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Applying Process Tools and Frameworks to Improve Organizational Performance: A TOC Primer
Evaluate the systemic causes of problems in, and develop solutions for, improving organizational performance, using concepts from the Theory of Constraints.
Theory of Constraints Primer1
Background of the Book The Goal
The Goal represents a specific, large-scale case study about organizational performance improvement. This case study shows a number of systems thinking concepts at work and introduces some new content and tools into your vocabulary of systems performance.
The Goal tells the story of a hypothetical manufacturing plant (the Bearington Plant) and its associated parent division of UniWare and Unico, Inc. The fictionalized story of Unico, Inc., represents a rich and complex example of organizational change and of systems dynamics within a continuous improvement context. As such, it is an exemplary basis from which to practice the analysis of systems dynamics and performance management.
Although fictionalized, those with rich organizational experience will recognize the accuracy of people dynamics and organizational inertia within the book’s “case study.”
[F]iction provides some significant advantages over a conventional business text. Strategy, technology, tangible assets, and conventional resources—all these and more are essential for a functioning business. But it can be said, with no sentimentality, that human beings are really at the core of every organization. A novel allows readers to experience business concepts as actual people might. We can reveal with fairly good accuracy where conflicts can develop, and the resolution of those conflicts. The story becomes a way to better engage the reader, and to explore the ideas as they actually might play out in the reader’s own environments. (Jacob, Bergland, & Cox, 2010, p. viii)
So, although the book is a business novel, it has been written in an accessible format to help people learn about organizational change, systems dynamics, organizational conflict, continuous improvement, performance measurement, and performance management. It has also been written so that one can analyze and understand the ways in which specific performance management tools and techniques can be implemented and contribute to improving organizational performance.
1 © 2015 Laureate Education, Inc. and W.C. Schulz
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Characters in the Book
This list of work-related characters should help you sort out who is who as you go:
Alex Rogo (Narrator and Bearington Plant Manager)
Bill Peach (Division Vice President, p. 1)
Bucky Burnside (President of UniCo’s Largest Customer, p.4)
Bob Donovan (Plant Production Manager, p.8)
Johnny Jons (Division Sales Manager, p.14)
Granby (Unico Owner, CEO, p.17)
Ethan Frost (Division Controller, p. 25)
Hilton Smyth (Assistant Division Controller, p.25)
Jonah Alex’s former professor (p.26)
Lou (Plant Controller, p. 44)
Stacey Potazenick (Plant Inventory Control Manager, p. 69)
Ralph Nakamura (Plant IT and Data Processing Manager, p. 126)
Business Models and the Goals of Business
One of the more interesting questions that arises, throughout the book, concerns the goal(s) of a business. There is a tension between how the senior leadership at Unico measures performance (a focus on cost reduction and efficiencies) and what is actually needed to be profitable and competitive over time.
It is argued in The Goal that the primary goal of a business is to maximize profit or, specifically, that the “most important objective was to boost productivity, and to bring down costs” (p. 11); however, if one considers a simple definition that profit is the net between total revenues and total costs, or π = TR – TC, over time, what is the only sustainable way to maintain or increase profits? Can, or should, an organization always seek to maximize profits? Is it always in the interest of the organization to have all of its sub-elements seeking to maximize productivity?
Local Maximization vs. Global Optimization
This theme of local maximization versus global optimization is an important one to emphasize. Traditional performance management approaches assume that if all the individual local parts are working at maximum “efficiency,” then the whole is optimized. But can this be so? What are the implications of the traditional approach to performance management when one must account for the flow and velocity effects of activities within a complex system?
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Is there a difference between optimization and maximization? There is, and The Goal explores this difference using the theory of constraints (TOC) as the primary logical framework for analysis.
The significant difference between optimization and maximization also relates to the primary goals of a business in the long term. Milton Friedman (1970) argued that the primary goal of a business is to maximize shareholder return, which has been translated by many to mean “maximize” profits; however, given your understanding of complex systems and interrelationships that must occur within both a business system, and within the environmental system that the business exists, is “maximization” the proper metric? What should be the goal of a business? What problems are inherent in the definition of the goal, if it is “to maximize profit?”
The problem with profit maximizing as the primary goal for a business is that it is not a sufficient goal for the same reason that optimizing is more important than maximizing. Most profit-maximization points of view and measurement assessment are too “short-term.” And because they are too short-term, the proper decision-making framework for ensuring the longer-term health of the system is ignored.
You can jump ahead to the definition of the goal given on page 295 of The Goal, where you will find that “the goal [of a business] “is to make more money—now, and in the future.” (That is in support of the organization’s mission/purpose.)
