Systems Thinking and the Theory of Constraints

Systems Thinking and the Theory of Constraints
Timo Hildebrandt Paul Sullivan Alice Wang

Agenda Outline of Topics Timo Hildebrandt Alice Xin Wang Paul Sullivan
Theory of Constraints (TOC) Alice Xin Wang Activity Based Costing (ABC) Paul Sullivan Theory of Constraints the Throughput World Perspective

Theory of Constraints (TOC)
Eli Goldratt, an Israeli physicist , created the Theory of Constraints when a friend asked for help scheduling his chicken coop business (i.e. a chicken house). He developed a scheduling algorithm that realistically considered the bottlenecks in the system. In 1979 he created a computer software which using mathematical programming and simulation , allowed for more complex scheduling of manufacturing systems. Optimized Production Technology (OPT)

OPT The idea behind the software is that in any process, there is one set or at most a few bottlenecks. The output of a process is constrained by the bottleneck. You need to focus on maximizing the productive use of the bottleneck and schedule it accordingly, and the non-bottleneck resources can be scheduled accordingly.

TOC and Systems Thinking (Uncommon Sense)
“Just like the links of a chain work together to pull or lift objects, the processes within the enterprise work together to generate profit for the shareholders. However, the ability of the chain to pull or lift objects is limited because the chain is only as strong as its weakest link. TOC maintains that: The goal of an enterprise is to make more money, now and in the future. Every system is interdependent process is subject to at least one constraint that limits system performance. That is, the money-making potential of the enterprise is limited by the enterprise’s weakest link or constraint.”

Lean Supply Chain Principle 10
Time lost at a bottleneck resource results in a loss of productivity for the whole enterprise (entire supply chain). Time saved a non-bottleneck resources is a mirage.

Local Optimization vs. Global Optimization
Address the complex problem of optimizing system performance by breaking down the system into smaller, more manageable pieces. Units were treated as either cost centers or profit centers and assigned targets. The logic was that if every unit improved then, ipso facto, the entire enterprise would improve. (Lean Supply Chain Principle 1) However it is not enough to promote isolated efforts that focus on improving specific functions.

Local Optimization vs. Global Optimization
Install measures that are truly global, i.e., measures that encourage actions consistent with the overall goals of the enterprise. These measures are based on the a throughput world perspective, an approach that focuses on meeting the goals through a growth strategy rather than through cutting costs. There are two groups of techniques: A Five-Step Focusing Process Thinking Process

The 5 Step Focusing Process of TOC (throughput world perspective)
Step 1: Identify the System’s Constraint(s) Step 2: Decide how to Exploit the System’s Constraints Step 3: Subordinate Everything Else to that Decision Step 4: Elevate the System’s Constraints Step 5: If a Constraint Was Broken in Previous Steps, Go to Step 1

Types of Constraints Physical Constraints
Physical, tangible; easy to recognize as constraint. Machine capacity, material availability, space availability, etc. Market Constraints Demand for company’s products and services is less than capacity of organization, or not in desired proportion. Policy Constraints Not physical in nature. Includes entire system of measures and methods and even mindset that governs the strategic and tactical decisions of the company.

Procedural Constraints
Mindset Constraints A constraint if thought process or culture of the organization blocks design & implementation of measures & methods required to achieve goals Measures Constraints A constraint if the measurement system drive behaviors that are incongruous with organizational goals Methods Constraints A constraint when procedures and techniques used result in actions incompatible with goals

Lets Look at Some Familiar Constraints
Littlefield Technologies Time: Limited duration to make changes and experiment with system design Capital: Cash to procure machines and raw materials Resources: Under utilization and over utilization Strategy: Decisive actions taken as early as possible to benefit profit maximization

The Cost World Perspective
Focuses on minimizing costs and improving operational efficiencies. Roots in the 20th Century when U.S. Industry grew U.S. Industry began to borrow money to pay for resources, bankers and lenders needed to know how these resources would perform. Determining product costs is important in deciding whether the product was profitable or not. Products costs have three components: Direct labor Direct Material Overhead Costs

Obtaining Accurate Product Costs
How do we allocate overhead costs to product costs so that product costs are accurate? Cost Accounting Standard Costing Activity Based Costing

