Presentation on theme: "Systems Thinking and the Theory of Constraints"— Presentation transcript:
1 Systems Thinking and the Theory of Constraints Timo HildebrandtPaul SullivanAlice Wang
2 Agenda Outline of Topics Timo Hildebrandt Alice Xin Wang Paul Sullivan Theory of Constraints (TOC)Alice Xin WangActivity Based Costing (ABC)Paul SullivanTheory of Constraints the Throughput World Perspective
3 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)
4 OPTThe 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.
5 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.”
6 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.
7 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.
8 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 ProcessThinking Process
9 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 ConstraintsStep 3: Subordinate Everything Else to that DecisionStep 4: Elevate the System’s ConstraintsStep 5: If a Constraint Was Broken in Previous Steps, Go to Step 1
10 Types of Constraints Physical Constraints Physical, tangible; easy to recognize as constraint. Machine capacity, material availability, space availability, etc.Market ConstraintsDemand for company’s products and services is less than capacity of organization, or not in desired proportion.Policy ConstraintsNot physical in nature. Includes entire system of measures and methods and even mindset that governs the strategic and tactical decisions of the company.
11 Procedural Constraints Mindset ConstraintsA constraint if thought process or culture of the organization blocks design & implementation of measures & methods required to achieve goalsMeasures ConstraintsA constraint if the measurement system drive behaviors that are incongruous with organizational goalsMethods ConstraintsA constraint when procedures and techniques used result in actions incompatible with goals
12 Lets Look at Some Familiar Constraints Littlefield TechnologiesTime: Limited duration to make changes and experiment with system designCapital: Cash to procure machines and raw materialsResources: Under utilization and over utilizationStrategy: Decisive actions taken as early as possible to benefit profit maximization
13 The Cost World Perspective Focuses on minimizing costs and improving operational efficiencies.Roots in the 20th Century when U.S. Industry grewU.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 laborDirect MaterialOverhead Costs
14 Obtaining Accurate Product Costs How do we allocate overhead costs to product costs so that product costs are accurate?Cost AccountingStandard CostingActivity Based Costing
15 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…
16 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 A9 minutes processing at Resource BRun’s 2 shifts 10 hours long, 25 days each monthEmploys 4 direct laborers across the 2 shiftsTherefore:
17 National Pontoons Data: Each operator works for 25 x 10 = 250 hours per monthDirect 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 $225,000Selling, General and Administrative costs were $200,000Raw Material Cost$10 per unitProcessing time at Resource A0.10 hours per unitProcessing time at Resource B0.15 hours per unitLabor Rate$10 per hourDirect Labor Wages Paid$120,000Manufacturing Overhead Costs$225,000SG&A Expenses$200,000
18 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.).
19 Direct Labor Costs Direct labor costs at Resource A Hourly rate $10 * time at resource 0.10 hours$10 * 0.1 = $1.00 per unitDirect Labor costs at Resource BHourly rate $10 * time at resource .15 hours$10 * 0.15 = $1.50 per unitTotal Direct Labor Costs = $2.50
20 Historical Data & Demand Average Demand = 40,000 steering wheels2003 Demand = 30,000 steering wheelsDirect Labor Costs =30,000 units * $2.50/unit = $75,000Actual Labor Costs =$120,000
21 Labor Efficiency Variance The difference between actual wages paid and the overhead labor attached to the units produced$120,000 - $75,000 = $45,000That means $45,000 of direct labor was not accounted for in product costs
22 Overhead RateTypically expressed in terms of direct labor hours or direct labor costs$225,000/$75,000 = $3.00 per direct labor dollarSince the direct labor cost is $2.50 the overhead per unit is$3.00 * 2.50 = $7.50 per unitThe finished product cost is$10 (direct material) + $2.50 (direct labor) + $7.50 (overhead) = $20.00
23 Valuing Inventory Costs Cost CategoryCost per UnitRaw Material$10.00Direct Labor Cost at Resource A$1.00Manufacturing Overhead allocation at Resource A$3.00Direct Labor Cost at Resource B$1.50Manufacturing Overhead allocation at Resource B$4.50Total Cost$20.00The 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!
24 Summary of The Standard Cost Accounting Method Captures the effort expended on the product in dollar termsThis 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!!)
25 Why is this all important? Focuses on increasing value of the productIncentive for shop supervisor to push products through the resources as quickly as possibleContrary to a Kanban system because downstream activities may not need these productsLeads to End-of-the-Month syndromeResults in even higher levels of inventory
26 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.”