The context of this goal and business model is actually very different from just maximizing profits. The goal is also a means to achieving the organization’s mission, which must be more than making money if talented and ethical people are to remain invested in the business. This goal is systemic, long term, and never-ending (one never reaches the end of “more”); however, it allows for the fact that there will be times where re-investment in the system (which may, in fact, minimize “profits” for some time period) is necessary and appropriate. One must balance the needs of the future against the imperatives of “now.”
Performance Measurements: False Dichotomy of Efficiency vs. Effectiveness
Another important theme that emerges in The Goal is that local efficiencies are not the fundamental prerequisite for optimal organizational performance. From a TOC perspective, productive behavior is only that behavior or activity that leads you toward your goal. In this case, the goal is to make more money now and in the future (Goldratt, 2004). Yet, for an activity to be productive, it must affect the systems’ constraint. In other words, it must touch on the “limiting factors” within the organization. As such, from a systems point of view, activities that support the flow of work within the constrained resources of the organization are considered both efficient and effective.
You will see a fundamental conflict emerge between the managers at UniWare’s headquarters and the TOC advocates on this very point. Nearly all of the UniWare computerized performance management systems are set up to measure local
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efficiencies, and the UniWare managers expect that as each local activity is made more efficient, total system-wide profits should be maximized. Given your understanding of complex systems, does this reasoning hold sound?
Again, reflect on the fundamental equation on how profits are created over time:
π = TR – TC
Systemically, which variable above is more likely to be “systems limited”—the revenue creation elements or the cost elements?
Alternate Points of View in the Book: Traditional “Cost World” Thinking and the Theory of Constraints, and “Throughput World” Thinking
Two primary performance management frameworks are introduced in The Goal. One is built within a more traditional productivity/efficiency perspective that argues that by minimizing waste and maximizing local efficiencies, the system as a whole reaches maximum performance. This is often referred to as “cost world thinking” by practitioners of the TOC. The senior managers at UniWare (Bill Peach, Ethan Frost, and Hilton Smyth) represent this point of view.
The other point of view that is rooted in concepts from the TOC, as the theory is discovered by Alex Rogo, Lou, Bob Donovan, Stacey Potazenick, and Ralph Nakamura, and as offered Socratically by Jonah (Alex’s former professor). The TOC holds that the performance of the entire system is fully dependent on the performance of any primary internal constraints and the subsystems that support such internal constraints.
Battle of Ideas
As you proceed through the book The Goal, you should begin to see the emerging conflicts between the proponents of traditional financial accounting/measurement and performance management and the TOC.
It seems that the more that efforts to maximize local productivity and “reduce costs” is put into effect, the worse both traditional and throughput-oriented measures of total systems performance are becoming—except, of course, measurements related to local efficiency (as measured in the UniWare information system). For example, throughout the book, it is noted that the key performance indicators (KPIs) from the UniWare performance measurement system were looking better (locally) but the financial results were getting worse. Resource utilization was as high as it had ever been in the plant, with nearly all workstations reporting higher productivity, and yet productivity was not translating into profitability. How can that be? (Hint: Remember from earlier notes what the definition of “productive” should be.)
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Other conflicts emerge around resource management policies. In particular, Bill Peach and others are critical when they see people on the shop floor “not working,” or when they see computerized robots “sitting idle.”
In order to replicate and show you the importance of understanding the fundamental impact that constraints have on the performance of an entire system, you read about the “balanced plant-based, or matches game” in the book. (If you get the chance, you should try to replicate the matches’ dice game on your own with some friends!)
What are the lessons of the balanced plant simulation? How does variation within a system that has sequential dependency limit the ability of a balanced plant (system) to produce or be effective? Can you think of any organizations that you have been a part of that are not subject to variation or sequential dependency?
One of the interesting and important facets of The Goal is that, in addition to showing you a concrete, product-oriented example of a complex system in action (via the Bearington plant production process), it also shows you that the optimization ideas of TOC can be applied to policies and services. The principles of the TOC apply to all organizational systems—not just those that produce physical products, or to those that seek profit (governments could learn from TOC too).
It is easy to say, “Oh, this theory of constraints thing only applies to manufacturing plants; it can’t be used in my organization, which is a not-for-profit service organization.” But that is not true, and such a thought is a perfect example of a policy constraint! TOC, is a general systems theory framework that can be applied to any organizational system.
Another of the interesting “apparent paradoxes” (but only a paradox within traditional ways of thinking about performance) that emerges in the book is that despite nearly all the efforts to automate the plant with “efficient robots,” overall organizational performance is not improving!
Why are the efficient robots’ “productivity” not making it to the bottom line?
Again, think carefully about the competing points of view, with respect to how one should manage the complex organizational system. Initially, the UniWare division headquarters is very clear about its priorities and goals. Peach, Frost and Smyth each insist that “efficiencies” and “reducing cost” is the primary, and only way to increase profit.
