The biggest constraint we Theory of Constraints consultants find is … (part 2)

By Dr Lisa Lang We have worked with companies around the globe and the constraint is always the same.  It's how we think.  In particular, it's how the business owner or leader of the company thinks. Last time, in Part 1, we discussed the efficiency mind-set and how focusing on efficiency can lead you astray.  I made the case that efficiency is NOT a precursor to improved performance, but a by-product.  In this installment I want to discuss another type of wrong thinking - the allocation mind-set. You buy the same equipment as your competitors. You hire from the same labor pool. The only difference is how you think. Unfortunately, you and your competitors also think the same way. So you are left to compete in a market where, from your customers' perspective, you're all the same. So they make decisions mostly based on price. Let me explain some of the common ways our thinking goes wrong and the negative effect this wrong thinking can have on your business. The allocation mind-set is where we believe that in order to ensure we are going to make a profit, we have to allocate some portion of our overhead to "product cost". The idea is that if every product we sell absorbs some of our costs, then we will know at what point we are making money and we can better ensure that we cover all our costs. So when we calculate the "gross margin" (GM) of a product it looks something like this: Selling price:       $100 -COGS:                -$60 ------------------------------ Gross Margin:    $40 (also called Gross Profit) Where COGS (Cost of Goods Sold) typically include raw materials and the direct labor used to create the product or deliver the service.  (Some companies may allocate more than direct labor, but this is the most common allocated cost.) But if you think about it, direct labor really is NOT a variable cost, unless you pay piece rate. And this is true for both manufacturers and service providers (again unless you pay piece rate - which is very rare). You are going to pay your employees this week whether you sell something or not. It is this allocation of direct labor to COGS that is what I'm referring to as the "allocation mind-set". The amount of direct labor allocated to a product/service is usually based on annual volume assumptions and the estimated time a particular job will take. This means that the allocation of direct labor costs to a job or opportunity influences your decisions: ·        Which jobs/projects you take. ·        Which markets you go after. ·        Which customers get preferential treatment. ·        How much you charge. So far, you're probably thinking - yeah, that's what we do, what's the problem? The problem is that the allocations you do are based on a volume assumption and time estimates. Both of which we know one thing for sure about - they are wrong. The question is by how much and in which direction.  Not only will the amount you allocate be wrong, more importantly, it can lead you astray. The best way for me to demonstrate that is with an example. Let's say that you have a customer who wants to give you more business.  They are one of your best customers and in exchange for the additional business they want a volume discount.  The volume discount is reasonable and something you do all the time.  The problem is that the way they want the product delivered along with their low inventory requirements it's going to require you to do 3X as many set ups as you would normally do for that volume.  Using the allocation mind-set you would calculate the gross margin of this new business. And you would allocate the additional setup time to opportunity. Your COGS would include the cost of the additional setups. Now, let's say that the result is that the gross margin percent is slightly NEGATIVE with these additional setups. What would you do? Pass on the additional business? Take the business but give that customer lower priority and complain about that customer every time you run their job? What decision will you make with this cost allocation mind-set? Who knows since this isn't a real situation, but before you continue reading, please give it some thought. How do you generally feel about more setups or about lower margin work? If you're like most people you would probably pass on the business or try to negotiate with your customer to take more products at once so that you could reduce the number of setups you would do. And you may even find yourself saying "the cost of those setups makes this business unattractive for us". Let's challenge our thinking with Theory of Constraints and Throughput Accounting concepts.  Let's challenge the allocation mind-set.  First, how much throughput would the additional volume generate?  Throughput = Sales - Truly Variable Costs.  Truly Variable Costs (TVCs) are all the costs you pay as a result of selling one more.  Typical TVCs include raw materials, purchase parts, outside services, subcontracted services, freight, and sales commission.  The Theory of Constraints definition of TVCs do NOT include direct labor unless you pay piece rate.  So when we calculate the "throughput" (T) of a product it looks something like this: Selling price:      $100 -TVCs:                  -$20 ------------------------------ Throughput:       $80 Next, determine if you will need to increase your fixed costs (operating expenses) if you take this additional volume? Will you need to hire anyone or buy any equipment? If so, how much? Let's say we do not need to hire anyone or buy any equipment. And if this is the case, we don't currently have an internal constraint.   We most likely have a market constraint. The way we recommend you think about this decision is by comparing the change in Throughput (ΔT) versus the change in Operating Expense (ΔOE) as a result of this additional business. And if the ΔT is greater than the ΔOE, the difference goes to covering all your operating expenses and helping you make a profit. The fact is that, in most cases, a setup doesn't cost ANYTHING (or they cost a little raw material to get the machine lined out).  They do, however, take time.  But it is imperative that you differentiate between cost and time.  If additional setups would consume so much capacity that you would need to add equipment or people, then it would be reflected in the change in OE. But to deliver that offer you need to do more setups.  But because YOU understand that set-ups do not cost anything you are willing to do it.  And your competitors are not!  Which means you can make thinking differently pay off by taking market share. I'm not saying that if ΔT > ΔOE that you must take the business, but I am trying to get you to look at the real situation and understand the real bottom-line effect. Because in this example we would potentially pass on business that would add incremental Throughput and if you do have a market constraint then don't you need more business? Shouldn't you be trying to determine what you would need to offer your market to take market share instead of trying to talk your customer out of doing more setups? The allocation mind-set has you striving to reduce YOUR setups so that you can reduce YOUR costs. Notice that it's all about you. Not a good place to be if you have a market constraint. Now imagine that it's not the customer coming to ask you to increase your set-ups, but instead you created a Mafia Offer that better served your customers needs by: ·        increasing availability of the right products ·        by reducing overall inventory ·        by reducing the amount of cash they have tied up in inventory You can hear an example of such a mafia offer here: http://www.scienceofbusiness.com/free-stuff/free-videos-audios/video-player/videoid/20.aspx So if you improve your operations by eliminating the efficiency mind-set we talked about in Part 1 and then challenge your thinking about allocations to create a great Mafia Offer - what would happen to your business? How much more money could you make? The combination of our Velocity Scheduling System Coaching Program (for custom job shops) or Project Velocity System Coaching Program (for your engineering department) with our Mafia Offer Boot Camp will accomplish just that. In Part 3 we will cover the cost mind-set. If you have questions or comments on Part 2, please click on the "Leave a Comment" link at the top of this post. Wishing you Success! Dr Lisa (c)Copyright Science of Business, Inc. All rights reserved.