27 ACTIVITY – BASED COSTING (ABC) Why ABC?- ABC provides an opportunity to obtain a better approximation of the true product costBasic Principle of the ABC system is “Activities consume costs and product consume activities”
28 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.
30 SUMMARY of Cost Accounting System The Standard cost accounting system allocates all overhead costs to the products using a broad measure such as labor costA more equitable allocation of overhead costs – ABC system can help approximate the product costThe problems of ABC systemsABC system can become difficult and expensive to maintain
31 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 outputConstraint : anything that inhibits a system’s performance toward its goals
32 THE THEORY OF CONSTRAINTS AND THE THROUGHPUT WORLD PERSPECTIVE TOC encourages systems thinkingTOC adopts the view that managers should focus on a system’s constraints as a basis for making the right decisionsTOC prescribes three performance measures- Throughput- Inventory- Operating expense
33 Three Performance Measures Throughput (T): the rate at which the system generates money through salesInventory (I): All the money invested in purchasing things the system intends to sellOperating expense (OE): All the money the system spends, turning inventory (I) into throughput (T)
35 National Pontoons Example Asset base as of January 1, 2003Activity in 2003RM Purchased in 2003 (units)40,000Number of Units Sold in 200330,000Unit Selling Price$30Direct Labor Wages$120,000Plant Manager’s Salary$150,000QC Inspector’s Salary$63,000SG&A Expenses$200,000Capital Assets Acquired in 2003$25,000Depreciation in 2003$12,000Fixed Assets$120,000Raw Material Inventory (Units)25,000WIP Inventory (Units)15,000Finished Goods Inventory (Units)20,000
36 National Pontoons Example Asset base as of December 31, 2003Fixed Assets$133,000RW Inventory (Units)35,000WIP Inventory (Units)15,000Finished Goods Inventory (Units)20,000
37 Three TOC measures: I (start of 2003) = $720,000 T ( in 2003) = $600,000OE (in 2003) = $545,000I (end of 2003) = $833,000Profit T –OE = $55,000
38 Traditional Financial Measures of Interest to an Enterprise Bottom Line MeasurementsNET PROFIT(Absolute)RETURN ON INVESTMENT(Relative)CASH FLOW(Survival)
39 TOC Financial Measures of Interest to an Enterprise Quite different from traditional cost accounting measuresThroughput (T) = The rate at which the system generates money through salesInventory (I) = All the money invested in purchasing things needed by the system to sell its productsOperating Expense (OE) = All the money the system spends, turning inventory into throughput.
40 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
41 Traditional Financial Measures vs. TOC Financial Measures Net Profit = Throughput – Operating Expense = T – OEReturn on Investment = Throughput – Operating Expense = T – OE InventoryIInventory Turns = Throughput = T Inventory = IProductivity = Throughput = T Operating Expense OETOC approach less than Traditional especially in Inventory turns b/c denominator in TOC includes all capital assets
42 Cost World vs. Throughput World Priority Cost WorldFirst: OESecond: TThird: IThroughput WorldTIOE distant3rd Priority
43 Leveraging Power of T and OE in National Pontoons Uses two resources A and B for productionResource A = Six minutes p/unitResource B = Nine minutes p/unitEach resource operated by a direct labor employeeWorked two 10 hr shifts with four direct laborersIn 2003, produced 30,000 units w/ selling price of $30 p/unitTime 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/yrIn 2003, National Pontoons operated at 75% capacity 4,500 / 6,000 hrs/yr
44 Leveraging Power of T and OE in National Pontoons Cost and Profit Data for National Pontoons without LeveragingITEMDATA FOR 2003Sales Revenue$900,000Raw Material Cost$300,000Direct Labor Cost$120,000Overhead Costs$425,000Total Expenses$845,000Net Profit$55,000
45 Leveraging Power of T and OE in National Pontoons Next, Focus on Leveraging Power of OE to become more profitable in 2004Only operating at 75%, reduces working hours by 25% in 2004 to 15 hours per dayAdjusts wages paid to direct labor by 25%Labor drops from $120,000 to $90,000 $120,000 x 0.75The $30,000 cost savings goes directly to bottom line
46 Leveraging Power of T and OE in National Pontoons Leveraging Power of OE for National PontoonsITEMDATA FOR 2003LEVERAGING POWER OF OESales Revenue$900,000Raw Material Cost$300,000Direct Labor Cost$120,000$90,000Overhead Costs$425,000Total Expenses$845,000$815,000Net Profit$55,000$85,000
47 Leveraging Power of T and OE in National Pontoons Next, Focus on using its installed capacity to improve T to become more profitable in 2004Starts marketing campaign to sell more units which drops price 5% and boosts its sales to 40,000 units in 2004Raw Materials increased by 33.33% to $400,000Selling price 0.95 x $30 = $28.50 p/unitResults in full capacity utilization at Resource B 40,000 x (9/60) = 6,000 hrs/yr
