Eli Goldratt famously said, ‘Tell me how you measure me, and I will tell you how I will behave. If you measure me in an illogical way… do not complain about illogical behaviour.’ If you measure and reward activity, then activity’s what you’ll get.

This is part 2 in a series. Read the other part here: Six Questions for Financial Performance

[ Listen to the audio version, read by David Hodes]

How tempting it is to make everyone busy with production. In our traditional accounting systems, we book all this activity to profits. Credit operating expense as you debit inventory (whether work in process or finished goods), and voilà, by the magic of generally accepted accounting principles, those operating expenses are now counted as an asset on the balance sheet. In other words, you’ve made a profit without adding a dollar of revenue. The chickens come home to roost when you have warehouses full of inventory that no one wants to buy, and you’re compelled to mark them down to raise some cash and clear the way for a product people want to buy.

And don’t think this idea of activity-based costing applies only to manufacturing. Projects, with their system of earned value and the ever-so-popular S-curves, do the same job of ‘absorbing’ activity onto the balance sheet, as operating expense is credited from the project’s profit and loss. But rarely is a link made between the costs thus absorbed and their tenuous link to the critical path of the project, which alone determines when the business benefits start flowing.

What’s an alternative way to assess our business decisions that doesn’t depend on a reductionist framework which mistakenly assumes that the sum of the parts is the determinant of the value created by the whole? After all, that reductionist assumption informs the accounting methods that use activity-based costing as their guiding light.

Let’s recall the words of Charles Horngren, Professor of Accounting at Stanford University, who declared: ‘Relevant information is the predicted future costs and revenues that will differ among alternative actions. The existence of a limiting factor changes the basic assumptions underlying the cost and revenue opportunity of a particular action.’ In simpler terms, he wrote: ‘A company will profit maximise when it sells the product or service with the highest contribution per unit of the scarce resource.’

“In all that complexity was the inherent simplicity of Newton’s laws of motion”

Underpinning Goldratt’s many achievements and insights is the idea that, even in the most complex of environments, there is always an inherent simplicity. I recall him regaling an audience on his only visit to my Sydney hometown with the story of how we view the cosmos. He pointed heavenward and talked of the infinite complexity of the expanding universe: the galaxies, the stars, the planets, the moons, and the swirl of gases. And in all that complexity was the inherent simplicity of Newton’s laws of motion. Using them, we could predict to a reasonable degree where which celestial body was now and where it would be in the future. We didn’t need Einstein or Bohr to approach a more fundamental truth, as what Newton provided us was sufficiently valuable to send man to the moon and back. Physicist that he was, he took this basic idea of inherent simplicity and applied it to the world of work management.

The idea of inherent simplicity is captured in the diagrams below. If we break our system into some assemblage of parts, then the sum of the parts is not equivalent to the whole. Each part on the right-hand side of the diagram, measured by its ability to optimise its production, would inevitably lead to the generation of silos, mis-synchronisation, and departmental conflicts.

On the other hand, if we look at the system view on the left, we can see that if we want to create a leveraged systemic effect, we need only pay attention to the orange sphere, as it is either directly or indirectly connected to every other sphere in the system. A slight improvement there could be a significant gain when measured against overall system performance.

Both Horngren and Goldratt are talking about the fundamental difference between making an improvement at the constraint or doing it anywhere else. How does this idea help us to answer the Six Questions for Financial Performance?

1. Is the overall business profitable?

We know that we can measure profitability using the idea of return on investment, or ROI. In the world of constraint accounting, we measure ROI according to the formula.

Where:

T = Throughput defined as sales less variable costs
OE = Operating Expense usually made up of labour and overheads
I = Investment

The great benefit of using this means of determining profitability is that it can be used from the board room’s global decisions to the work supervisors’ local decisions. And it can be applied to horizons from short to medium to long.

In most cases I’ve encountered, sometimes with more effort than others, this formula can even be applied to decision-making on the shop floor. Should I work on this breakdown or that? Well, which one is likely to have the most significant impact on T, OE, and I? Indeed, any decision we make should have the calculation of ΔT, ΔOE and ΔI, where Δ is the change in the value of the variable that arises as a result of any given decision.