Standard Cost Accounting Systems
A standard set of guidelines and operating procedures used to decide whether or not to approve purchases of new equipment or scheduling of equipment. The cost world directs the manager to think locally, but the throughput world forces the manager to think globally. Lets look at an example…

National Pontoons, Inc. Assumptions:
Only 1 product – (Black Vinyl Steering Wheels) Raw materials cost $10/unit – (Blanks) Uses two resources to machine and fabricate the product – (Resource A & Resource B) 6 minutes processing at Resource A 9 minutes processing at Resource B Run’s 2 shifts 10 hours long, 25 days each month Employs 4 direct laborers across the 2 shifts Therefore:

National Pontoons Data:
Each operator works for 25 x 10 = 250 hours per month Direct laborers are paid $2,500 (250 hrs * $10/hr) The total wages paid per year are ($2500 * 4) * 12 or $120,000 ($10,000 * 12) The manufacturing overhead costs were $225,000 Selling, General and Administrative costs were $200,000 Raw Material Cost $10 per unit Processing time at Resource A 0.10 hours per unit Processing time at Resource B 0.15 hours per unit Labor Rate $10 per hour Direct Labor Wages Paid $120,000 Manufacturing Overhead Costs $225,000 SG&A Expenses $200,000

How the Accounting System Determines Costs:
The standard cost for the product is the sum of the standard direct labor cost (the absorbed labor cost), plus the unit raw material cost, plus a unit overhead cost that accounts for the manufacturing overhead. Direct labor is a Fixed Cost (FC) because it does not rise or fall with production like the raw material cost (Variable Cost V.C.).

Direct Labor Costs Direct labor costs at Resource A
Hourly rate $10 * time at resource 0.10 hours $10 * 0.1 = $1.00 per unit Direct Labor costs at Resource B Hourly rate $10 * time at resource .15 hours $10 * 0.15 = $1.50 per unit Total Direct Labor Costs = $2.50

Historical Data & Demand
Average Demand = 40,000 steering wheels 2003 Demand = 30,000 steering wheels Direct Labor Costs = 30,000 units * $2.50/unit = $75,000 Actual Labor Costs = $120,000

Labor Efficiency Variance
The difference between actual wages paid and the overhead labor attached to the units produced $120,000 - $75,000 = $45,000 That means $45,000 of direct labor was not accounted for in product costs

Overhead Rate Typically expressed in terms of direct labor hours or direct labor costs $225,000/$75,000 = $3.00 per direct labor dollar Since the direct labor cost is $2.50 the overhead per unit is $3.00 * 2.50 = $7.50 per unit The finished product cost is $10 (direct material) + $2.50 (direct labor) + $7.50 (overhead) = $20.00

Valuing Inventory Costs
Cost Category Cost per Unit Raw Material $10.00 Direct Labor Cost at Resource A $1.00 Manufacturing Overhead allocation at Resource A $3.00 Direct Labor Cost at Resource B $1.50 Manufacturing Overhead allocation at Resource B $4.50 Total Cost $20.00 The raw material in front of resource A is $10.00/unit; the value of a WIP present between Resource A and Resource B is $14.00 ($10 + $1 + $3); hence the finished goods inventory is valued at $14 + $6 ($ $4.50) = $20!

Summary of The Standard Cost Accounting Method
Captures the effort expended on the product in dollar terms This is an approximate method because it assumes that every manufacturing-related expense, including depreciation of equipment and facilities, indirect labor, and utilities is allocated to individual resources. (This doesn’t include SG&A expenses!!)

Why is this all important?
Focuses on increasing value of the product Incentive for shop supervisor to push products through the resources as quickly as possible Contrary to a Kanban system because downstream activities may not need these products Leads to End-of-the-Month syndrome Results in even higher levels of inventory

Summing it all up: “Under absorption costing, building inventories tends to reduce the apparent average COGS. When production exceeds sales, fixed costs are spread across more units, and some of the fixed costs are reported on the balance sheet as part of additional inventories rather than on the income statement as part of COGS. Under standard cost variance reporting, a work center with a fixed labor force can improve its efficiency measure only by producing more output.”

