Review of A TOC Case Study, Part 2
In my last post, I presented an overview of the “Herbie Hunt” process we used to locate our primary constraint. We exploited the primary constraint before subordinating the rest of the process to its pace. I also discussed how our team involved the hourly employees in the improvement effort, and then concluded the post by explaining how corporate’s use of the efficiency performance metric was actually hurting our business.
Our second learning—throughput accounting
In Part 3 of this series, I will continue this discussion, describing some of the lessons we learned through trial and error as we attempted to “right this ship.”
One of the key lessons I learned by reading The Goal  was the concept of throughput accounting (TA). I had never been introduced to TA, so it was an eye-opening experience for me. Actually, I had never been responsible for a company’s financials before, and I had difficulty understanding some of the “rules” of traditional cost accounting (CA). In this role, I was held accountable to CA, but quite frankly, some of the rules made no sense at all to me. So I questioned things. For example, how could excess inventory be viewed as an asset? Doesn’t inventory tie up cash?
When I read The Goal, I had an epiphany of sorts. Goldratt introduced the business world to a new way of looking at profitability through a completely different spectrum. While cost accounting preaches profitability through saving money, Goldratt argued that companies should focus on trying to make money rather than trying to save money. As I would soon discover, the two approaches are drastically different!
One of the principle lessons within The Goal is that the primary objective of for-profit companies is to make money now and in the future. Goldratt analogized a company to a chain with a weak link. This weakest link limits how much money a company will make. He explained that attempts to strengthen any other part of the chain (or company) without addressing the weakest link will do nothing to drive up profitability. From an organizational perspective, this means that every decision made and every action taken must be considered based upon potential money-making impact. If a persuasive case cannot be made that a decision or action will get your company closer to the goal, then don’t take that action. We heeded that advice.
We learned that the optimum conditions for maximizing profitability are to have throughput (T) increasing while inventory (I) and operating expense (OE) are decreasing or remaining constant. It is certainly a plausible scenario to have OE increasing to drive T higher, but that doesn’t result in optimum profitability. We learned the definitions of the three components of profitability according to the Theory of Constraints (TOC):
- Throughput (T): The rate that the organization generates new money, primarily through sales. Goldratt provided this formula for T:
Throughput (T) equals Revenue (R) minus Totally Variable Costs (TVC), or
T = R – TVC
TVC includes things that vary with the sale of a single unit of product, such as the cost of raw materials, sales commissions, and shipping costs.
- Inventory (I): The money that an organization invests in items that it intends to sell. This category would include inventory of all kinds (i.e. WIP and Finished Goods).
- Operating Expense (OE): The money an organization spends to turn ( I ) into (T) which includes ALL labor costs, office supplies, employee benefits, utility bills, etc.
With these three simple definitions, our team was able to take actions and make decisions in real time, with assurance that our plans would positively impact our bottom line. We also learned four other definitions that helped us reap even more benefits:
- Net Profit (NP) = NP – T – OE
- Return on Investment (ROI) = T-OE/I
- Productivity (P) = T/OE
- Inventory Turns (IT) = T/I
Our team made an informed decision to resist what had been the company culture when we decided to use throughput accounting. Our approach required us to overcome some internal resistance, but it ultimately worked very well. Because of the simplicity of the definitions for each component, we were able to teach our workforce how to use them, and get everyone on the same page.
Yes, we had to continue using cost accounting to satisfy GAAP reporting requirements, but for daily strategic decision making, we found throughput accounting to be vastly more beneficial to the business than cost accounting.
A visit from a customer
One of the pleasures of being part of a turnaround is seeing the transformation of the systems, people, product, and especially, the customer. On this last point, I want to relate an event that took place about five months after we began our transformation. This was a visit we had from a customer. He was a purchasing executive from the German car manufacturer. Since we had improved so rapidly, he decided to pay us a visit to see first-hand just what we had done to improve our quality and delivery.
