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CIRAS - TOC - Fundamentals

Measurements

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"Tell me how I will be measured
and I can predict how I will behave."  (Unknown)

"Change my measurements to new ones
that I do not fully comprehend,
and nobody knows how I will behave...
not even me." (Goldratt)

 

 
Conventional vs. TOC
 
 Throughput
 
Inventory & investment
 
Operating expense

 

Inventory dollar days

 

Throughput dollar days
 

Why are measurements so important?

Measurements are the primary method of accounting for the results of actions being taken within an organization. As such, they can be considered to be an output of the system. Measurements are the primary source of feedback to managers and workers alike.

However, measurements also act as an input. They have a huge influence on the actions that employees chooses to take in the first place. Since measurements are usually tied formally (or informally) to performance evaluation, workers tend to try do more of whatever has a positive impact on their measurements, and less of whatever has a negative impact. And, as the Goldratt quote above says, measurements that are not clearly understood will cause the system to experience chaos.

This is why TOC practitioners often begin by examining the measurements being used by an organization.


Conventional measurements vs. TOC measurements

Conventional accounting systems in for-profit companies tend to focus on measurements like Net Profit, Return On Investment, and Cash Flow. This is good and appropriate, because these measures are important indicators of the success of a company, and are required for financial reporting. The problem comes when these measures are used for making day-to-day operating decisions. Doing so is a little like driving your car with paper blocking the view forward through the windshield - that is, you are blocked from seeing the immediate impact of any decision you may make; you can only see the results sometime in the future by looking in the rear view mirror known as year-end or quarterly figures. In effect, the manager is forced to ask, "What do I think the impact of this decision will be on Net Profit at year end?" This is a very difficult outcome for managers to predict, and virtually impossible for the average worker.

This inadequacy has long been recognized, and has resulted in the creation of "local" measurements that are believed to be connected to net profit or ROI. These measures generally are intended to more precisely determine the "cost" of producing a certain product, or to calculate the cost variance (i.e. the difference between a predetermined "standard cost" and the calculated "actual cost"). Such attempts are based on assumptions that are faulty and usually lead to poor management decisions. What is needed are "local" measurements that truly are linked directly to the long term global measures of Net Profit, ROI and Cash Flow.

Throughput, Inventory, and Operating Expense are measurements which, when properly understood at the global level, make it possible for everyone in the organization to predict the immediate impact a decision they are faced with will have on net profit, return on investment, and cash flow. The impact that a decision is likely to have on the investment in Inventory is usually clear: if new investments have to be made in equipment, and/or more raw material will have to be held, then Inventory will rise by the corresponding amount. When figuring the impact of any decision on Operating Expense, note that amounts of direct or indirect labor are immaterial; the true bottom line impact can only be judged by determining whether people will be hired or fired, or whether overtime will have to be worked. Finally, the impact on Throughput can be judged by determining the selling price minus totally variable costs times the volume of the sales. These figures enable a manager to predict much more reliably how an immediate local action will impact net profit, ROI, and operating expense. And the best part is that even the workers can easily understand the definitions and can accurately predict the impact that some immediate decision they have to make will have on Throughput, Inventory, and Operating Expense.

 

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Throughput

In the book The Goal, (North River Press, 1984), throughput is defined as:
   The rate at which the system generates money through sales.

Using this definition, some people equate sales revenues with throughput. This is incorrect. Financial credit should only be given to your system for the value that your system has added, i.e., after you've paid your vendors. The term for sales revenue minus payments to vendors is "contribution" dollars. Rewording the conventional definition to make it clear that revenues that simply pass through your books on the way to you vendors results in the following:
   The rate at which contribution dollars are coming into the system.