ACTIVITY – BASED COSTING (ABC)
Why ABC? - ABC provides an opportunity to obtain a better approximation of the true product cost Basic Principle of the ABC system is “Activities consume costs and product consume activities”

ACTIVITY – BASED COSTING (ABC)
ABC focuses on cost drivers that can guide the allocations with greater accuracy. Cost drivers are allocated into one of four categories: - Unit-lever activities: activities performed for each product. (Example: direct labor, direct material cost) - Batch-level activities: activities that are performed once for each batch of products. (Example: machine setup costs, material handling costs) - Product-level activities: activities support the production of a product type or model. (Example: engineering support costs, depreciation cots of equipment) - Facility-level: include the costs of operating the Accounting, HR, General Administration, Sales, and Plant Maintenance functions.

Product Costs with Standard Cost Accounting and ABC
Cost Category Standard Costing ACTIVITY-BASED COSTING Vinyl Wood-Trim Raw Material $ 10.00 $10.00 Direct Labor $ 2.50 Depreciation $ 0.40 Mfg. O/H (QC Inspector) $ 2.10 Mfg. O/H (Plant Manager) $5.00 $ 5.00 $ 1.50 $ 22.50 Product Cost $ 20.00 $ 16.50 $ 37.50

SUMMARY of Cost Accounting System
The Standard cost accounting system allocates all overhead costs to the products using a broad measure such as labor cost A more equitable allocation of overhead costs – ABC system can help approximate the product cost The problems of ABC systems ABC system can become difficult and expensive to maintain

THE THEORY OF CONSTRAINTS AND THE THROUGHPUT WORLD PERSPECTIVE
Two Premises of TOC: - The goal of a business is to make more money not and in the future - A system’s constrain determine its output Constraint : anything that inhibits a system’s performance toward its goals

THE THEORY OF CONSTRAINTS AND THE THROUGHPUT WORLD PERSPECTIVE
TOC encourages systems thinking TOC adopts the view that managers should focus on a system’s constraints as a basis for making the right decisions TOC prescribes three performance measures - Throughput - Inventory - Operating expense

Three Performance Measures
Throughput (T): the rate at which the system generates money through sales Inventory (I): All the money invested in purchasing things the system intends to sell Operating expense (OE): All the money the system spends, turning inventory (I) into throughput (T)

Model for Relating T,I, and OE (page 199)

National Pontoons Example
Asset base as of January 1, 2003 Activity in 2003 RM Purchased in 2003 (units) 40,000 Number of Units Sold in 2003 30,000 Unit Selling Price $30 Direct Labor Wages $120,000 Plant Manager’s Salary $150,000 QC Inspector’s Salary $63,000 SG&A Expenses $200,000 Capital Assets Acquired in 2003 $25,000 Depreciation in 2003 $12,000 Fixed Assets $120,000 Raw Material Inventory (Units) 25,000 WIP Inventory (Units) 15,000 Finished Goods Inventory (Units) 20,000

National Pontoons Example
Asset base as of December 31, 2003 Fixed Assets $133,000 RW Inventory (Units) 35,000 WIP Inventory (Units) 15,000 Finished Goods Inventory (Units) 20,000

Three TOC measures: I (start of 2003) = $720,000
T ( in 2003) = $600,000 OE (in 2003) = $545,000 I (end of 2003) = $833,000 Profit T –OE = $55,000

Traditional Financial Measures of Interest to an Enterprise
Bottom Line Measurements NET PROFIT (Absolute) RETURN ON INVESTMENT (Relative) CASH FLOW (Survival)

TOC Financial Measures of Interest to an Enterprise
Quite different from traditional cost accounting measures Throughput (T) = The rate at which the system generates money through sales Inventory (I) = All the money invested in purchasing things needed by the system to sell its products Operating Expense (OE) = All the money the system spends, turning inventory into throughput.