It also makes sense to track the trends of T, OE and I over the last five years and see if T is growing faster than OE over the longer haul. Useful ratios are T:OE, which measures how much throughput is generated for every dollar of operating expense incurred. Anything less than 1, and you’re losing money. T:I is a useful idea for capital productivity—that is, how much throughput is generated for every dollar invested. Both of these ratios should also be plotted over the previous five years to see if you are getting better at generating cash, and forecast for the next five to understand the impact of any investments you might make.

2. Is a given strategic business unit within the overall business profitable?

When we look at the profitability of a given business unit, we must be sure to understand which costs and revenues are strictly associated with that business unit and which are part of the funny money that arises from transfer pricing and cost allocation decisions. In other words, we need to know what happens to T, OE and I at the parent company level if we are to assess the subsidiary business unit properly. We must know the business unit constraint and whether it’s in supply, make or the market. We must understand what cash flows (investments, revenues, margins and costs) the business can generate in the short, medium and long term.

And then, even if the answer to all of these questions comes up in the positive, we must not forget to question the opportunity cost of focusing the ultimate constraint of management attention on this business unit versus the other opportunities available to the parent business.

3. Is a given product or service attractive for us to make and sell?

Once we understand where our constraint is, we can use Horngren’s formula for profit maximisation to establish which of our products or services delivers the most bang-per-buck per unit of the constraint. We call this bang-per-buck ‘product octane’. The chart below shows a plot of a range of products, all of which require the use of the constrained engineering resource. The x-axis shows how much throughput that product will deliver over a year; the y-axis measures the octane—that is, how much scarce resource the product consumes. The blue lines represent the average octane and throughput per annum for all products.

Quadrant one products should be high on the agenda for sales promotion, as they yield a high throughput for every engineering day. There is also the chance to establish elasticity of demand—that is, what happens if you have a slight drop in price that doesn’t affect octane too much?

Quadrant two products are the star performers, and you should always look to be selling more of these. If you can’t further penetrate existing markets, then go out and look for new segments or territories.

Quadrant three represents those products that deliver low sales while overusing the scarce resource (engineering in this case). They should be dropped from the range of products or perhaps outsourced so that they don’t use precious constrained engineering time.

Quadrant four represents solid performers in annual throughput contribution. However, it would be even better if they could be moved into quadrant two by relooking at their design such that they spend less time in engineering.

A similar idea to product or service octane applies to project octane when selecting the portfolio of projects you undertake in any given horizon.

4. Is a given customer or customer segment attractive for us to do business with?

If your constraint is in the marketplace, that is, you cannot get enough customers to buy the capacity you have for generating products and services, you at least need to know if servicing a given customer is profitable. That is, the throughput generated by their sales exceeds the operating costs that would go away if you stopped servicing them.

If your constraint is in make or supply, you could view your customer portfolio through the lens of the octane grid and assess where each customer lands in terms of octane and throughput against the same metric for the next best customer. Rather than saying no to the marginal customer, using them to test your assumptions about pricing is often worthwhile. A price increase could improve octane and make them more attractive than the next best option.

5. Should we make the product or service ourselves or buy it from a third party?

Using the ΔT, ΔOE and ΔI framework gives you a robust way of testing whether a product should be outsourced. As mentioned above, a low octane, low throughput product could be a good candidate for outsourcing if it makes way for more productive use of the capacity it yields. However, if the constraint is in the market, you need to test what the actual impact will be on T, OE and I through the decision to outsource. Proper analysis may indicate it’s better to invest in additional capacity than to outsource production because of the impact on lead times, delivery reliability and the negligible impact it may have on the remaining operating expense.

6.Should we make a given investment?

Investments are usually made as part of the Uplift step of the 5-Step FOCUS. It’s relatively simple to assess if an investment is required due to an existing or anticipated constraint. Notwithstanding the inherent risk associated with any investments, assuming you have done your homework on your assumptions, you can apply the TOEI framework to your decision-making. For any given investment, so long as the uplift in risk-adjusted throughput is sufficiently positive relative to any increase in operating expense, there will be a nett benefit in terms of ROI. Which, after all, is what we’re in business to do.

Read Part One: Six Questions for Financial Performance

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What’s next?

The change to using Theory of Constraints (TOC) as an underlying operating system is both profound and exhilarating. We’ve developed the Systems Thinker Course to bring the ideas into your organisation.

• View the Systems Thinker Course Guide (no email required to download)
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  [Background image: KPI graph on Shutterstock]

   

   
   
   
   

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