What are the implications of this, from a systems performance standpoint? Improvement in what primary measurement would alone allow UniWare to reach or exceed its goal year after year? Why are these “leaders” so fixated on the operating expense measurement?
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A Measurement Primer on TOC
The TOC management framework simplifies business systems performance measurement and is rooted in systems thinking and marginal cost economic thinking.
There are three primary measurements that, as they interrelate with one another, tell the most critical story of an organization’s health. They are “throughput,” “inventory,” and “operating expense.” Goldratt insists, correctly, that these are the only measurements one needs to both define a business system and to measure its performance.
The definitions below provide how TOC measures business performance:
Throughput: T = GSR – DVC
Throughput (T) = GSR (gross sales revenue—recognized only at time of actual sale and receipt of money from outside the business system) – DVC (all direct variable costs associated with a sale)
Note: This is very close to gross profit margin.
Inventory (I) = all money invested in items the system intends to/can sell
Operating Expense (OE) = all the money the systems spends converting I into T. Operating expense items should be considered fixed costs.
Note: This is a tertiary measure—it is the least important of the three, but it is the one that most traditional managers spend, by far, the most time measuring and “managing.”
Note that the TOC definition of inventory is much broader than traditional definitions of inventory. Obviously, it includes things that the company buys, which it can then transform and sell. It also includes things that the company invests in, such as its people, which it could then sell, such as through consulting. People are an asset within the TOC definitions and are part of inventory. When you pay people a salary, that payment is considered an operating expense. At the outer boundaries, nearly everything that is considered an asset in traditional accounting could eventually be sold and is considered inventory as part of TOC. Of course, subcategories of inventory still exist and are needed, such as working inventory, work in process, etc.
In terms of relating how the three principal measures of TOC work with respect to traditional financial measures, it is good to note that within the TOC framework:
Profit = T – OE, or Profit (π) = (GSR – DVC) – (Fixed Costs)
Inventory Productivity = π/I
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So, using the three primary measurements from TOC, one can replicate many of the most important traditional measurements used in managerial accounting. The important thing to note, however (and as you will see in the Corbett readings), is that sunk costs are irrelevant in TOC, and the primary measurements are really related to flow (rates). TOC is interested in how much flow-rate an entire system can produce at any given time, given specific (and hopefully known) internal physical bottlenecks (constraints), policy constraints (thinking constraints), or market constraints (customers not buying enough).
As you proceed through the final chapters of The Goal, you can begin to see how Alex and his team are able to turnaround the Bearington Plant, through the applications of effect-cause-effect and systems thinking—along with their recognition that traditional cost accounting and activity based accounting can actually get in the way of the organization making decisions that optimize profit. The Corbett (2006) and other articles in the resource list address this last phenomenon by introducing the concept of “throughput accounting.”
Throughput Accounting
In his article “Three Questions Accounting (CITE),” Thomas Corbett (2006) argues that sound managerial decision making rests on the ability to answer three fundamental questions about a given situation:
What will be the impact of our decision on the amount of money the company generates (throughput)?
What will be the impact of our decision on the amount of money we spend to operate the company (operating expense)?
What will be the impact of our decision on the amount of money captured in the company (investment in inventory)?
Corbett discusses the concept of “throughput accounting,” which he demonstrates as a method to account for the relationship among a system’s three primary measurements in order to evaluate the impact a decision will have on a company’s profitability (Corbett, 2006, p. 52).
From a traditional cost accounting point of view, as represented in UniWare’s performance management system, reductions in operating expense will always lead to an anticipated increase in profit. That said, given our understanding of opportunity cost and its relationships to constraints, only measurement systems that account for the value of time at the constraint can help you make good managerial decisions. If one, for example, reduces operating expenses and inventory at the constraint—thereby reducing the constraint’s capacity and the throughput capacity for the entire system—that system in all likelihood will show less profit (it definitely will over time).
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The Value of Activities Within a Constrained System
One of the very important (and least discussed) benefits of a TOC approach to organizational management is that it is a very sound way to implement and understand economic reasoning concepts. In economics, decision-makers are taught that optimal choices come where marginal revenue equals marginal cost (MR = MC = P in microeconomic equilibrium).
In the real world of complex systems, however, most economists cannot tell you how to find this organizational sweet spot. That said, TOC can get you in the ballpark. How? What defines MC in a constrained system?
The constraint, of course!
In the case of Uniware, despite the best efforts to deploy “efficient robots” and to keep people busy, by increasing local productivity, profit—the real king—is not improving.
Why is that? Because the Uniware senior leaders believes that improvements that will exploit the constraint and subordinate the work of non-constrained resources will reduce “efficiencies” and increase “costs,” in part because they are not as interested in increasing throughput!