48 Leveraging Power of T and OE in National Pontoons Leveraging Power of T for National PontoonsITEMDATA FOR 2003LEVERAGING POWER OF OELEVERAGING POWER OF ISales Revenue$900,000$1,140,000Raw Material Cost$300,000$400,000Direct Labor Cost$120,000$90,000Overhead Costs$425,000$435,000Total Expenses$845,000$815,000$955,000Net Profit$55,000$85,000$185,000
49 Leveraging Power of T and OE in National Pontoons 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 costEnterprises 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
50 Long-term Increase or Short-term Gain? A chain can demonstrate how the cost world focus sacrifices long term throughput increases for short-term gainsInstead 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
51 Long-term Increase or Short-term Gain? Assume a chain of 10 linksEach link = 100 lbs of carrying capacity except for one link has only 50 lbs of carrying capacityManagement unhappy with cost of maintaining the nine strong links so it sells the nine heavy linksIt replaces each link with a carrying capacity of lbs which makes a truly efficient chain since every link is capable of carrying exactly same loadWhat is the problem?
52 Long-term Increase or Short-term Gain? The problem is the enterprise is locked into the current performance levelIt now has ten links, any one of which can breakIn the future, if improved performance is desired, it will have to work all ten links in the chainThe same problem occurs when enterprises eliminate overcapacityIf business picks up, it will be harder to recruit employees, why?Fearful of being fired in the next downsize
53 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?
54 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 approachThe TOC presents a five-step focusing process for identifying the root cause of a problem and dealing with it effectively
55 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 DecisionStep 4 Elevate the System’s ConstraintsStep 5 If a Constraint Was Broken In a Previous Step, Go Back to Step 1
56 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 futureThe system’s constraints prevent it from making more money
57 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 identifyMarket Constraints – Harder to IdentifyPolicy Constraints – Hardest to IdentifyBottleneck
58 Physical Constraints The easiest to identify Can be machine capacity, staff availability, space availability, human capability, etc.TangibleTechniques for getting the most from capacity constraints:Eliminate periods of idle timeReduce setup time and run time per unitImprove quality controlPurchase additional capacity
60 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 performanceExcess capacity is easily identified as a market constraintCan arise when an enterprise produces and does not have enough capacity to satisfy all of the demand
61 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 companyHardest to IdentifyIn theory, there should be no policy constraints, but most constraints to system performance are policy constraints
62 Policy Constraints Methods Constraints Measures Constraints A constraint when procedures and techniques used result in actions incompatible with goalsCould be created by never producing a batch of units below an EOQMeasures ConstraintsA constraint if the measurement system drive behaviors that are incongruous with organizational goalsAggressively seeking quantity discounts would lead to increased raw material inventoryMindset ConstraintsA constraint if thought process or culture of the organization blocks design & implementation of measures & methods required to achieve goalsShop Supervisor has the attitude that all operators should be busy all of the time
63 Step 2 : Decide How to Exploit the System’s Constraint(s) Exploiting the constraint means using the constraint as profitably as possibleUntil the constraints are overcome by other means, the enterprise should work them as profitably (effectively) as possible: the real meaning of the word exploitIf constraint is physical resource, ensure the resource is never idleIf the market is the constraint, exploit by ensuring not a single sale is lost as a result of our action or inactionMarket constraint implies extra capacity, so we exploit this by guaranteeing 100% on time delivery to customer
64 Step 3 : Subordinate Everything Else to that Decision Need to manage every part of the profit-generating systemWe do not want those non-bottleneck resources becoming bottlenecks because of our negligence because of focusing on constraintsDeals with process of schedulingWork must be started and sequenced so the constraint can always work or work smarterDrum-buffer-rope (DBR), or pull-from-the-bottleneck model, is similar to kanban systemExcept the input process of DBR is linked to the rate or production of the constraint to utilize it as much as possible
65 Step 4 : Elevate the System’s Constraints Tries to lift the restriction that is preventing the enterprise from making more moneyElevating the constraint means identifying ways that the performance of the system can be improved, relative to its goalsThis step should only be performed after the exploit step, step 2If the constraint still exists, or another emerges, then it is time to execute the fourth step
