Systems Thinking and the
Theory of Constraints
Complex solutions do not work, the more
complex the problem the simpler the
solution must be. Eli Goldratt.
The Read Cost of Inventory
Inventory adversely affects all competing edges (P/Q/V/D)
 Has cost
 Physical carrying costs
 Financial costs
 Cause obsolescence
 Due to market changes
 Due to technology changes
 Leads to poor quality
 Feed back loop is long
 Hides problems
 Unreliable suppliers, too much scrap, large changeover
times, machine breakdowns.
 long flow time
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
2
Theory of Constraints (TOC)
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Lean evolved from the collective effort of a number of
individuals. TOC owes its origin to Eli Goldratt, an
Israeli physicist. The basic idea originated in 70s and
was published in The Goal (1984).
Like the links of a chain working together to lift
objects, the processes within a supply chain work
together to generate profit. The ability of the chain is
limited by the strength of its weakest link.
The goal of an enterprise is to make more money,
now and in the future.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
3
Bottleneck Resources
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Every system of interdependent processes has one or,
at most few bottlenecks that limits system
performance.
If you can focus on maximizing the productive use of
the bottleneck and schedule it accordingly, then you
will maximize your productive output. The other
resources can be schedule subsequently since they
have available capacity by definition.
Any loss of output at the bottleneck resource(s)
results in a loss of revenue for the enterprise.
Any local optimization to improve the performance of
other resources does not increase the throughput.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
4
Systems Thinking
LEAN SUPPLY CHAIN PRINCIPLE 10
Time lost at a bottleneck resource results in a loss of
productivity for the entire supply chain. Time saved at a
non-bottleneck resource is a mirage.
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Integrated decision making
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“Big Picture” Thinking
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Thinking “Globally” rather than “Locally”
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Understanding how localized decision making can affect
the overall goal
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
5
Traditional Decision Making
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In practice, it is harder for managers to see the forest
for the trees because of the traditional management
metrics they have to work with
How are investment decisions usually made?
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Usually based on cost considerations (right)?
“The Cost-World” Perspective
Consider how the cost-world perspective affects the
push towards parts per million (PPM) quality and
“Zero” inventory
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
6
The Cost World Perspective: Cost and PPM
Quality
Reducing
Scrap
From To
Annual
Cost
Savings
Annual
Investment The Cost
Needed
Judgment
8%
2% $60,000
2%
0.5% $15,000
$20,000 Do It!
$20,000 Indifferent
$20,000 Do NOT Do
0.5% 0.1% $4,000
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
7
Is 99.9% Quality Good Enough For You?
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Doctors in New York State hospitals dropI’ll do better
next time!
288 babies per year
Post Offices in New York State lose
61,626 pieces of mail per day
Chicago O’Hare International Airport has
1,264 unsafe arrivals / departures per
year
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
No problem.
Everything is
OK!
8
Local Optimization
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Traditional management addresses the problem of
optimizing system performance by breaking down the
system into smaller pieces.
Cost or profit centers  achieve/beat targets; if every
unit improved locally then the entire enterprise would
improve globally.
The lack of a systems perspective leads to performance
metrics, policies, procedures, organizational structure
and functions that promote local rather than global
optimization. To improve overall system performance,
it is not enough to promote isolated efforts that focus
on improving specific functions. Such an approach
ignores the interactions between the various functions.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
9
Throughput World
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An increase in the cost of an engine of $30 would have
decreased the cost of the transmission by $80. The
center producing the engine was reluctant to do so
because it adversely affected that center's profits.
The traditional management is based on a cost world
perspective; minimizing costs and improving
operational efficiencies.
TOC presents a set of simple, global measures to
achieve enterprise goal of making more money goal.
Throughput world perspective; an approach that
focuses on meeting the goal through a growth strategy
rather than just through cutting costs.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
10
Standard Cost Accounting
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TOC provides two groups of techniques: a Five-Step
Focusing Process and a more generic problem solving
approach referred to as the Thinking Process.
How managers decide
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Sales dept  to accept a new customer order?
Operations dept  what products to schedule and
what batch size to run?
Controller  to approve purchase of new equipment?
Based on a standard set of guidelines and operating
procedures  Standard cost accounting system.
