Cost and Management Accounting

Assignment on
Theory of Constraints

Submitted to:
Prof. Khyati Shah, IMNU
Submitted by:
Group No. 25
Prakriti Dutta (147131)
Nancy Rastogi (147163)
BBA Year II

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 Declaration

We, Prakriti Dutta (147131) and Nancy Rastogi (147131), students of Institute of
Management Nirma University, declare that the Report of Group Assignment titled
“THEORY OF CONSTRAINTS” submitted to Prof. Khyati Shah for the course Cost and
Management Accounting of Semester III of BBA-MBA (Five Years Integrated) Programme
is the outcome of our own efforts and no part of this has been copied in any unauthorized
manner and no part in it has been incorporated without due acknowledgment.

Name: Prakriti Dutta Name: Nancy Rastogi

Sign: Sign:

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 Table of contents

1. Executive Summary.................................................................................. 3

2. Theory Of Constraints – History............................................................... 4

3. Understanding the theory....................................................................... 5-6

4. Performance Measurement Processes........................................................7

5. Constraints............................................................................................... 8

5.1 Types of Constraints............................................................ 8

6. Basic Principles....................................................................................... 9

7. The Five Focusing Steps of TOC........................................................... 10

8. Applications of the theory...................................................................... 11

9. Companies resorting to TOC to stay ahead in the game.................. 12-13

10. Conclusion..............................................................................................14

11. Bibliography...........................................................................................15

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Executive summary

Theory of constraints (TOC) is a philosophy of management put forth by Eliyahu M.

Goldratt, which claims that each system has at least one constraint. Although initially in
manufacturing method, TOC has now developed into a theory of Management: a powerful
systemic problem structuring and problem solving methodology which can be used to
develop solutions with both intuitive power and analytical rigour. This philosophy is applied
in many functional areas of companies, ranging from production flow management,
marketing, services and project management to being a tool of logical reasoning.

The project aims at defining the theory and its applications, followed by presenting some real
life examples of firms using TOC to fix their supply chain so as to survive in this era of stiff
competition.

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Theory of Constraints - History
In the early 1980’s, Eliyahu Goldratt, an Israeli physicist turned business guru, and a number
of his associates pioneered “optimized production technology.” This software package
quickly and effectively scheduled production in even complex environments by separating
bottleneck (i.e., the constraint) and non-bottleneck operations. “The Goal”, first published in
1984, explained the foundational concepts of bottlenecks and how to alleviate them through
the fictional story of a plant manager struggling to improve the performance of a
manufacturing facility. Building from this foundation, Goldratt developed a revolutionary
method for production scheduling known as the Theory of Constraints (TOC) as a problem-
solving approach relevant to a wide array of settings.

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Understanding the Theory

“The strength of any chain, either a process or a system, is only as good as its weakest link.”

This adage is aptly reflected by the Theory of Constraints. It was created by Dr Eli Goldratt
and was published in his 1984 book "The Goal."

According to Goldratt, the performance of an organisation is dictated by constraints. These

are the restrictions that prevent an organization from maximizing its performance and
reaching its goals. Constraints can be people, supplies, information, equipment, or even
policies, and can be internal or external to an organization.

The theory says that every system, no matter how well it performs, has at least one constraint
that limits its performance which is the system's "weakest link." The theory also says that a
system can have only 1 constraint at a time, and that the other areas of weakness are "non-
constraints" until they become the weakest link of the system.

TOC is a systemic way to identify the constraints that hinder the system’s success and to
bring the necessary changes so as to remove them.

TOC consists of separate, but interrelated concepts such as: the performance measurement
processes, logical thinking processes and logistics. Goldratt also developed a tool known as
‘the five focusing steps’, to help systems deal with the constraints.

An Example

To better understand the theory of constraints and non-constraints, consider a production

system that runs raw materials through three component processes and then turns them into a
finished product.

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 Within this system, each process is equivalent to a link in the production chain. Where is
the constraint in this chain?
Process B is the weakest link. Process B produces the least at only six units per day.
Process A and C are the non-constraints.

 Imagine that the manufacturer improves process B until it can produce 18 units per day.
Now, process C becomes the system constraint while the non-constraints are everywhere
else.
 If process improvements continue until all processes are producing 18 units/ day or higher,
the system constraint becomes the marketplace, which can accept only 15 units per day.

 At this point, internal constraints have been replaced by an external constraint. Overall, the
theory of constraints emphasizes upon fixing the weakest link in the chain which is the
system constraint and temporarily ignoring the non-constraints. In this way, the theory has
a profound impact on process improvement.

 Rather than spreading limited time, energy, and resources across an entire system (which
may or may not result in tangible results), teams focus on that part of the system with the
potential to produce immediate system improvement.