http://velocityschedulingsystem.wordpress.com/?p=371

A Process Of On-Going Improvement (POOGI) - Part 32

We are continuing our series based on The Goal by Eliyahu M Goldratt and the Theory of Constraints. {This series was co-written with Brad Stillahn.}

To make managing a complex organization easier, we break organizations into pieces. Many of the current measurements have the purpose of measuring local performance, under the erroneous assumption that the overall performance of the organization will be maximized if each department maximizes its performance.

The role of measurements is to induce the parts to do what’s good for the organization as a whole. What’s good for the organization as a whole is achieving the three objectives stated above.

In previous articles, we’ve referred to some of the measurements used by TOC practitioners:

• Throughput (T) is rate at which the system generates money through sales.
• Inventory (I) is the money invested in purchasing things which it intends to sell.
• Operating Expense (OE) is the money the system spends to turn Inventory into Throughput.

To determine Throughput, subtract truly variable costs (TVC) from Sales dollars. Truly variable costs include raw materials, outsourcing, freight, and sales commission. Throughput is most similar to Gross Profit, except that direct labor is considered an Operating Expense in Theory of Constraints (TOC). It’s not that direct labor does not vary, but it is a period expense and does not necessarily need to vary with sales. Dramatic improvements in Net Profit can be gained when Throughput increases without a proportionate increase in Operating Expense.

...to be continued.

Here's to maximizing YOUR profits!
Dr Lisa Lang
(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

A Process Of On-Going Improvement (POOGI) - Part 18

We are continuing our series based on The Goal by Eliyahu M Goldratt.

You can also perform a sensitivity analysis to determine the breakeven level of T/CU. In this example, it would be the Operating Expense level of $615,000 divided by 2,912 which is $211.20.

Pricing with Throughput Accounting is much easier and potentially much more dangerous. It is easier because there is no such thing as “product cost” to calculate. Instead, each product is evaluated for its Throughput per Constraint Unit. And overall, for the business, the average T/CU must be enough to achieve the Net Profit goal. It’s dangerous because any amount of Throughput does contribute to the bottom-line, but there must be the discipline to maintain the T/CU average needed to achieve the Net Profit goal. Pricing to achieve incremental business is not for novices.