  • Notice that throughput is a "Global" measurement, i.e. only the "system" generates throughput! It is NOT appropriate to try and measure departmental throughput. This usually leads to local optimization efforts that would move the company farther from the true goal.
  • Throughput cannot be measured in terms of units produced (such as pieces or impressions); it must be measured in the same units as the goal: i.e., dollars.
  • Throughput is a rate. Time, then, becomes important to measuring it. Therefore, when comparing the profitability of two products it is insufficient to compare the contribution $/unit of two products. You must also know how many units/time (hour, day, month, etc.) that the system can produce. Knowing both, you can determine the actual throughput dollars each product can generate. This will yield a true picture of the relative profitability of the two.
  • Building product to place in stock as finished goods inventory is NOT counted as throughput because if it isn't sold yet, it is not generating money!
  • Since throughput is a measure of the rate at which dollars are being generated by your system, it is necessary when calculating throughput to subtract any money that you get from the sale but that you just pass through to your suppliers. Raw materials and purchased components are example of such items. For example, a wooden bird house that sells for $40 and contains $15 of raw wood and fasteners would produce contribution of $25 per unit. If a factory can sell and produce 10 birdhouses an hour, then throughput is $250/hour. Other "totally variable expenses" (i.e. expenses that would not have occurred if you had not manufactured and sold the product) should also be subtracted. In most cases, however, labor is NOT a totally variable cost!

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Inventory & investment

Inventory was originally defined in The Goal by Goldratt as:
   Everything the system invests in that it intends to sell.

Using that definition, many people tend to think of only raw materials, work in process, and finished goods inventory. However, the concept is larger. For that reason, we will label this measurement "Inventory&Investment." A working definition is:
   All the money that is tied up inside the system.

  • Obviously, there are two categories that fit this definition.
         The first is the inventory that is familiar to us. It is that which moves through the operation and ends up being sold to our customers. We generally break that into 3 types: raw material; work in process (WIP); and, finished goods.
         The second type is made up of investments. These generally do not move through the organization like materials do, and include all the items that are owned and are "being held" by the company because they are necessary to produce throughput. The building, machinery, computers, fixtures, etc. are common examples. Notice that all items that fit the investment portion of this measure could be converted to cash if desired—but the system chooses to "hold" them as investments because they are needed to produce throughput.
  • Asset or Liability? This is an interesting question that really requires more of an answer than the space here allows. Suffice it to say that inventory&investment that provides the protective capacity in materials, workforce and equipment needed to ensure throughput, is an asset. So called "just-in-case" inventory that is pushed into the system because it will be needed eventually is a liability.

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Operating expense

Operating expense is formally defined as:
   All the money the system spends in order to convert Inventory into Throughput

A reworded definition is:
   All the money leaving the system.

  • All employee time is operating expense. It makes no difference whether the person is performing "direct labor", "indirect labor", is on vacation or sick leave. If they get paid the same amount at the end of the week, then their pay is operating expense.
  • The implications of the preceding statement are profound because most manufacturers decisions on the production floor are highly influenced by measurements such as direct labor hours/unit, ratios of indirect to direct labor hours, etc. TOC exposes the erroneous actions that are often taken as a result and makes visible the real impact on the bottom line.

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Inventory dollar days (IDD)

A measure of the effectiveness of a supply chain – i.e., did it do things that it shouldn’t have done and as a result is the supply chain holding inventory of products the customer doesn’t want? IDD accounts for two things: 1. the time from when a unit is placed in stock until it is actually needed by a customer; and, 2. the monetary value of the inventory being held. IDD is calculated by multiplying the monetary value of each inventory unit on hand by the number of days since that inventory entered the responsibility of that link. The system should strive for the minimum IDDs necessary to reliability maintain zero throughput dollar days.

NOTE: The resulting unit of measure is "dollar-days". It is neither monetary nor time based. Attempts to compare dollar-days to other monetary measures are invalid. IDDs can be compared only to other IDD levels.

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Throughput dollar days (TDD)

A measure of the reliability of a supply chain. TDD considers two things: 1. the monetary value of the things a link is committed to deliver but does not; and, 2. the number of days by which the link misses its commitment to deliver. TDD is the summation of the commitments not delivered on time during the chosen time period. The TDD value of individual missed commitments is calculated by multiplying the dollar value of the end product times the number of days the commitment is/was overdue. The system should strive for zero throughput dollar-days.

NOTE: The unit of measure "dollar-days" is neither monetary nor time based. Attempts to compare dollar-days to other monetary measures are invalid. TDD levels can be compared only to other TDD levels.

 

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You may notice that the word "money" plays the central role in this definition. This is because of the "goal" of a for profit company is to make money now and in the future. (See What is the Goal?)   For this reason, it only makes sense that the primary measurements of progress toward the goal must be expressed in the same unit of measure as the goal – namely money.