in rooting out policy constraints. This is why you will likely see them applied in win-win conflict situations or when communication problems exist within the organizational structure. The Thinking Processes are also seen to be effective in delegation of duties and responsibilities, empowering employees and fostering teamwork within the organization.

Basically, the TOC, through the Thinking Processes, aids managers in addressing these questions, with respect to decision-making with respect to continuous improvement of systems and processes:

  • What needs to be changed?
  • What should it be changed to?
  • How should we cause the change?

When Goldratt formulated the Thinking Processes, he also introduced the Categories of Legitimate Reservation (CLR), a set of logic rules to guide change agents in making decisions for continuous improvement.

There are several tools that make up the Thinking Processes, often referred to as the “four trees and a cloud”. We will look at each of these components briefly.

Current Reality Tree (CRT)

This is the first tool to make use of the cause-and-effect logic. In fact, it is seen as the most probable and realistic cause-and-effect chain, since it is designed to depict the current actual state of a given system.

The objective of the CRT is to identify the various issues that are currently being faced, and understand how they are interrelated. This understanding is what will enable you as a change agent to come up with a probable solution for the problem. In the process, a top-down approach is utilized.

  1. Undesirable effects are identified.
  2. The probable causes of those undesirable effects are postulated.
  3. The postulated causes are tested by running them through the CLR.

Evaporating Cloud (EC)

The EC goes by several other names, including “conflict cloud”, “conflict resolution diagram”, and “dilemma cloud”.

The focus of this tool is the second question: “What should it be changed to?”In order to answer this question, as the change agent you must go beneath the surface and seek out underlying assumptions, which will subsequently be tested through the CLR. The testing could invalidate or replace, these underlying assumptions. If this happens, the conflict is “evaporated”, hence the name.

Among the identified Thinking Processes tools, the EC is considered to be the most multi-purpose one, best used in coming up with win-win solutions, without having to make compromises. It is also very useful in situations that require making tough business decisions and negotiations.

The EC is not only proven to resolve conflicts while avoiding compromises; it is also a great tool in creating breakthrough solutions that allow both sides of a conflict to win.

Future Reality Tree (FRT)

Yet another tool that makes use of the cause-and-effect structure, the FRT takes a look at how the changes that are being contemplated or proposed are likely to affect reality if they are actually implemented. Usually, what you will look at is whether the proposed changes can give rise to favorable outcomes. The goal of FRT is to turn the undesirable effects into desirable ones, by using cures or “injections” on the identified causes of those undesirable effects.

At first glance, you’d probably say that the FRT is similar to the CRT. You won’t be wrong, because they do have similarities. However, the FRT takes it a step further with the inclusion of the proposed solutions.

The FRT finds excellent use, among other things, as an initial planning tool, since it allows effective testing of new ideas prior to committing resources to implementation.

Transition Tree

This is the third of the three tools that derive support from the cause-and-effect logic. This time, it is concerned with the third question, which is on the “How” of things. How can you make the change happen?

This tool derives its name from an action plan, which is also called a transition tree. Its objective is to allow change agents to implement change. In order to do that, they must determine the specific actions that are necessary to implement the solution, and this requires delving into the details of the action plan. The other tools take a broader tack in their approaches; the Transition Tree goes into the small details that make up the whole, making it an ideal “operational tool”.

Successful application of the Transition Tree is possible if all the four elements, as identified by Dettmer, are present.

  • A current, actual condition, or a condition of existing reality
  • An unfulfilled need
  • A specific action that must be taken to fulfill that need
  • The expected effect, result or outcome from the application of the identified action to fulfill the need that exists in reality

As mentioned earlier, Transition Tree is most effective for change implementation, and this is largely because of how it provides a step-by-step guide for implementation of actions that will bring about the changes. It also allows you to move things along the change process without deviating from the original goal or objective.

Prerequisite Tree (PRT)

Just because you thought of an idea does not mean that it has actually become a solution. It is a mere idea of one, and the only time it becomes an actual solution is when it is fully implemented, and the desired favorable outcome is obtained.

PRT works by identifying the obstacles that prevent the achievement of desired outcomes and subsequently identify the remedies that can do away with these obstacles. It is also useful in coming up with action plans, with the actions mapped out in a sequence of responses, all aimed at achieving the desired results.