Remember earlier, I explained that there were 48 measurement points to determine how well a hard top mounted to the vehicle. We greeted the executive team that had accompanied the purchasing executive, exchanged pleasantries and got to know each other. Then he announced that he was going to our manufacturing area and would randomly select a completed hard top and have it mounted on their vehicle.
He further stated that his quality manager would inspect all 48 control points for conformance to specifications. The quality manager took his time, inspected each point, and concluded that all points met their specs. The purchasing executive’s eyebrows rose in disbelief, and with a very heavy German accent said, “Mr. Sproull, the measurements are only part of what we expect.” Then he said, “Mr. Sproull, you will drive me on the interstate at a high rate of speed and I will listen for air entering into the vehicle.”
I drove him to the interstate and he instructed me to accelerate until he told me to stop accelerating. His ear was pressed close to the hard top mounting area as he listened for the slightest sound of air passing underneath. At 65 mph, there was no sound, so he instructed me to accelerate again up to 75 mph, but there was still no air entering the vehicle. He had a very disappointed look on his face, so I continued to accelerate to 90 mph, then 100 mph, and finally to 105 mph. He looked at me with a fearful look on his face and instructed me to return to our facility. We had passed his functionality test with flying colors!
When we returned to the plant, he explained that he wanted to mount a black hard top on his vehicle so that he could compare our paint job to his. Painting at our facility was something we now took pride in, but this was not the case in the beginning.
A quick rewind…When I had arrived at the Kentucky plant, our paint jobs were dismal. We had an old paint booth which was apparently full of dust particles that ended up on the surface of our vehicles. To resolve this problem, I put together a team of maintenance mechanics and explained that we needed to figure out a way to keep our paint booth free of particles, and that I needed some good ideas from them. One of the maintenance mechanics had a side business for lawn sprinklers. He had this bright idea that if we mounted a sprinkler-style system in the paint booth, we could clean the air between paintings by emitting a fine mist of water. We tried it, and it worked brilliantly! Back to our case study.
A serious problem
The purchasing executive randomly selected a completed black top and we mounted it on his vehicle. We parked it in a highly lighted area and he scrutinized it for a good 30 minutes. When he was finished, he summoned me to the vehicle, looked me in the eye and said, “Mr. Sproull, we have a serious problem!” I asked him what the problem was and he told me that our paint job did not match the paint on his vehicle. I was shocked because I knew our painting was the best in the industry. When I asked him what was wrong with our hard top’s paint job, he sneered at me and said absolutely nothing! The problem was with his vehicle. There was an enormous amount of orange peel on his vehicle’s surface. I asked him, “Would you like us to add orange peel to our hard top’s surface?” He looked at me sternly and said, “I don’t find any humor in that remark!”
An epic day for our plant
All of the hard work and dedication of our employees had paid off as the purchasing executive from Germany told us that he wished all of his suppliers were as good as we were. I asked him to speak to my employees and let them know his feelings, which he did. That day was clearly a turning point for our plant, for our reputation and for the morale of our workforce. They had pride for the first time in years, and since then, I have always maintained that “people who feel good about themselves produce great results.”
Just for the record, during the first month that I took over this failing facility, we lost about $600,000. But within two and a half months, we were making roughly $500,000 per month. It was such a joy to see this wonderful team of people doing so well. I was so proud of every single employee for making it happen!
One of the things the management team learned, and something I insisted upon, was that all improvement ideas would be considered on merit. Good ideas would be implemented, as long as they didn’t violate company rules, safety policies, or customer requirements. I can honestly say that 95 percent of all of the solutions came directly from the shop floor workers, the true subject matter experts. Since that fateful turn-around, I have successfully used this basic idea, which I refer to as “active listening.” It worked for me then as a general manager and it continues to work for me today as a consultant.
Coming in the next post
In the final installment of this series, I will explain how we used the Theory of Constraints to “fix” this manufacturing facility. I’ll review the steps we took to reduce incidents of part stock-outs, even while reducing our inventory by nearly 50 percent!
Until next time,
 The Goal–The Theory of Constraints–A Process of Ongoing Improvement, by Eliyahu M. Goldratt and Jeff Cox.
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