The major insight here is that when a system’s primary constraint is physical, that constraint subsystem defines marginal cost for all the products that depend on the constraint resource. This, then, has implications for marginal revenue and even pricing. In fact, product pricing very much depends on understanding the system’s constraints.
The value of time at the constraint is the value of all lost sales of the entire system’s throughput (that depends on the constraint). If the system could have sold $100,000 of final goods inventory in a day and the constraint puts the system out of operation for a day, then the cost of that downtime is $100,000, not the cost of labor, materials, etc. That is, the value of time of a constrained subsystem is the opportunity cost of sales that that system is limiting.
This, then, is how the TOC is related to good economic reasoning—investments in resources outside the constrained subsystem are essentially wasted, as are improvements in productivity outside the constrained subsystems. The opportunity cost for changes in the non-constrained subsystems is near zero—unless they impact products that do not depend on the constrained resources.
Effect-Cause-Effect Reasoning
As you proceed into the final third of the book The Goal, you should begin to see Alex and his team wrestle with the various causes and effects of various actions, both within the Bearington plant and across the Division (through Alex’s new job). It has become apparent to everyone that pursuing initial process improvements throughout the system
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is insufficient in improving the entire organization’s performance for the longer term. They discover that a process for thinking about “what to change,” “what to change to,” and “how to change,” in combination with the five focusing steps for constraint management, can lead to ongoing and sustainable performance improvements.
Alex and the team are under dire pressure to turn the situation around, determining whether the organization will be closed or sold.
This pressure puts an interesting organizational change dynamic into play. What is it?
Resolving the Relationship Between LSS and TOC: Essay at the End of the Book
One of the major themes in The Goal, and especially the essay after the novel (required reading), is that it is important to understand the interrelationships and the fundamental assumptions of the management paradigms, tools, and techniques that we use when making decisions. It is also important to understand the fundamental goal of the system.
One of the central insights from Goldratt’s essay, “Standing on the Shoulders of Giants,” (beginning on page 340) centers around the relationship between Lean Six Sigma and the TOC. As he notes, Lean has not worked in many implementations because it requires a very specific set of starting/system states to work. However, if one uses principles of the TOC, one can use Lean Six Sigma to optimize nearly any organization’s performance.
Overall, a very sound management process would be to use TOC to identify the bottleneck/constraints relationships within an organization, then apply Lean and Six Sigma to reduce variation and improve flow through the bottleneck subsystems—and to apply Lean to all other areas such that they do not become constraints or affect the buffer of the system’s bottleneck. Remember, this is a general systems outcome—and the thinking processes can be applied to service organizations just as effectively as manufacturing organizations!
Sticking to the Core Measurements
Of course, Alex and his team do implement an action plan based upon their effect-cause-effect/undesirable effects analysis, despite Peach’s insistence that there must not be any backsliding on any of the metrics. Note how ironic it is that if Alex’s team were to meet Peach’s request seriously, the overall organizational performance would degrade—that is, the company would make less money, have more inventory and waste, and have unhappy customers.
The only metrics the organization needs to keep its eye on, from a strategic standpoint, are T, I, and OE, and the relative changes in each given potential strategic or tactical choices. So long as a decision leads to a delta-T that is greater than the sum of delta-I +
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delta-OE, profit will increase. If ΔT ≥ Σ (ΔI + ΔOE), then that decision will help an organization move toward its goal (to make more money now and in the future in pursuit of its mission).
By the end of the book, it is clear that, despite tremendous improvement in profitability and overall performance of the Bearington plant, Hilton Smyth still does not get what is important and continues to insist that the only way to profit is through reducing costs and increasing efficiency everywhere!
Of course, you now know the rest of the story and can explain why that is not good systems thinking!
Smyth’s paradigm rests on the assumption that increases in local efficiency, or reductions in “waste,” will always lead to increased profit. He, like many other organizational leaders who do not think systemically, cannot understand that only a critical few activities within an organization actually make a big difference in organizational performance, at the margin.
Leaders who learn how to successfully identify major physical, policy, and market constraints—and then deploy appropriate tools such as TOC, sound economic reasoning, Lean process improvement, Six Sigma, total quality management, and others—will do well, whereas those that focus on local KPIs will likely be ripe for the taking.
References
Corbett, T. (2006). Three-questions accounting. Strategic Finance, 87(10), 48–55. Retrieved from the Walden Library databases.
Friedman, M. (1970, September 13). The social responsibility of business is to increase its profits. New York Times Magazine, 122–126.
Goldratt, E. M., & Cox, J. (2012). The goal: A process of ongoing improvement (30th anniversary edition). Croton-on-Hudson, NY: North River Press.
Jacob, D., Bergland, S., & Cox, J. (2010). Velocity: Combining Lean, Six Sigma, and the theory of constraints to achieve breakthrough performance. New York, NY: Free Press.