For example, say you are quoting a new job. You estimate it will take 50 hours of milling. The Truly Variable Costs are estimated to be $5,000. Here is your estimate:

Hours of milling 50
T/CU desired $258
Throughput desired $12,900
Truly Variable Costs $5,000
Total Estimate $17,900

We understand that this method is much different and you may have many questions. If so, and/or you would like help calculating T/CU for your business, please feel free to contact us.

If you’d like to learn more about Throughput Accounting, we recommend the following materials (which were also used in developing the discussion above):

• “The Haystack Syndrome” by Dr. Goldratt,
• “Throughput Accounting” by Corbett.
• "Maximizing Profitability" by Dr Lisa (hit the ground running w/ 3 hr audio and workbook)

...to be continued.

Here's to maximizing YOUR profits!
Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

Next GROUP Mafia Offer Boot Camp is July 30, 31, Aug 1 2008!Also check out our FREE Theory of Constraints videos. New videos added very week! http://www.scienceofbusiness.com/free-stuff/free-videos-audios.aspx

A Process Of On-Going Improvement (POOGI) - Part 17

We are continuing our series based on The Goal by Eliyahu M Goldratt.

Let’s apply this to your business. In order to do so, you’ll need to make some calculations. First, write down your annual sales. Second, subtract the Truly Variable Costs (these include raw materials, outsourcing, freight in and out, and sales commissions). The difference between the two is your dollar Throughput.

From throughput subtract all of your fixed costs which we call Operating Expense. The difference is your Net Profit.

For example:

Sales $1,400,000
Truly Variable Costs -$650,000
Throughput =$750,000
Operating Expense -$615,000
Net Profit =$135,000

Let’s further assume that you have lathes and mills in your machine shop. You have identified that milling is your constraint resource. You have only two milling machines operating one shift. You have calculated the available capacity as:

Number of mills 2
Hours per year 2,080
Percent available 70%
Available hours 2,912

The 2,912 hours is how many “Constraint Units” you have available.

The Throughput of $750,000 divided by 2,912 hours is $257.55. That is your “Throughput per Constraint Unit” (T/CU).

What is the meaning of this number? The Throughput per Constraint Unit is the amount of margin needed per operating hour of your limiting resource to cover Operating Expense and achieve your Net Profit. It is the rate at which you make money.
...to be continued.

Here's to maximizing YOUR profits!
Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.
Next GROUP Mafia Offer Boot Camp is June 25, 26, 27 2008!
Also check out our FREE Theory of Constraints videos. New videos added very week! http://www.scienceofbusiness.com/free-stuff/free-videos-audios.aspx

A Process Of On-Going Improvement (POOGI) - Part 16

We are continuing our series based on The Goal by Eliyahu M Goldratt.

Dr. Goldratt says it this way: “If a process of ongoing improvement is what we are after, which of the three avenues of Throughput, Inventory, or Operating Expense is more promising? If we just think for a minute the answer becomes crystal clear. Both Inventory and Operating Expense we strive to decrease. Thus, both of them offer limited opportunity for ongoing improvement. Both of them offer only limited opportunity for ongoing improvement. They are both limited by zero. This is not the case with the third measurement, Throughput. We strive to increase Throughput. Throughput does not have any intrinsic limitation; Throughput must be the cornerstone of any Process Of On-Going Improvement (POOGI). It must be first on the scale of importance.”

Therefore, to make decisions according to Theory of Constraints (TOC) and Throughput Accounting, we need to quantify a decision’s impact on these three measurements and then we will be able to determine the change in net profit and return on investment.

The role of the company’s constraint is fundamental for quantifying the decision’s impact on the three measurements. Thus, to identify which products contribute the most to the company’s net profit, TOC also advocates the use of the measurement of “Throughput per time of the constraint (T/CU)”. This method is much simpler than the product costing and it allows for fast decisions that are directly linked to the bottom line.

...to be continued.

Here's to maximizing YOUR profits!

Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

Next GROUP Mafia Offer Boot Camp is June 25, 26, 27 2008!

A Process Of On-Going Improvement (POOGI) - Part 15

We are continuing our series based on The Goal by Eliyahu M Goldratt.

We have discussed some of the problems with Cost Accounting, yet only touched on the alternative, “Throughput Accounting”. We promised to explore Throughput Accounting in more depth, and explain how implementing its concepts will help you understand the rate at which your company makes money. We also promised to discuss how Throughput Accounting can influence pricing decisions.

