The Theory of Constraints

The Theory of Constraints

 Eli Goldratt, a physicist.

 OPT: a scheduling package.

 The Goal and the Theory of Constraints.

 Goldratt challenges the conventional

approach to managing organizations.
 Traditional Decision Making
 How are investment decisions usually made?

“The Cost-World” Perspective

 Consider how such a perspective affects

the push towards parts per million (PPM)
quality and “Zero” inventory.
 The Cost World Perspective:
Cost and PPM Quality

Reducing Annual
Scrap Cost Investment The Cost
From To Savings Needed Judgment
8% 2% $60,000 $20,000
2% 0.5% $15,000 $20,000
0.5% 0.1% $4,000 $20,000
 The Cost World Perspective:
Cost and Inventory Turns
Increasing Annual
Inventory Cost Investment The Cost
Turns Savings* Needed Judgment
3 6 $2M $2M
6 12 $1M $2M
12 24 $0.5M $2M

* Assuming starting inventory of $15M and 25% carrying cost

 The Real Cost of Inventory
 Inventory adversely affects all the factors
that give you a competitive edge (Price,
Quality, and Delivery). It results in
Increased costs due to obsolescence, storage
costs, overtime, etc.,
Defects not being detected soon enough,
Longer lead times and poorer delivery
performance.
 Assume the following data
Raw Material cost per unit: $10
WIP value per unit: $20
Finished Goods value per unit: $35
Sale Price per unit: $50
Other Operating Expenses: $4 Million in 1996; $3.75 Million in 1997
1996 1997

Beginning WIP Inventory (1000 units) 50 50

Beginning FG Inventory (1000 units) 40 40
Raw Material (1000 units) 400 330
Sales (1000 units) 400 400
Ending WIP Inventory (1000 units) 50 10
Ending FG Inventory (1000 units) 40 10
 The Income Statement
1996 1997
Sales (1000 $) 20,000 20,000
Beginning WIP Inventory (1000 $) 1,000 1,000
Beginning FG Inventory (1000 $) 1,400 1,400
Raw Material Purchase (1000 $)
Other Expenses (1000 $)
Ending WIP Inventory (1000 $)
Ending FG Inventory (1000 $)
Cost of Goods Sold (1000 $)

Profit (1000 $)
 Product Costs

 How do we calculate a company’s profit?

Net Profit = Sp Revenuep - Sc Expensec.

 Note: first summation is on product types,
second summation is on categories.
 So, how can we use this information to, say,
decide on launching a new product?
 Product Costs
 Allocate! If we can allocate costs correctly:

 Net Profit = Sp Revenuep - Sp Expensep

= Sp (Revenuep - Expensep)
 How to determine product cost accurately?
 Standard Costs:
Activity Based Costing (ABC)
Product Costs At National Pumps
 National Pumps, Inc. has obtained the
standard cost for one of its pumps:
Direct Material $500
Direct Labor $100
Overhead Allocation $400
Standard Cost $1,000
This pump sells in the US for $1,250.

Plant is currently running at 80% capacity

Product Costs At National Pumps
 There is a big demand for this pump in the
Asian market.
Should National Pump cut its selling price to
penetrate the Asian market?
If so, by how much should it discount its price?
 The Theory of Constraints

 The Theory of Constraints (TOC) is based

on two premises:
The Goal of a business is to make more
money, … in the present and in the future.
A system’s constraint(s) determine its output.
 Types of Constraints
 Physical Constraints
 Physical, tangible; easy to recognize as constraint.
Machine capacity, material availability, space
availability, etc.

 Market Constraints
 Demand for company’s products and services is less
than capacity of organization, or not in desired
proportion.

 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 company.
 Policy Constraints
 Mindset Constraints
A constraint if thought process or culture of the
organization blocks design & implementation of
measures & methods required to achieve goals.
 Measures Constraints
A constraint if they drive behaviors that are
incongruous with organizational goals.
 Methods Constraints
A constraint when procedures and techniques
used result in actions incompatible with goals.
 Local Performance Measures:
The Sales Department
 A 1% sales commission: 2 products:
Cadillacs: $40,000
Beetles: $20,000
 Which product will the sales person push?