66 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 constraintPerformance will not be dictated by another element that has become the weakest linkTo find this new weak link, we must revisit all the steps once againGoldratt 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
67 Example of the Five-Step Focusing Process Think of a small production system for manufacturing two products, P and QGoal is to maximize profitWeekly demand for P is 110 units & for Q is 60 unitsFour resources used to meet demand: A, B, C, and DLet’s take a look at the process flow chart which includes the cost and time for each stepStep 1 is executed to determine if a constraint prevents us from meeting the market demand
68 Example of the Five-Step Focusing Process A Production System Manufacturing Two Products, P and Q$90 / unitP:Q:$100 / unit110 units / week60 units / weekDDPurchased Part10 min.5 min.$5 / unitCBC10 min.5 min.25 min.BAA15 min.10 min.10 min.RM1RM2RM3$20 per$20 per$25 perunitunitunitTime available at each work center: 2,400 minutes per weekOperating expenses per week: $6,000
69 Step 1 : Identify the System’s Constraint(s) Work CenterLoan on P units)Load on Q units)Total Time RequiredTime AvailableA1,6506002,2502,400B1,1002,1003,200C3001,950D1,400Do a Capacity analysis and we find Resource B is overloaded
70 Step 2 : Decide How to Exploit the System’s Constraint(s) Have to Decide which product we want prioritized and produce it firstProduct contribution is selling price less the price of materials used in the productContribution of P = $90 - $5 - $20 - $20 = $45Contribution of Q = $100 - $20 - $25 = $55Cost World Analysis – work with product cost and product profitsQ 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 PMeans producing 60 units of P (2100 minutes of Resource B), leaving 300 minutes which is enough to produce 30 units of PProduct Mix results in a net profit of $45(30) + $55(60) - $6,000 = -$1,350
71 Step 2 : Decide How to Exploit the System’s Constraint(s) From a system’s perspective (throughput world), product costs do not have much weight for we are primarily in system’s profitsTo get maximum profits, we want to exploit the constraintRunning Q through constraint, Resource B, requires 35 min/unit and Q’s profit margin is $55The Rate at which the constraint generates profit is $55/$35 = $ p/minRunning P through constraint, Resource B, requires 10 min/unit and P’s profit margin is $45The Rate at which the constraint generates profit is $45/10 = $4.50 p/minShows we want to produce as many units of P as the market would bear and use remaining capacity on constraint for Q
72 Step 2 : Decide How to Exploit the System’s Constraint(s) To produce 110 units of P needs 110 x 10 = 1,100 minutes of Resource BSince Time Available is 2,400, it leaves 2,400 – 1,100 = 1,290 minutes available time on Resource B each week to produce QWith the available time, we can produce 1,290 / 35 which equals 36 units of QTotal Marginal Profit of Q $45 x $55 x 36 = $6,930Since operating expense was $6,000, net profit = $930Cost World Approach Net Loss of -$1,350Throughput Approach Net Profit of $930Quite a difference!
73 Step 3: Subordinate Everything Else to This Decision Relating to example, this step means keeping Resource B running at all timesWe 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 QIf more than 36 units of A are produced, they would accumulate in front of Resource B
74 Step 4 : Elevate the Constraint(s) The bottleneck has now been exploitedBesides 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 choicesGenerate more demand for Product PBuy another Resource BEither way, we have elevated the constraint so we now have to execute steps 1 through 5 again.THIS IS THE PROCESS OF ONGOING IMPROVEMENT
75 ConclusionsSystems are like chains. Every system has a weakest link, or constraint, which limits the success of the entire systemCost Accounting Systems can identify where costs are being incurred, but care is needed when allocating fixed costsTOC avoids those allocations and uses a set of three measures to gauge the financial impact of any decisionMany enterprises improve performance by improving all their processes at the same time which removes waste but makes the enterprise’s focus become diffusedStrengthening links other than the weakest link does not improve the strength of the chain
76 ConclusionsThe Cost World perspective is adopted by enterprises when theyReduce costs and trim resources so the capacity of all the resources match the capacity of the weakest linkPromote local thinking and encourage behavior that runs against enterprise goalsThe focus should be on growth or improving throughput which is TOC or a Throughput World perspectiveEnterprises that adopt a Throughput World perspective have an immediate competitive advantage because most of the competition is stuck in the Cost World perspectiveThe Five-Step Focusing process identifies bottlenecks and shows how to exploit and elevate those bottlenecksThe Focusing process works especially with physical constraints