TOC Financial Measures of Interest to an Enterprise
Throughput (T) = Sales Revenue - Variable Cost (Materials) Operating Expenses (OE) = Fixed Costs (Direct Labor + Overhead) These can be equated with traditional financial measures

Traditional Financial Measures vs. TOC Financial Measures
Net Profit = Throughput – Operating Expense = T – OE Return on Investment = Throughput – Operating Expense = T – OE Inventory I Inventory Turns = Throughput = T Inventory = I Productivity = Throughput = T Operating Expense OE TOC approach less than Traditional especially in Inventory turns b/c denominator in TOC includes all capital assets

Cost World vs. Throughput World
Priority Cost World First: OE Second: T Third: I Throughput World T I OE  distant 3rd Priority

Leveraging Power of T and OE in National Pontoons
Uses two resources A and B for production Resource A = Six minutes p/unit Resource B = Nine minutes p/unit Each resource operated by a direct labor employee Worked two 10 hr shifts with four direct laborers In 2003, produced 30,000 units w/ selling price of $30 p/unit Time Required at Resource B = 30,000 x (9/60) = 4,500 hrs/yr (This is the Capacity Constraint) Resource B is available 20 hrs/day and 25 days/month or 500 x 12 = 6,000 hrs/yr In 2003, National Pontoons operated at 75% capacity  4,500 / 6,000 hrs/yr

Cost and Profit Data for National Pontoons without Leveraging ITEM DATA FOR 2003 Sales Revenue $900,000 Raw Material Cost $300,000 Direct Labor Cost $120,000 Overhead Costs $425,000 Total Expenses $845,000 Net Profit $55,000

Next, Focus on Leveraging Power of OE to become more profitable in 2004 Only operating at 75%, reduces working hours by 25% in 2004 to 15 hours per day Adjusts wages paid to direct labor by 25% Labor drops from $120,000 to $90,000  $120,000 x 0.75 The $30,000 cost savings goes directly to bottom line

Leveraging Power of OE for National Pontoons ITEM DATA FOR 2003 LEVERAGING POWER OF OE Sales Revenue $900,000 Raw Material Cost $300,000 Direct Labor Cost $120,000 $90,000 Overhead Costs $425,000 Total Expenses $845,000 $815,000 Net Profit $55,000 $85,000

Next, Focus on using its installed capacity to improve T to become more profitable in 2004 Starts marketing campaign to sell more units which drops price 5% and boosts its sales to 40,000 units in 2004 Raw Materials increased by 33.33% to $400,000 Selling price  0.95 x $30 = $28.50 p/unit Results in full capacity utilization at Resource B  40,000 x (9/60) = 6,000 hrs/yr

Leveraging Power of T for National Pontoons ITEM DATA FOR 2003 LEVERAGING POWER OF OE LEVERAGING POWER OF I Sales Revenue $900,000 $1,140,000 Raw Material Cost $300,000 $400,000 Direct Labor Cost $120,000 $90,000 Overhead Costs $425,000 $435,000 Total Expenses $845,000 $815,000 $955,000 Net Profit $55,000 $85,000 $185,000

Example suggests that the leveraging power of Throughput (T) exceeds the leveraging power of operating expense (OE) For most manufacturing enterprises, the material cost is a large percentage of the total product cost Enterprises that focus on reducing OE can only do so by trimming labor costs because it is harder to get rid of fixed assets and infrastructure

Long-term Increase or Short-term Gain?
A chain can demonstrate how the cost world focus sacrifices long term throughput increases for short-term gains Instead of strengthening the weakest link (improving T), we focus on improving efficiency at the current level of performance (improving OE) Let’s take a look at an example

Assume a chain of 10 links Each link = 100 lbs of carrying capacity except for one link has only 50 lbs of carrying capacity Management unhappy with cost of maintaining the nine strong links so it sells the nine heavy links It replaces each link with a carrying capacity of lbs which makes a truly efficient chain since every link is capable of carrying exactly same load What is the problem?

The problem is the enterprise is locked into the current performance level It now has ten links, any one of which can break In the future, if improved performance is desired, it will have to work all ten links in the chain The same problem occurs when enterprises eliminate overcapacity If business picks up, it will be harder to recruit employees, why? Fearful of being fired in the next downsize

Lean Supply Chain Principle 11
Decisions should promote a growth strategy. While enterprises should attempt to simultaneously increase throughput, decrease inventory, and decrease operating expenses, the focus must be on improving throughput. What is this guy doing? 

