TOC Economics : Top Management Decision Support

By Eli Schragenheim

Introduction

All organizations have to make critical decisions that are complex and uncertain. Business organizations in particular have to translate every decision into money, asking the question would the decision at-hand increase the net-profit or decrease it?

The most basic decisions every organization has to make are:

What should the organization sell?

What variety of products?

Which market segments should be the target of the sales force?

How much available capacity the organization has to maintain?

Should we accept a special deal or an order?

Could we reduce costs even when we might harm a little the demand?

Many of the above decisions, like agreeing on a deal with a big client, find their way to the top management requiring quick response.

This article describes a holistic way, based on periodical meeting of Sales, Operations, Finance and possibly several other top management teams, to make these decisions.  The proposed way simulates a series of “what-if” scenarios to come up with the full ramifications of the decisions at hand on sales, capacity and its impact on the financial outcomes.

Comment: TOC stands for the Theory-of-Constraints, a managerial approach and a holistic school of thought, developed by the late Dr. Eliyahu Goldratt, the author of The Goal.

The software support to the described process has been developed by Vector consulting Group in collaboration with Eli Schragenheim

The Current Practice

There are various management accounting techniques that estimate the cost-per-unit of every product, or even the cost of maintaining a specific client.

Another way is to rely on the informal knowledge of key people, which cannot be captured in the current computer programs.  This knowledge is actually “intuition”, based on daily touch with the subject matter and truly caring about it.  Sales people are able to outline market trends that the data of past sales is unable to reveal.  Production people know what can and cannot be done on the floor, even when the data system tells otherwise.

However, intuition can be wrong, especially at times of change; but data can also be false due to mistakes or intentional manipulation, and the processing algorithm may be flawed.  This is part of the overall daily uncertainty we live in, leading us to find the best way to nonetheless make good decisions.

TOC has clearly shown that cost-per-unit is grossly misleading.  The famous P&Q example was widely used to show the cost-per-unit fallacy.

There is a current hidden paradigm behind cost-accounting:

The cost of capacity is linear

Without that assumption there is no way to construct a reliable cost-per-unit without updated information on the amount of total capacity consumed. Linear functions are easy to use.  However, when a function is not linear a significant distortion is introduced.

Capacity is usually purchased in certain quantities like the capacity of a machine, the physical space of a warehouse or the amount of hours an employee is supposed to work during a month.  This immediately means that the cost of capacity is not linear but a step function like the following graph:

Cost of Capacity

The TOC Throughput Accounting (TA) methodology looks whether the additional decision might overload one of the resources. The current practice of using throughput-accounting (TA) is limited in its capability to support relatively large decisions that might overload more than just the one capacity constraint.  I’m suggesting a wider scope of TA, call it Throughput Economics, to lead a process of decision-making, using the ability of software to calculate the financial impact of any given scenario, together with the intuition of key people, notably in Sales and Operations.

The Essence of the Solution

The objective is to be able to answer the following key question:

Would the decision at-hand, or a combination of several decisions, increase the bottom-line or decrease it?

The question highlights the predicted change in the bottom-line relative to the no-change-in-decisions prediction. We like to make a change only when there is added value relative to continuing to do what we do now.  In itself any change brings a certain risk and thus, if we do not expect added-value there is no reason to make the change.

The solution does NOT use “per-unit” numbers as any per-unit mechanism might lead to a wrong decision. The idea is to add the decision to all the other current sales and simulate the financial and the capacity situation that would result. When the level of protective capacity of even one resource is penetrated there are two different avenues:

  1. Reduce certain sales, preferably much less profitable, in order to free the required capacity.
  2. Add capacity that can be purchased quickly. For instance, adding overtime or using outsourcing. Of course, this increases the level of operating expenses.

Comment: the term protective capacity is defined as the necessary amount of excess capacity absolutely required in order to not to cause too long delays that would lead to serious dissatisfaction in the market.

The overall financial calculation reveals whether the net impact of the new decision is positive or negative.

Special supporting software has been developed by Vector Consulting Group to provide the quick simulation and financial calculations necessary to lead the management team to the most profitable product mix possible.

New important terms

Critical resources:

The current main paradigm of TA is focusing on one internal constraint.  However, even when there is one active capacity constraint, the trade-off between different opportunities might cause other resources to emerge as interactive constraints and ruin delivery performance.

Thus, there is a need to update the paradigm and recognize a relatively small group of resources as ‘critical resources’ that might exhaust their capacity due to a significant change.  The important part comes when new opportunities are analyzed.  The decision makers get to know whether the additional load might penetrate into the protective capacity of any critical resource.

Products and T-generators:

The term ‘product’ has two different meanings. One is simply the output of Operations, for instance, a printed book.  The other is something that is sold to clients. It could be the same printed book, but it could be also a service where the printed book is wrapped as a gift and sent by courier to a specific address. Another selling offer could be a package of three books by the same author sold at a special price.

Let’s define the following:

Product is an output of operations.  T-generator is a unit of sale.

The distinction between products and T-generators allows using the same product for different sales and for different prices and thus encourage the search for new opportunities based on the same products, as well as launching new T-generators that include new products.

Capacity buffers:

Capacity is available in two ways. One is when the capacity has been already purchased by the organization, and the other is when smaller units of capacity can be quickly purchased per usage.

Machines, the space of the shop or employees are examples for available capacity. Overtime is a common example for quick purchase of additional capacity, and so is outsourcing.