III. Throughput Accounting

Goldratt was cognizant of how TOC is not supported by traditional accounting systems, and this is what spurred him to provide for an accounting method for measuring performance and providing information that will guide management decisions, in accordance with the principles of TOC, and it is called Throughput Accounting.

Traditional accounting practices and methods, when applied in consonance with TOC, will undoubtedly result to distortions that will be in contradiction with the goal of organizations on why they are applying the TOC in the first place. Even the slightest distortion can be very harmful, since it will have an effect on decision-making processes of managers with regards to operations.

As an alternative accounting method, Throughput Accounting (TA) eliminates these distortions and supports the increase of profits through the TOC. It is decidedly more simple, and geared towards management accounting than straightforward financial accounting.

Many have mistaken TA to be the same as variable cost accounting. That is not true. They are two different beans, although they may have come from the same pod. To be more precise, it is safe to say that TA is an offshoot of variable cost accounting.

The main principle of TA involves the treatment of Direct Materials Costs as the only variable costs. All other costs are assumed to be fixed.

According to TA, there are only three ways to boost the profits of a company.

Increasing Throughput

“Throughput”, in this context, refers to the money coming into the company, generated through its revenue or profit-generation activities. In short, it is the total sales, decreased by the Truly Variable Costs.

As the level of sales increases, so will the variable costs, but only up to the extent of the cost of making and selling additional units. The other costs remain fixed, which means that the company will definitely register an increase in profits.

Reducing Investment

By TOC definition, “investment” refers to the money currently tied up in the system. Certain sources make use of the old term, which is “inventory” instead of “investment”, but the principle still applies.

Essentially, a business invests when it makes or sells a product or service. This could be in the form of acquisition, maintenance and usage of equipment, machinery, facilities, and various inventories. In short, it costs money to make money.

By minimizing investments – without compromising the quality of products and services – the company can definitely maximize throughput and, ultimately increase its profits.

Reducing Operating Expenses

This follows the same line of reasoning as the reduction of investment. “Operating expenses” are all the money spent turning investment and inventory into throughput, which will then be sold to generate revenue. It can refer to direct labor, supplies, and utilities. Even depreciation of assets will fall under this category.

With all things being constant, specifically the sales and the fixed costs, a reduction in the incurrence of operating expense will increase profit.

It is to be noted that, in order for TOC to guarantee profit increase, all three measures have an interdependent relationship with each other. For example, a reduction in operating expense will mean a corresponding reduction in the amount of investment. Similarly, if throughput is increased by making and selling more units, the amount of inventory remaining in the company will decrease.

If we take a look at the nitty-gritty of the measurement processes in Throughput Accounting, there are four derived measures to take note of.

Net Profit

The net profit is the income remaining to the company after all operating expenses have been deducted from the revenues generated through the sale of products and services. The formula is:

Net Profit  =  Throughput – Operating Expenses

In other instances, the formula can be translated to total Sales, decreased by total Variable Costs and Operating Expenses.

Return on Investment (ROI)

This refers to the gains obtained from the investment, in comparison with the total cost of investment. Essentially, it is a comparison of how much profit the company earned with respect to the total amount of capital investment. The formula is:

ROI  =  Net Profit / Investment

Productivity

TA defines “productivity” as the average measure of the efficiency of production, comparing the production output to the input placed at the beginning of the production process. In this case, input refers to the operating expenses, while the output refers to the throughput. The formula is:

Productivity  =  Throughput / Operating Expenses

Investment Turnover

Also referred to as “investment turns”, this is the ratio of the value of the throughput (sales or revenues) in relation to the value of the investment, or capital invested. The formula is:

Investment Turnover  =  Throughput / Investment

In order to successfully ensure the achievement of the goal of TOC, which is increased profitability, it is important to maximize throughput while keeping investment and operating expenses at a minimum. Take note that the priority among the three is the throughput. That is because the TOC puts more emphasis on maximizing Throughput (by increasing Sales) more than cutting down on investment and other operating costs and expenses.

To this day, the Theory of Constraints remains to be a highly pervasive discipline, also giving rise to other management concepts that are widely used and applied across industries, not just in manufacturing. Therefore, do not be surprised when you come across TOC concepts when you are on a foray to other management concepts, especially lean production or lean manufacturing.

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