We are discussing Throughput Accounting from the perspective of the Theory of Constraints (TOC), a body of knowledge developed by Dr. Eliyahu M Goldratt and others over the last thirty years to support a process of ongoing improvement.

The fundamental concept in TOC is that every real system, such as your for-profit business, must have at least one constraint. If it were not true, your business would produce an infinite amount of net profit. Because a constraint limits your business system from getting more net profit, then if you want more net profit you must manage constraints. These constraints will determine the net profit of your business whether they are acknowledged and managed or not.

TOC and Throughput Accounting introduce three measurements for increasing net profit:
1. increase Throughput (Sales minus truly variable costs such as raw materials),
2. decrease Investment, particularly in inventories,
3. decrease Operating Expenses (that is, fixed costs).

...to be continued.

Here's to maximizing YOUR profits!

Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

A Process Of On-Going Improvement (POOGI) - Part 13

We are continuing our series based on The Goal by Eliyahu M Goldratt.

The core idea in the Theory of Constraints (TOC) is that every real system, such as a for-profit business, must have at least one constraint. If it were not true, then the system would produce an infinite amount of net profit. Because a constraint is a factor that limits the system from getting more net profit, then a business manager who wants more net profit must manage constraints. The constraints will determine the output of the system whether they are acknowledged and managed or not.

Dr. Goldratt says it this way: “Before we can deal with the improvement of any section of a system, we must first define the system’s global goal; and the measurements that will enable us to judge the impact of any subsystem and any local decision on this global goal”.

It is impossible to disentangle using TOC in operations (DBR) from TOC accounting (known as “Throughput Accounting”). Any attempt to run TOC in operations while using traditional management accounting measures and controls is doomed to failure. TOC is a radically different way to control operations and does not work with conventional cost accounting systems.

As an alternative, TOC and Throughput Accounting introduce three measurements for increasing net profit:
1. increase Throughput (Sales minus truly variable costs such as raw materials),
2. decrease Operating Expenses (that is, fixed costs), or
3. decrease Investment, particularly in inventories.

To make decisions according to TOC, we need to quantify the decision’s impact on these three measurements and then we will be able to determine the change in net profit and return on investment.

...to be continued.

Here's to maximizing YOUR profits!
Dr Lisa Lang

(c)Copyright 2008, Dr Lisa, Inc. All rights reserved.

Should I factor my receivables?

Question: Should I factor (sell) my receivables? I could use the cash, but the cost seems too high.

Answer: This question is hard to answer without more information, so let’s look at an example:

Let’s say it costs you $40 to make a product you typically sell for $100. If you could get $100 dollars in 60 days from your customer or $80 dollars in 10 days from selling the invoice, which would you prefer?

To compare the 2 options, let’s calculate the amount of Throughput that each option would generate in 60 days. Remember, Throughput = Sales Price – Truly Variable Costs.

Option 1: We wait to collect the accounts receivable in 60 days. Therefore in 60 days we generate $100-$40 = $60 in Throughput.

Option 2: We sell the invoice and receive $80 in 10 days. Therefore we have generated $80-$40= $40 in 10 days. But we still have 50 days to go, so we invest our $40 in more raw materials and sell another product. For that product we also sell the invoice and generate another $40 in Throughput. We now have 40 days to go, so we repeat the process 4 more times. In 60 days we generate $240 in Throughput.

So the answer is “it depends”. If you have a use for the money that will generate additional Throughput, then you’re on your way to maximizing your cash flow and your profitability! If you have plenty of cash, then it doesn’t really make sense.

Another way to accomplish the same thing is to offer very deep discounts if your customers pay very quickly. However, if you decide later that you don’t want to offer this option anymore, then you have to explain that to your customers.

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
P.S. Happy birthday to my sister Tammy!

Sales Commission -- Effect on Throughput

Continuing our cash velocity discussion started on March 16, 2007
We last left off on Friday April 6, 2007.

Deceasing sales commission is not necessarily where we want to focus either, but make sure that the commission you’re paying is in alignment with where you’re making your money and/or with the products/services with the highest cash velocity. If you have varying T/CU[1] across your products/services, but you are paying sales people a commission on selling price or gross margin, you may not be motivating them to sell the products that provide the highest throughput for the least amount of your most precious resource. In addition, the traditional way of paying sales people does not take into account the cash velocity either. The ideal commission structure would motivate sales people to sell the highest T/CU combined with the best velocity products/services.