Capacity buffers are all the available options for quickly purchasing capacity per usage.  Usually such an option has to be prepared a priori.  Temporary workers might not be available unless the organization actively uses them. Capacity buffers are required for maintaining the flexibility to grab opportunities without having to invest heavily and without being sure the demand exists.

The new decision making process

Periodic key decision making meetings have to be established to consider a number of new ideas/opportunities/deals. At the meeting, it is imperative that the heads of Operations, Marketing, Sales and Finance and the CEO spend time together to finalize decisions.  Such a meeting is much more than a Sales and Operations (S&OP) session that just establishes the understanding between Sales and Operations of what would be accomplish in the immediate next period, and does not check the economics of various ideas.

Every meeting looks for a specific horizon of time: Month, quarter or a year. It could be that a certain decision is checked by a short horizon as well as by the long-term, where each checking reveals different aspects of the decision.

Each meeting has to prepare the following relevant information:

  • The expected sales profile when no new decision is taken – by T-generators and their respective throughput (T).
  • The resulting load versus available capacity of the critical resources.
  • Another input is the regular level of Operating Expenses (OE).
    • OE contains the money spent to maintain all the regular available capacity of the organization, like all the salaries, marketing, maintenance, energy, transport etc.
      • All the expenses that do not vary with every single sale.
  • A list of new opportunities mostly based on intuition.

During the meeting, with the support of the designated software, every opportunity is checked by simulating the decision being added to the reference sales and capacity.

The first check is calculating delta-T; the overall additional throughput due to the opportunity at hand. Then comes a check whether the regular available capacity can deal with the additional load without penetrating the protective capacity.

When the load on at least one resource penetrates the protective capacity, the managers can resolve the situation by two ways:

  1. Manage Demand – reduce sales of specific T-generators in order to free capacity.
    1. Sales people need to confirm that it is possible to reduce the specific sales without causing negative impact on other sales!
    2. The preference should be reducing sales from T-generators with low T/Unit-of-specific-loaded-resource-capacity.
    3. The financial calculation eventually reveals whether accepting the new opportunity, while giving up other sales, adds value or creates a loss.
  2. Managing/adding capacity.
    1. The most regular use of adding capacity is from the capacity buffer.
    2. The management team might consider checking the potential financial result from purchasing long-term capacity, such as additional machines and manpower, taking into account the predicted increase in T. Usually such an analysis requires a longer term horizon.
    3. Additional capacity requires delta-OE. The re-calculation of delta-T minus delta-OE should clarify whether the addition improves the bottom line.

Every meeting should consider any number of new opportunities and eventually be able to come up with the best mix of decisions regarding sales on one hand, and keeping adequate protective capacity on the other hand.  The total T-OE gives an acceptable estimation of the bottom-line for the purpose of making the decision.

Dealing with uncertainty

Sales are highly impacted by uncertainty. Thus, it would be senseless to claim that it is possible to accurately predict the impact on the bottom-line.

The main value of the process is to make better decisions, by speculating about the impact on the bottom-line.  The minimum requirement is to be able to determine whether the net impact would be positive or negative.  This valuable partial information is enough to lead the management team to better decisions.

Management should be aware of the amount of uncertainty and try to predict the reasonable range of the profit or loss of various future scenarios.

Significant uncertainty comes from predicting the demand resulting from a move, such as offering a new T-generator for 10% price reduction. The analysis of such ideas should consider two different predictions of the impact on sales: The reasonable pessimistic impact and the reasonable optimistic impact.

Note that it is not always true that the optimistic assessment shows higher profit than the pessimistic. On one hand, the higher the sales, the higher the direct delta-T.  But on the other hand, higher sales might require delta-OE for additional capacity OR giving up existing T which reduce the overall delta-T.  So, the total delta-T minus delta-OE is often tricky to guess.

It is clear that if the new idea is found to add positive profit (delta-T minus delta-OE) on BOTH checks then this idea should be accepted. When both checks show negative results –the idea should be dismissed.  When one of the checks is negative and the other is positive, then management should make the decision based on the relationship between the results and their risk aversion.

Inquiring a most-likely impact on the bottom-line does not add valuable information that might impact the decision.  The most-likely results are somewhere between the pessimistic and the optimistic.  Even when one of the extreme results is negative, while the other is positive, the most-likely does not truly assess the “expected value” from mathematical point-of-view and anyway making the proposed move in such a case should be done only when the positive is much above the negative.

Supporting Software

The process cannot be managed manually because of extensive data and calculations involved. Thus, a dedicated software package, entitled DSTOC (Decision Support in the TOC way), has been developed by Vector Consulting Group India together with Eli Schragenheim.

The software is used for large scale calculations based on huge amount of data items concerning products, T-generators, sales, capacity requirements and availability of critical resources. The implementation of the process requires a way to transport data from the organizational database into the DSTOC software through the use of Excel.

The software only objective is to support the high-level decisions by allowing the intuition of key people to be translated into numbers, so the full ramifications can be viewed.  The decisions are still made by humans, supported by both their intuition and knowledge and by the mass calculations that current computers can easily do.

The organization gains the value of deep understanding the TOC way of supporting decisions under uncertainty without losing the right focus.

Another powerful benefit is the new drive and motivation for Sales and Operations to better understand the real issues of each other.

Organizations and TOC consultants who would like to learn more about the process, as well as see a demo of the supporting software, should contact Eli Schragenheim by email at: elyakim@netvision.net.il   or elischragenheim@gmail.com

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