Theory of Constraints Handbook - James Cox Iii [267]
Often appropriation requests are constructed to justify investment heavily weighted on reducing cost of the product. For example, if we can reduce the time it takes in one step of the process by 25 percent, then the product cost is reduced (due to less total labor content) and this will translate to an assumed bottom-line improvement. In reality, since these investments and process improvement initiatives (driven by the product cost equation) do not consider constraints or buffers, there is no effective way to judge whether any time reductions at any resource will result in bottom-line improvement. It is quite likely that without the consideration of constraints and buffers, most changes would not result in a net positive ROI position—and often negatively impact performance of the constraint and thus of the whole system as many of these changes require an investment or spending of some sort.
If we push for cycle time improvement at a non-constraint, generally what is the predictable outcome? Remember, a non-constraint means that this part of the system is not currently dictating the pace at which the company is making money. This means that if a non-constraint local resource were enabled to produce faster, the system would experience:
1. No increase in sales or shipments to the customer—no increase in Throughput.
2. A likely increase in parts produced that are not able to be immediately consumed—increased inventory. Increased WIP could also result in longer lead times, decreasing DDP and ultimately reducing Throughput.
3. Some investment was probably made to make the improvement. Potentially, there are additional space requirements or costs of borrowing associated with increased Inventory. In addition, most often the improved rate of production did not allow for any reductions in labor—no decrease in OE.
In other words, locally judging this “improvement” results in Throughput, Inventory, and OE moving in the wrong direction. Judging the potential action on its impact on the constraint would have resulted in saving this money in investment for something that would provide the opportunity for a real bottom-line return.
If one thing can be learned from this book it is the understanding of the impact the constraint has on the system. If the 25 percent improvement in velocity happens to be on a bottlenecked resource, the impact to the bottom line would likely be much greater than the small cost savings that the product cost measurement suggests. In addition to the savings, increased Throughput would result thus improving the organization’s bottom-line. Thus, the product cost argument would dramatically understate the need for this improvement.
The discussion above helps explain why so often cost reduction projects approved by senior managers end up having no impact on the bottom line at all, and then why management have such difficulty understanding what went wrong.
FIGURE 14-4a TOC break-even chart of initial profit potential.
Profit Maximizing in TOC
Since most for-profit companies have a goal related to ROI or RACE and profit is a major component of those measures, we need to understand the basic strategy for profit maximization for each company. Remember one of the most relevant factors is the location of the constraint, the company’s major leverage point. TOC goes back to fundamental economics as the basis for management accounting information (Horngren et al., 1993, 156) to