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Performance Measurement Processes: There are three key performance indicators –
throughput, inventory and operating expense.

 Throughput is the rate at which the system generates money through sales and not
through production. Goods are not considered as an asset unless and until they are
sold.

 Inventory is the money invested in goods that the firm intends to sell or the material
that the firm intends to convert into saleable items.

 Operating Expense is the money that the firm spends in converting the inventory into
throughput

The typical objective of a firm is to increase the throughput by reducing the inventory and
the operating cost, thereby in-turn increasing the profit, return-on-investment and cash-flow.

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Constraint

A constraint is anything that hinders the firm from achieving its goal of increasing
throughput and/or decreasing inventory or operating cost. Some examples of constraints are
capacity, material, logistics, the market (demand) and behaviour.

Types of Constraints

There are two broad categories of constraints that exist in business environments, "internal
constraints" and "market constraints". The category of internal constraints is further sub-
divided into physical constraints and policy constraints.

Internal Constraints

 Physical Constraints
Physical constraints can be broken down further into two categories. The first is that of
"capacity (or resource) constraints," which includes the labour, machines, and
buildings needed to convert purchased material into an end product. The second category is
that of "material constraints", which are the raw goods, work-in-process, etc. that are
converted to finish product by the resources of the company.
 Policy Constraints
Policy constraints can be divided into the categories of "mindset constraints," "measures
constraints," and "methods constraints."

Mindset refers to the thought process or culture of the organization. It is mindset that
organizes the company’s thinking and assigns priorities to different courses of action. New
measures that contradict the prevailing mindset have little chance of being implemented.

Measures constraints may be responsible for creating situations that encourage behaviours
that have a negative effect on the performance of a business. Bonuses that have an overall
negative impact on the bottom-line of a firm would fall into this category.

Methods constraints refer to the procedures and techniques that determine how the day-to-day
operation of the organization is carried out.

Market Constraints

 Market constraints exist when the demand for a company’s products and services is less
than or equal to the capacity of the organization.
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Basic Principles
Goldratt outlines several principles that help creates an environment conductive to the
prescriptive part of his theory. The prescriptive part of the theory of constraints helps
organizations answer three management questions regarding systems and their constraints:

 Where is the constraint?

 What should we do with the constraint?
 How do we implement the change?

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The five focussing steps of TOC
The logical thinking process of TOC gives us a series of steps that combine cause-effect,
experience and intuition to gain knowledge. This is known as the ‘five focusing steps’.

Step 1: Identify the Constraint

This implies the need to examine the entire process to determine which process limits the
throughput.
This should be started by looking at the processes that the firm uses regularly. Here, it can
help to use tools like Flow Charts , Storyboarding , and Failure Modes and Effects
Analysis to map out the processes and identify what's causing issues.
The constraints may not just be physical. They can also include intangible factors such as
ineffective communication, restrictive company policies, or even poor team morale.
Also, according to the theory, a system can only have one constraint at a time. So, it is
important to decide which factor is the weakest link, and then focus on that.

Step 2: Manage the Constraint

Once the constraint is identified, the next step is to figure out how to manage it so as to
increase efficiency in this area and cure the problem.
The solutions will vary depending on the team, the goals, and the constraint we are trying to
overcome. For example, it might involve helping a team member delegate work effectively,
modifying lunch breaks or vacation time to make workflow more efficient or reorganizing the
way that a task is done to make it more efficient.

Step 3: Subordinate everything to the Constraint

Subordinate and synchronize everything else to the above decision. Assure that every other
part of the system makes it possible for the constraint to operate as efficiently as possible.

Step 4: Elevate the performance of the constraint. Specifically, if the performance of the
constraint is still less than desired, acquire more of this resource so it is no longer the
constraint.

Step 5: Once the constraint is a constraint no longer, find a new one and repeat the steps.

As the constraint effective utilisation increases, it may cease to be a constraint as another

process becomes one. In that case, the emphasis shifts to the new process constraint.
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 Applications Of the theory

The processes defined in the theory have been applied to the areas of Manufacturing, Project
Management, Distribution, Marketing, Sales, and Finance. Given below are some examples
of applications and solutions related to this theory:
 Manufacturing
Within manufacturing operations management, the solution seeks to pull materials through
the system, rather than push them into the system. This prevents bottlenecking while ensuring
resource exploitation.

 Project Management
This is sometimes called Critical Chain Project Management (CCPM), which is a method of
planning and managing projects that puts more emphasis on the resources used to execute
project tasks. The solution will tend to keep resources levelly loaded, but will require them to
be flexible in their scheduling.