 Suppose the profit margins are

Cadillac: $1,500
Beetle: $2,500
 Which product will the CEO want you to push?
Conflicting goals (local and global).
 TOC and Systems Thinking
 TOC promotes “Systems Thinking”: global
optimization (not local optimization).
 The performance measures advocated by
TOC are global measures.
 The Theory of Constraints

 The Theory of Constraints (TOC) is based

on two premises:
The Goal of a business is to make more
money, … in the present and in the future.
A system’s constraint(s) determine its output.
 TOC Performance Measures

 Throughput (T): The rate at which the

system generates money through sales.
 Inventory (I): All the money invested in
purchasing things needed by the system to
sell its products.
 Operating Expenses (OE): All the money
the system spends, turning inventory
into throughput.
 Relating TOC Measures to
Traditional Measures
 T = Sale Price - Direct Material Cost

 OE = Direct Labor Cost + Overhead

 Net Profit = T - OE

 Return on = Net Profit = ( T - OE ) / I

Investment inventory
 Inventory = throughput
Turns inventory
The Throughput World: The Five
Step Focusing Process of TOC
 Step 1: Identify the System’s
Constraint(s)
 Step 2: Decide how to Exploit the
System’s Constraints
 Step 3: Subordinate Everything Else to
that Decision
 Step 4: Elevate the System’s Constraints
 Step 5: If a Constraint Was Broken in
Previous Steps, Go to Step 1
 Identifying Constraints
 Identifying Physical Constraints:
A Typical WIP Inventory Profile:
Ave. WIP Inventory

R1 R2 R3 R4 R5 R6
 How can we get the most from
Physical Constraints?
 Techniques for optimizing capacity
constraints:
Eliminate periods of idle time
Reduce setup time and run time per unit
Improve quality control
Reduce the workload
Purchase additional capacity

 Is there anything else we can do?

 An Example:
A Plant Producing Two Products
$90 / unit $100 / unit
P: 100 units / week Q:
50 units / week

D D
Purchased Part 15 min. 5 min.
$5 / unit
C C B
10 min. 5 min. 15 min.

A B A
15 min. 15 min. 10 min.

RM1 RM2 RM3

$20 per $20 per $20 per
unit unit unit
Time available at each work center: 2,400 minutes per week
Operating expenses per week: $6,000
A Production System Manufacturing Two Products, P and Q
 Can We Meet The Demand?
 Perform a Capacity Analysis

Processing Requirements (all times in minutes)

Product A B C D
P 15 15 15 15
Q 10 30 5 5

 Available time / week on each resource: 2400 min.

 Can We Meet The Demand?
 Resource requirements for 100 P’s and 50 Q’s are:
 Resource A: 100 x + 50 x = minutes

 Resource B: 100 x + 50 x = minutes

 Resource C: 100 x + 50 x = minutes

 Resource D: 100 x + 50 x = minutes

 Any Bottlenecks?
 B is a bottleneck.
 A, C, & D are not bottlenecks. They all have
spare capacity at desired production levels..
 We cannot achieve desired levels of production
due to the capacity constraint on B.
 So, what production levels do we set for P & Q?
 The Production Decision
 Which product has higher profit margin?
Product P:
Product Q:
 Which product requires less effort?
Product P:
Product Q:
 So, it looks like is the star and is the “dog.”
We will first offer the star to the market. If we
still have residual capacity, we will offer the dog.
Makes sense, does it not?
 What Is The Net Profit?
 Consider the bottleneck, B. To produce 50 units of Q we
need 50 x = min. on B.
 This leaves min. available on B, for producing P.

 Each unit of P requires minutes on B. So, we can

produce units of P.

 If we produce and sell 50 units of Q and units of P each

week, we get 50 x $60 + x $45 = $ per week.
 When we factor in operating expense ($6,000), we find we
 Do We Shut The Plant Down?
 Wait! We are not adopting the
“throughput world” perspective are we?
 We worked with “product profits.”
 In the throughput world, there is no such
thing as product profit, is there? Only
company’s profit.
 What is the second focusing step?
DECIDE HOW TO EXPLOIT THE
CONSTRAINT.
 Exploiting The Constraint
 Each unit of Q brings $ to the company.
How many minutes of B do we use for one
unit of Q? minutes.
So, by promoting Q, we receive $
per constraint minute.
 Each unit of P brings $ to the company.
How many minutes of B do we use for one
unit of P? minutes.
So, by promoting P, we receive $
per constraint minute.
 Throughput World vs Cost World

 The throughput world perspective indicates

that we should first focus on producing
product .