Products costs have three components: direct labor,
direct material, and overhead costs. Overhead costs
are difficult to trace to specific products.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
11
Standard Cost Accounting
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The rise of the US industry coincided with the rise of
cost accounting as the primary decision-making tool.
Allocating overhead costs to determine product cost
was not a major problem because they were relatively
low and typically only a few products were produced.
The cost world directs the manager to think locally.
The throughput world forces the manager to think
globally.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
12
National Pontoons, Inc.
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Assumptions:
Only 1 product – (Black Vinyl Steering Wheels)
 Raw materials cost $10/unit – (Blanks)
 Uses two resources to machine and fabricate the
product – (Resource A & Resource B)
 6 minutes processing at Resource A
 9 minutes processing at Resource B
 Run’s 2 shifts 10 hours long, 25 days each month
 Employs 4 direct laborers across the 2 shifts
Therefore:

Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
13
National Pontoons Data
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Processing time at resource A = 0.1 hour/unit
Processing time at resource B = 0.15 hour/unit
Direct Labor 10 hours per day, 25 days per month,
$10 per hour = $2500 per month per worker, 4
workers $10,000 per month, $120,000 per year.
The manufacturing overhead costs were $225,000
Selling, General and Administrative costs were
$200,000
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
14
Direct Labor Costs
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Direct labor costs at Resource A; 10(0.1) = $1.0/ unit
Direct Labor costs at Resource B; 10(0.15) = $1.50/
unit
Total Direct Labor Costs = $2.50
Average Demand = 48,000 steering wheels
Demand (year 2003) = 30,000 steering wheels
Direct Labor Costs = 30,000(2.50) = $75,000
Actual Labor Costs = $120,000
Direct labor is a Fixed Cost (FC) because it does not
rise or fall with production like the raw material cost
which is variable cost (VC).
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
15
Labor Efficiency Variance, Overhead Rates
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The difference between actual wages paid and the
overhead labor attached to the units produced
$120,000 - $75,000 = $45,000
That means $45,000 of direct labor was not
accounted for in product costs
Overhead Rate in terms of direct labor hours or costs
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225,000/75,000 = $3.00 per each dollar of direct labor
3.00(2.50) = $7.50 per unit
The finished product cost is
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$10 (direct material) + $2.50 (direct labor) + $7.50
(overhead) = $20.00
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
16
Valuing Inventory Costs
Cost Category
Cost per Unit
Raw Material
$10.00
Direct Labor Cost at Resource A $1.00
Manufacturing Overhead
allocation at Resource A
$3.00
Direct Labor Cost at Resource B $1.50
Manufacturing Overhead
allocation at Resource B
$4.50
Total Cost
$20.00
The raw material in front of resource A; $10.0/unit.
WIP between the two Resources; $14.0 (10+1+3).
The finished goods inventory is valued at 14+6 (1.5+
4.5) = $20!
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
17
Standard Cost Accounting
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SCA allocates manufacturing-related expenses
(depreciation, indirect labor and utilities) proportional
to the time at the individual resources.
SG&A are also allocated based on product costs.
Absorbing costing and variance reports lead to
behavior that runs counter to enterprise goals. Ex.
Since every item processed on a resource increases
the value of the product, shop supervisor pushes
products through the resources as quickly as possible.
Products may not be needed downstream. But he/she
is measured based on overhead absorption and
meeting targets. End-of-the-month syndrome (
hockey-stick effect).
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
18
Standard Cost Accounting
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Because supervisors are evaluated based on how
efficiently they utilize their resources, they are given
incentives to create production schedules that operate
the individual work centers work at close to 100%.
Lead to higher levels of inventory when the output
from the work centers is not consistent with the
requirements downstream.
The local optimization mindset, combined with the
cost world idea of adding value to the raw material
cost as it progresses to become finished goods
inventory can lead to other bizarre outcomes.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
19
Activity Based Costing (ABC)
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The standard cost accounting uses a simple formula
to allocate indirect costs. Ex. the overhead costs are
allocated based on direct labor costs.
It was fine when labor was the biggest factor in
production, and the products were not too different.