Improving Throughput (T)
How do we leverage the growth model advocated by the throughput world ? What should we do when the enterprise finds it has excess capacity? In the National Pontoons example, the focus on T generated a much better return than did the cost world focus on OE. This is not the only approach one can pursue. Improving the bottom line is the best done with a logical approach The TOC presents a five-step focusing process for identifying the root cause of a problem and dealing with it effectively

The Throughput World: Five Step Focusing Process of TOC
Step 1  Identify the System’s Constraint(s) Step 2  Decide how to Exploit the System’s Constraint(s) Step 3  Subordinate Everything Else to that Decision Step 4  Elevate the System’s Constraints Step 5  If a Constraint Was Broken In a Previous Step, Go Back to Step 1

The Throughput World: Five Step Focusing Process of TOC
The Five Step focusing process to improve system performance is based on two simple premises of TOC: The goal of the enterprise is to make more money, now and in the future The system’s constraints prevent it from making more money

Step 1 : Identify the System’s Constraint(s)
The TOC asserts that any enterprise has few real constraints, at most, a handful. The system’s constraints can be: Physical Constraints – Easiest to identify Market Constraints – Harder to Identify Policy Constraints – Hardest to Identify Bottleneck

Physical Constraints The easiest to identify
Can be machine capacity, staff availability, space availability, human capability, etc. Tangible Techniques for getting the most from capacity constraints: Eliminate periods of idle time Reduce setup time and run time per unit Improve quality control Purchase additional capacity

Identifying Physical Constraints
A Typical WIP Inventory Profile: Ave. WIP Inventory R1 R2 R3 R4 R5 R6

Market Constraints Harder to identify than physical constraints
A market constraint exists if the demand for the enterprise’s products and services is less than the enterprise’s installed capacity or limits the bottomline performance Excess capacity is easily identified as a market constraint Can arise when an enterprise produces and does not have enough capacity to satisfy all of the demand

Policy Constraints Not physical in nature.
Includes entire system of measures and methods and even mindset that governs the strategic and tactical decisions of the company Hardest to Identify In theory, there should be no policy constraints, but most constraints to system performance are policy constraints

Policy Constraints Methods Constraints Measures Constraints
A constraint when procedures and techniques used result in actions incompatible with goals Could be created by never producing a batch of units below an EOQ Measures Constraints A constraint if the measurement system drive behaviors that are incongruous with organizational goals Aggressively seeking quantity discounts would lead to increased raw material inventory Mindset Constraints A constraint if thought process or culture of the organization blocks design & implementation of measures & methods required to achieve goals Shop Supervisor has the attitude that all operators should be busy all of the time

Step 2 : Decide How to Exploit the System’s Constraint(s)
Exploiting the constraint means using the constraint as profitably as possible Until the constraints are overcome by other means, the enterprise should work them as profitably (effectively) as possible: the real meaning of the word exploit If constraint is physical resource, ensure the resource is never idle If the market is the constraint, exploit by ensuring not a single sale is lost as a result of our action or inaction Market constraint implies extra capacity, so we exploit this by guaranteeing 100% on time delivery to customer

Step 3 : Subordinate Everything Else to that Decision
Need to manage every part of the profit-generating system We do not want those non-bottleneck resources becoming bottlenecks because of our negligence because of focusing on constraints Deals with process of scheduling Work must be started and sequenced so the constraint can always work or work smarter Drum-buffer-rope (DBR), or pull-from-the-bottleneck model, is similar to kanban system Except the input process of DBR is linked to the rate or production of the constraint to utilize it as much as possible

Step 4 : Elevate the System’s Constraints
Tries to lift the restriction that is preventing the enterprise from making more money Elevating the constraint means identifying ways that the performance of the system can be improved, relative to its goals This step should only be performed after the exploit step, step 2 If the constraint still exists, or another emerges, then it is time to execute the fourth step

Step 5 : If a Constraint Was Broken in a Previous Step, Go Back to Step 1
Can we stop with the fourth step? If we elevate the constraint, it will probably not remain a constraint Performance will not be dictated by another element that has become the weakest link To find this new weak link, we must revisit all the steps once again Goldratt adds this warning: “Do not allow inertia to cause a system’s constraints.” Step 5 is crucial because it prevents inertia from derailing continuous improvement process

Example of the Five-Step Focusing Process
Think of a small production system for manufacturing two products, P and Q Goal is to maximize profit Weekly demand for P is 110 units & for Q is 60 units Four resources used to meet demand: A, B, C, and D Let’s take a look at the process flow chart which includes the cost and time for each step Step 1 is executed to determine if a constraint prevents us from meeting the market demand