 The cost world perspective had indicated

that we should first focus on producing
product .
 Which Perspective Is Correct?
 If we focus on P first, we can sell 100 Ps / week,
requiring minutes of B. That leaves
minutes available on B to produce Q.
 Each unit of Q requires minutes on B. So, we
can produce units of Q.
 By producing 100 units of P and units of Q, we
get 100 x $45 + x $60 = $ each week.

 After subtracting $6,000 for operating

expenses, we obtain a net profit of
 Cost World or Throughput World?

 So, what product will you focus on?

 Shifting Paradigms
Current Priority New Priority
First: OE T
Second: T I
Distant Third: I OE

Cost World Throughput World

Moving to the Throughput World
 If you move to the throughput world, you
have a competitive advantage, since most of
your competitors are still in the cost world.
How do you shift the perspective to the
throughput world?
How do you effect the change?
 Implementing TOC
In The Shop Floor
 How do we implement a scheduling
technique in the shop floor in line with the 5
focusing steps of TOC?

 Recall the fundamental steps:

Identify the constraint
Decide how to exploit it

 Drum-Buffer-Rope (DBR) technique.

 A Troop Analogy
FINISHED RAW
GOODS MATERIAL

WORK-IN-PROCESS
 Spreading troops = high inventory. Closely
packed troops = lower inventory.
 How can we prevent troops from spreading?
 A Troop Analogy
 Put the slowest soldiers at the front and the
strongest ones in the rear.
 A Troop Analogy
 In other words, restructure your factory so
that the most loaded machines (the capacity
constraints) are at the first operations, and
place the machines that have a lot of excess
capacity downstream.
 A Troop Analogy
 Put a drummer at the front to set the pace.
 Have sergeants constantly urge the soldiers
to close any gaps.
 A Troop Analogy
 That’s common practice now:
The sergeant is the expeditor and the drummer
is the material management system assisted by
a computer
But can the soldiers follow the drum beat?
 A Troop Analogy
 “If a worker doesn’t have anything to do,
let’s find him something to do.”
As long as this mentally exists, each soldier
will proceed according to his potential and not
according to the constraints of the troop.
Do efficiencies, incentives and variances allow
your workers to follow the drum beat?
 A Just-In-Case System

FINISHED RAW
GOODS MATERIAL

 A “push” system. The drum beat is set by

the gating operation: it is the rate at which
the first machine executes.
Result:
Inventory is high
Current throughput is protected
Future throughput is in danger
 A Troop Analogy
 Henry Ford: The assembly line.
 Taiichi Ohno: Kanban system

Rate of production regulated by Kanbans.

Workers are instructed to
“Stop work when kanbans are full!”
 A Just-In-Time System

FINISHED RAW
GOODS MATERIAL

 The drum is held by marketing demands

Result:
Inventory is low
Current throughput is in danger
Future throughput is increased
Just-In-Time Systems & Kanbans

 Work is “synchronized.”

 Inventory is low

 But any significant disruption will cause the

entire system to stop.
 A Troop Analogy

 Since the weakest soldier dictates pace:

To prevent spreading, tie weakest soldier to the
front row.
To protect overall pace, provide some slack in
the rope.
 Synchronized Manufacturing
The Drum-Buffer-Rope Way

FINISHED RAW
GOODS MATERIAL
Major Capacity Constraint A rope tying the
gating operation to
Time Buffer the buffer
 The 5 Focusing Steps (Contd.)
 What is Step 4?
 Elevate the System’s Constraints
How does it affect us here?
 The Marketing Director Speaks Up :
“Another constraint in our company.”
 It is the market

A Great Market in Japan!

“Have to discount prices by 20%”
Do We Try To Sell In Japan?
Processing Times
Product A B C D
P 15 15 15 15
Q 10 30 5 5
Product Costs and Profits
Product Selling Manufg. Profit per
Price Cost unit
P (domestic) 90 45 45
Q (domestic) 100 40 60
P (Japan) 72 45 27
Q (Japan) 80 40 40
Maybe We Should Not Sell in Japan?
 Right now, we can get at least $ per
constraint minute in the domestic market.
 So, should we go to Japan at all?
Okay, suppose we do not go to Japan
 Is there something else we can do?
 Recovering Our Investment
Prod Unit $/const
Type Profit minute Plan A

PD $45 3.00 $4,500

(100)
QD $60 2.00 $1,800
(30)
PJ $27 1.80 -

Q $40 1.33 -
J

OE $6,000
Profit $300