[1] Thoughput per Constraint Unit. This is the amount of money you generate on a sale divided by the amount of your limited resources capacity consumed in order to produce the sale. See Throughput Accounting as part of Goldratt's Theory of Constraints.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increase Throughput to Increase Cash Velocity

Continuing our cash velocity discussion started on March 16, 2007

Increasing Throughput

Throughput (as defined in Goldratt's Theory of Constraints Throughput Accounting) is sales revenue minus truly variable costs. Therefore we can increase your throughput by either 1) increasing sales, 2) increasing our selling prices, or 3) decreasing our truly variable costs.

Let’s start with the last one, first. To decrease our truly variable costs we can:

• Negotiate a lower price with raw material suppliers
  
• Negotiate a lower price with outside services, freight suppliers, or with any other truly variable cost vendors that we have
  
• Decrease the sales commission we pay to our sales people

There is a limit to how much we can reduce our costs. If our costs go to zero, then we are no longer in business. Therefore, we want these costs to be in line, but this is not where we want our focus.

... to be continued ...

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Increasing Cash Velocity Can Increase Throughput

Continuing our cash velocity discussion started on March 16, 2007

Now let’s look at the impact on what we discussed yesterday had on our throughput.

Let’s say we immediately visit a customer whose complete order was shipped and had just been received by that customer. We make, and they accept, our 20% Discount Mafia Offer and we collect $320 in cash. We pay the sales commission of $40 so we have $280 left. With the $280 we can buy 2 sets of raw materials ($100 each) to produce 2 more products and still have $80 in cash.

We then sell those 2 products with our discount offer collecting $640 ($320 x 2). We pay sales commission of $80 but had $80 in cash from the first offer, so we now have $640 in cash. We buy 6 sets of raw materials and have $40 in cash left. We sell all 6 products with our discount offer collecting $320 x 6 = $1,920. We pay $240 in sales commission leaving $1,920 - $240 + $40 = $1,720 in cash. Let’s go one more time, a 4th cycle. We take the $1,720 in cash and buy 17 sets of raw materials, leaving $20. If we sell all 17 products with our discount offer we collect $320 x 17 = $5,440. We pay sales commission of $680 leaving $4,760, plus the $20 left from the previous cycle, we now have $4,780 in cash.

So, in 53 days you can sell 1 product and generate $260 or you can make a “discount” offer which enables you to sell 17+6+2+1 = 26 products and generate $2,520 in throughput in 52 days.

Here's to maximizing YOUR profits!
"Dr Lisa" Lang
(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

Decreasing Cash-to-Cash Cycle Time

The components of your cash-to-cash cycle time depends on your business but generally includes procurement, raw materials inventory, production, finished goods inventory, logistics, and your accounts receivable. To reduce cash-to-cash cycle time, you can reduce all or any one component. Let’s start at the front end of a typical process and work our way to collecting our cash.

Cash-to-cash cycle time starts when you have to pay for your raw materials. This means that we take into account your payment terms. Consider the raw material on hand. If you received an invoice with your shipment, and if it’s due in 30 days from the date shipped, and it spends 4 days in transit, and you normally operate with 90 days of inventory on hand, you then have 64 days that count toward your cash-to-cash cycle time. If you are given the option to take a 2% discount if you pay within 10 days, then that effects both your Throughput and your cash-to-cash cycle time. We’ll come back to that option later. If you have multiple raw materials with different terms, transit times, different prices, and different amounts of inventory you can calculate a weighted average but let’s keep our conversation simple.

Next, we convert the raw material into our product. Let’s say that our manufacturing lead-time is 4 weeks or 28 days. That’s the time from when we take the raw material out of inventory and start to convert it to our end product.

We are in a make to order environment, so when we complete the order we ship the order to our customer. So we have no finished goods inventory. Our terms to our customers are 30 days from our ship date, but our accounts receivable (A/R) is typically 42 days.

In this example our cash-to-cash cycle time is 64 + 28 + 42 = 134 days. Let’s further say that we sell our product for $400 and that our raw materials are $100.

To reduce the cycle time, we can:

• Reduce the number of days to produce and ship the product
• Reduce the number of days the raw material is on-hand
• Reduce the time it takes to collect payment from our customers

(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.