Example of the Five-Step Focusing Process
A Production System Manufacturing Two Products, P and Q $90 / unit P: Q: $100 / unit 110 units / week 60 units / week D D Purchased Part 10 min. 5 min. $5 / unit C B C 10 min. 5 min. 25 min. B A A 15 min. 10 min. 10 min. RM1 RM2 RM3 $20 per $20 per $25 per unit unit unit Time available at each work center: 2,400 minutes per week Operating expenses per week: $6,000

Step 1 : Identify the System’s Constraint(s)
Work Center Loan on P units) Load on Q units) Total Time Required Time Available A 1,650 600 2,250 2,400 B 1,100 2,100 3,200 C 300 1,950 D 1,400 Do a Capacity analysis and we find Resource B is overloaded

Have to Decide which product we want prioritized and produce it first Product contribution is selling price less the price of materials used in the product Contribution of P = $90 - $5 - $20 - $20 = $45 Contribution of Q = $100 - $20 - $25 = $55 Cost World Analysis – work with product cost and product profits Q has higher profit margin ($55) than P ($45) With this approach, use the constraint to produce as many Q’s as possible and use remaining capacity to produce P Means producing 60 units of P (2100 minutes of Resource B), leaving 300 minutes which is enough to produce 30 units of P Product Mix results in a net profit of $45(30) + $55(60) - $6,000 = -$1,350

From a system’s perspective (throughput world), product costs do not have much weight for we are primarily in system’s profits To get maximum profits, we want to exploit the constraint Running Q through constraint, Resource B, requires 35 min/unit and Q’s profit margin is $55 The Rate at which the constraint generates profit is $55/$35 = $ p/min Running P through constraint, Resource B, requires 10 min/unit and P’s profit margin is $45 The Rate at which the constraint generates profit is $45/10 = $4.50 p/min Shows we want to produce as many units of P as the market would bear and use remaining capacity on constraint for Q

To produce 110 units of P needs 110 x 10 = 1,100 minutes of Resource B Since Time Available is 2,400, it leaves 2,400 – 1,100 = 1,290 minutes available time on Resource B each week to produce Q With the available time, we can produce 1,290 / 35 which equals 36 units of Q Total Marginal Profit of Q  $45 x $55 x 36 = $6,930 Since operating expense was $6,000, net profit = $930 Cost World Approach  Net Loss of -$1,350 Throughput Approach  Net Profit of $930 Quite a difference!

Step 3: Subordinate Everything Else to This Decision
Relating to example, this step means keeping Resource B running at all times We can first have Resource B work on raw material RM2, during which Resource A would be processing 36 units of raw material RM3 each week to produce product Q If more than 36 units of A are produced, they would accumulate in front of Resource B

Step 4 : Elevate the Constraint(s)
The bottleneck has now been exploited Besides identifying Resource B as a bottleneck, we have found another: the Product Mix (water level effect) Ideally, we would like to have more demand for product P, but we have two choices Generate more demand for Product P Buy another Resource B Either way, we have elevated the constraint so we now have to execute steps 1 through 5 again. THIS IS THE PROCESS OF ONGOING IMPROVEMENT

Conclusions Systems are like chains. Every system has a weakest link, or constraint, which limits the success of the entire system Cost Accounting Systems can identify where costs are being incurred, but care is needed when allocating fixed costs TOC avoids those allocations and uses a set of three measures to gauge the financial impact of any decision Many enterprises improve performance by improving all their processes at the same time which removes waste but makes the enterprise’s focus become diffused Strengthening links other than the weakest link does not improve the strength of the chain

Conclusions The Cost World perspective is adopted by enterprises when they Reduce costs and trim resources so the capacity of all the resources match the capacity of the weakest link Promote local thinking and encourage behavior that runs against enterprise goals The focus should be on growth or improving throughput which is TOC or a Throughput World perspective Enterprises that adopt a Throughput World perspective have an immediate competitive advantage because most of the competition is stuck in the Cost World perspective The Five-Step Focusing process identifies bottlenecks and shows how to exploit and elevate those bottlenecks The Focusing process works especially with physical constraints

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