 Distribution
The solution for supply chain constraints is to move to a replenishment model, rather than a
forecast model. The replenishment model would represent an inventory that is able to meet
customer demand while being regularly replenished by some manufacturing facility or other
source.

Marketing and Sales

While originally focused on manufacturing and logistics, Goldratt’s Theory of Constraints
has expanded into areas of marketing, sales and finance. The application here is surprisingly
similar to that of Manufacturing and is sometimes called Customer Manufacturing. The
solution is to avoid market bottlenecking while ensuring maximized sales and marketing
resources.

 Finance
The solution for finance and accounting is to apply holistic thinking to the finance
application. This has also been called “throughput accounting” and suggests that one
examine the impact of investments and operational changes in terms of the impact on the
throughput of the business.

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 Companies resorting to TOC to stay ahead in the game

 Five years ago, Dr Reddy's Laboratories (DRL) was facing a difficult time in the US. It had
a significant number of backorders and supplier ratings were at an all-time low. That's when
the company started implementing processes advocated by the theory of constraints (TOC) to
fix its supply chain. Last year, it won a best supplier award in the US. Saumen Chakraborty,
DRL's chief financial officer, says, "When selling in the US, two things matter: your product
quality rating and your supplier rating. Today, TOC has become a part of our management
philosophy. It defines our manufacturing and R&D pipeline and helps us understand where
we need to focus and improve."

At DRL, TOC has not only tightened the supply chain with a focus on better inventory
management in the US and Russia, but also in finance and project management. "Shifting to
a throughput based system where we track operating expenses has simplified
management accounting and reporting. Ultimately it helps the management focus. With
critical chain project management too, where there is too much uncertainty in new product
development, it enables us to look at alternatives for development. The focus is on
specifically understanding which part of the value chain is weak and needs to be
supplemented. Once that is fixed then you move on to the next aspect", says Chakraborty.

 In a steel plant, a replenishment-based supply chain is considered a novel idea. Tata Steel
has used the TOC framework in areas ranging from out-bound supply chain to
implementation of shut-downs and equipment upgrades. It even tried using it to develop
business objectives and strategies. The company's process is consumption rather than
forecast driven. "It results in much shorter lead times, lower working capital requirement
from our channel partners and a leaner system with higher throughput," says Alok Krishna,
chief of Total Quality Management (TQM), Tata Steel. "It also helps us take informed
decisions on what to produce, for whom to produce, when to produce and how much to
produce, helping in making the overall system leaner and minimizes excess or shortage of
stocks."

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 At Bajaj Electricals, having an efficient supply chain is critical to both the B2B and the B2C
parts of the business. "We are seeing a significant jump in sales in B2C in areas where we
have implemented the process and a significant reduction in lead time of project
completion in B2B," says chairman and managing director Shekhar Bajaj. In the EPC
business where 100% delays were the norm, the company has been delivering projects before
time. "TOC is about aligning all the functions of the organization - tendering, sales, design,
logistics, supply chain, execution -- towards one single goal," says Girish Bhave, vice-
president-corporate services, Bajaj Electricals. If the different departments working on a
single project are focused only on their own efficiency, the project is sure to get delayed. The
challenge is to synchronize various functions to ensure more than 95% reliability of project
delivery. This also helps eliminate wastage of working capital in delayed projects which at
times eat up entire margin of the project.

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Conclusion

In the beginning the TOC was primarily used on the shop floor, later the application broadened
to supply chains and constraints in business-relations. Besides that, increasing attention is given
to strategy: what to change, in what direction and how do you communicate about that. The
theory of constraints is an important tool for improving process flows. The implications of the
theory are far reaching in terms of understanding bottlenecks to a process and better managing
these bottlenecks to create an efficient process flow. The impact of the TOC is much bigger than
one should think, regarding the relatively small number of companies which has chosen it as
their main method for continuous improvement.

It provides an effective, systematic approach for identifying constraints to the overall business
and developing a plan to alleviate these constraints. TOC provides a global system methodology
that promotes achieving the organizational goal of making more money both now and in the
future.

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 Bibliography

http://articles.economictimes.indiatimes.com/2014-10-17/news/55148149_1_supply-chain-
drl-saumen-chakraborty

http://www.toc-goldratt.com/tocweekly/category/articles/

http://www.e-ijaet.org/media/38I7-IJAET0703704-REVIEW-ON-THEORY-OF-
CONSTRAINTS.pdf

http://www.bexcellence.org/Theory-of-Constraints.html

http://www.brighthubpm.com/project-planning/4088-goldratts-theory-of-constraints-part-one/

https://www.mindtools.com/pages/article/toc.htm

http://www.systemdynamics.org/conferences/1999/PAPERS/PARA104.PDF

http://www.projectperfect.com.au/white-paper-theory-of-constraints.php

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