Standard cost accounting  products consume
overhead costs. ABC  activities consume costs and
products consume activities (activities may or may
not add value to the product).
ABC identifies the specific activities that go into
making a specific product and attempts to figure the
cost of those activities.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
20
ABC Cost Drivers
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standard cost accounting driver: direct labor cost.
ABC cost drivers: unit-level, batch-level, productlevel, and facility-level cost.
Unit-level: activities performed for each product unit.
Ex. cost of a tool changeover to continue producing
the same product unit after a fixed number of units
are produced.
Batch-level activities: activities that are performed
once for each batch of products, independent of the
number of units in a batch. Ex. Wages of production
supervisors, machine setup costs not traceable to
specific products, and material handling costs.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
21
ABC Cost Drivers
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Product-level activities: They do not depends on the
number of batches. Ex. engineering support costs,
and costs of equipment dedicated to a product line.
Facility-level costs: Accounting, HR, Administration,
Sales, and Plant Maintenance functions.
Using different cost drivers to allocate costs reduces
the overhead costs that are allocated arbitrarily.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
22
ABS at National Pontoons
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QC inspects the product at the same level of detail:
$63,000/30,000 = $2.10/unit. Unit-level cost; using
production volume as the cost driver. Depreciation is
also applied at unit level; 12,000/30,000=$0.40/ unit.
National Pontoons is promoting its wood-trim wheels.
The plant manager: 25% vinyl wheels and 75%
wood-trim wheels. Allocation made at the product
level. Overhead allocation:
0.25(120,000)/25,000= $1.50 for a vinyl wheel
0.75(120,000)/5,000= $22.50 for a wood-trim wheel.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
23
Standard Cost Accounting vs. ABC
Cost Category
Raw Material
Direct Labor
Depreciation
MFG OH
QC Inspector
Plant Manager
Product Cost
SC
Vinyl
Wood
$10.00 $10.00
$2.50
$2.50
$0.40 $0.40
ABC
Vinyl
Wood
$10.00 $10.00
$2.50 $2.50
$0.40 $0.40
$2.10
$2.10
$5.00
$5.00
$20.00 $20.00
$2.10
$2.10
$1.50 $22.50
$16.50 $37.50
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
24
Cost Drivers
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ABC needs additional information.
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High cost of information gathering.
Arbitrary cost drivers.
The choice of cost drivers has behavioral implications
as well. Purchase department  Cost driver  # of
purchase orders  functional units  fewer orders 
larger order size  higher cycle inventory  opposite
of what the enterprise would like to see.
Instead, cost driver  # of SKUs  development of
products that utilize common parts  positive impact.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
25
Cost Drivers
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Cost drivers allocate cost or quantify some measure
of past performance. Encouraging appropriate
behavior is more important than measuring some
aspect of past actions.
ABC did help provide a way to allocate overhead costs
among the products more equitably based on the
activities involved, these costs may drive behavior
that runs counter to enterprise goals. Ex. ABC made
the wood-trim wheels so much more expensive. Yet,
this is the product National Pontoons wants to
promote: and at this price, the customer is less likely
to buy it and may instead settle for the cheaper vinyl
wheel or shop elsewhere for a wood-trim wheel.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
26
Summary
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ABC suffers from arbitrariness with regard to how to
allocate. The choice of a cost driver is more difficult
when costs are shared by more than one product. No
single cost driver can reflect all the relevant activities
that take place in the Accounting Department.
The problem becomes worse regarding costs that are
unrelated to a particular product or a particular
customer. Ex. CEO's salary and building and grounds
maintenance. Leading one to conclude that, in
general, there is no such thing as a true product cost.
It is simply a result of a number of arbitrary
assumptions.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
27
Summary
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ABC systems can become difficult and expensive to
maintain because the information requirements are
significantly large.
As we observed from the National Pontoons example,
the allocation can sometimes make a product that the
enterprise wishes to promote, prohibitively expensive
to the customer, making it even harder to sell the
product. So, though ABC has its uses in terms of
determining where costs are incurred, its use for
determining product costs, determining which
products are truly profitable, and setting product
selling prices become questionable.
Theory of Constraints: 1- Cost Accounting
Ardavan Asef-Vaziri
Jul-09
28