The Theory of Constraints & Throughput: Part 1 - Basics
Updated: Nov 30, 2020
One of the primary roles of any business owner is to maximize your return on your investment in the company. This requires you to find the most efficient way to use your resources. How to increase your output given your inputs and the constraints on your system. This constant drive for improved efficiency gave birth to a large field of study in process improvement. We will cover many different systems of process improvement throughout the course of this blog because they are closely intertwined with how you look at capital allocation, budgeting, and cost accounting strategies.
One of these methods is known as the Theory of Constraints (TOC). TOC states that in every organization, there must be at least one constraint within the organization's processes. The constraint is slowest part of the process or the one with the least capacity. Think of it as the weakest link in the chain. According to TOC, the best way to improve efficiency across the entire company, is not trying to simultaneously improve all processes, but rather focus on improving the constraint process. Since the constraint process is the slowest, improving performance upstream of it, without improving the constraint will only cause a backlog at the constraint process tying up valuable working capital in Work-In-Process inventory. Likewise, improving the processes downstream of the constraint will be meaningless because they will constantly be starved of work which is locked up in the constraint process. Improving efficiency can lower overall costs, but what we are trying to do with the theory of constraints is improve total output.
Many people mistakenly believe this only applies to manufacturing, but that is simply not the case. Any company can benefit from reviewing their processes using the theory of constraints. Lets consider a software firm that wants to increase sales on a new structural modeling software product. The CEO hires two new sales people to increase sales leads, and they do a great job and greatly increase the number of people interested in the product. However, none of those people will purchase until they have had a demonstration of the software by a demonstration specialist, which they haven't hired any more of. The result is an increase in people interested in the product, initially, but when they have to wait weeks for a sales demo, because, even working round the clock, the demonstration technician can't keep up with the increased interest, the company may not see any increase in sales, or worse, the disgruntled customers might purchase a competitors product instead. Clearly a lose-lose situation. So now that we've explored the basic premise of the Theory of Constraints and shown that it applies to every company, we should cover a few definitions before we move on.
The Drum - this is another term for the constraint also known as the bottleneck operation. Its referred to as the "drum" because this is the operation that sets the pace of all the others. It is the drum beat to which everything else marches.
The Buffer - the buffer is a minimal amount of work-in-process inventory maintained immediately ahead of the bottleneck operation to ensure that it is always running. Without a small buffer there is a risk that the bottleneck operation may run out of work. Since the bottleneck operation determines the output of the entire system, any downtime drops straight down to your bottom line. Applying this to the software sales example earlier, if any potential client cancels a demo, the sales people should immediately work to reschedule another potential client to that time slot. The demonstration technician's time is the limited resource, so any of the technician's time not utilized for production is money lost. It's worth mentioning that normally you seek to eliminate inventory in the company because it is a waste of working capital, but in this case, a small amount is necessary since the potential lost revenue from not keeping your constraint running is more costly.
The Rope - the rope is the sequence of activities upstream of, and including, the bottleneck that coordinates the release of inventory at just the right time to ensure the buffer and bottleneck are supplied with the correct amount of work-in-process inventory. This is very similar to the concept of Just-In-Time manufacturing. If the upstream processes release inventory too quickly, you will get a pile-up of inventory immediately ahead of the bottleneck, which will tie up valuable working capital dollars in a non-value-adding activity. If the upstream processes releases inventory too late, the bottleneck will experience downtime, which drops straight to the bottom line. Another possibility is the worst case, where it releases large chunks of inventory intermittently, starving the bottleneck at times, and dumping excess inventory into the buffer at others.
Sprint Capacity - the system's sprint capacity is the ability for the system upstream of the bottleneck to quickly increase production levels to make up for unforeseen downtime before the bottleneck is starved for work. These shortages could be caused by any number of reasons: an unexpected machine failure, labor shortage, delayed component delivery, etc. Sprint capacity is something you'll want to consider when evaluating you production capacity levels in your organization. Someone not considering sprint capacity may see excess production capacity upstream of the bottleneck as a waste of invested capital or labor, but if you consider it as risk mitigation (increasing your sprint capacity to cover for unforeseen down-time events upstream of the bottleneck) the excess capacity might make sense. You should evaluate situations like this carefully. If excess capacity is identified downstream of the bottleneck, you might be OK to eliminate the excess.
Throughput Margin - Throughput margin is equal to the sale price minus the direct materials costs. This is derived from the concept of throughput costing which states that only the direct material costs are truly variable over the short-term, and thus the only relevant costs that must be considered in the short run. Throughput costing is sometimes also referred to as supervariable costing - as opposed to variable costing which considers the relevant variable cost to be direct labor, direct materials, variable overhead, and other costs that vary directly with production volume. The reason throughput costing considers only direct materials to be variable is that the other variable costs are often not actually that variable over short periods of time, for example, with labor you may have policies, or contractual/union obligations that require paying and employing staff even if work loads drop.
That covers the basics of the theory of constraints and throughput accounting. In the next post, we will cover TOC analysis, and managing and capital budgeting considering the Theory of Constraints. If you would like to learn more, or think your company could benefit from working with Augelli Consulting, LLC please contact us for a free initial consultation at firstname.lastname@example.org