Evaporating Cash Constraint

Goldratt India

Agenda
          

 

Organizational Goal Conventional measurements for the Goal Five levels of Goal achievement New operational measurements Concept of Constraint Process Of On Going Improvement -Five focusing steps Implemented case studies from India Constraint identification Cash Constraint-definition Issues with cash constraint Managing cash constraint Exploitation and subordination  Right measurements  Increasing cash to cash velocity  Selling obsolete material  Elevating cash Next steps after breaking cash constraint Summary

The Goal?

What is the Goal of your organization?

Goldratt India

The Goal?
Some organizations state that their Goal is to be a World Class Quality Company. Stated differently they would like to delight their customers now as well as in future.

Goldratt India

The Goal?

Many other organizations say that their Goal is to keep their employees happy now and in future.

Goldratt India

The Goal?

A few organizations declare that their Goal is to make money now and in future!

Goldratt India

The Goal?

Is there any conflict between the three Goals stated or a hierarchy of Goals?

Goldratt India

The Goal?
For example let us choose that our Goal is to delight customers now and in future.  In order to achieve our chosen Goal i.e. to delight our customers now and in future, it is absolutely necessary to keep our employees happy now and in future.  Similarly it is imperative to make money now and in future in order to continue to keep our employees happy.

Goldratt India

The Goal?
Now let us decide that our Goal is to keep our employees happy now and in future.  In order to achieve our chosen Goal, it is absolutely necessary to make money now and in future.  It is impossible to make money now and in future unless we continue to delight our customers now and in future.

Goldratt India

The Goal?
Now if we decide that our Goal is to make money now and in future, is it really possible to achieve it without delighting our customers now and in future!  And can we satisfy our customers without keeping our employees happy now and in future!


Goldratt India

The Goal?
In reality there is no conflict between the three different Goals.  Choose any of the three Goals, the other two become the necessary conditions for achieving the chosen Goal!  For the purpose of this presentation we will assume that the Goal is making money now and in future.

Goldratt India

Measures for the Goal-Making GoalMoney

Generally accepted measures are  Profit  Return on investment  Cash flow We do not question the validity of these measures. However we do question the usefulness of these measures as operational measures!
Goldratt India

Current situation


 

Only 23 out of 3000 (0.8%) companies actively trading on the Bombay Stock Exchange have increased their profits continuously in the last 10 years (The Economic Times 24th September 2005) And the Goal of the organization is to make more and more money Hence as per our agreed definition of Goal, 99.2% organizations are not achieving their Goal!
Goldratt India

Five levels of financial health Making more and more money

1. 2. 3. 4. 5.

Unable to meet financial commitments Meeting financial commitments but not making profits Meeting financial commitments, not making losses, but profits fluctuating Profits increasing continuously period after period Return On Investment (ROI) / Return On Capital Employed (ROCE) increasing continuously
Goldratt India

What measurements should we use?

For the average employee, seeing the effect that any given action has on Net Profit (NP) or Return On Investment (ROI) is almost impossible.  As a result we have created local measures like efficiency & utilization because we believe that they are linked to NP or ROI.  We do know that 99%+ organizations are not achieving their Goal.

Goldratt India

What measurements should we use?

New Operational Measures  Throughput (T)  Investment (I)  Operating Expense (OE)

Goldratt India

Flow of money
Goal Units

RM

+ OE
Goldratt India

Throughput (T)
The rate at which Contribution Rupees are coming into organization.  Only Rupees generated by the system are counted; e.g., Rupees spent on purchasing raw material or services do not count as they are passed on to your suppliers.  T=(Net sales-all truly variable costs)


Goldratt India

Investment (I)
All the money currently tied up inside the system.  All the inventory in raw material, WIP, or in Finished Goods.  Money blocked in plant and machinery.  Receivables are also part of I.


Goldratt India

Operating Expense (OE)

All the money that system spends on converting inventory into throughput.  All the expenses are clubbed together as OE and are thought as fixed.  All employee expenses are part of OE.


Goldratt India

Financial Links
Is there any link between the new Operational Measures T, I, & OE, and conventional measures as P, ROI, & Cash Flow?  P = T- OE  ROI = P/ I = (T-OE)/I  What happens to P, ROI & cash flow when we improve either T, I or OE, keeping other two as constant?
Goldratt India

Financial Links
If we increase T keeping I & OE constant, P=(T-OE) improves, ROI= NP/I improves, and so does the cash flow.  If we decrease I, keeping T & OE constant, P improves due to reduced carrying cost, ROI improves, and of course cash flow improves.  When we reduce OE keeping T, and I constant, P, ROI, and cash flow improve.

Goldratt India

Financial Links
Improving Throughput, Investment and Operating Expense have a positive co-relation with improving P, ROI, and cash flow.  Throughput, Investment and Operating Expense are valuable operational measures that can guide our day to day actions to making money now and in future.


Goldratt India

Constraint for making money

What is that limits your organization to achieving more of its Goal - to make more and more money?

Goldratt India

Theory of Constraints (TOC)



The core idea in the Theory of Constraints is that every real system such as a profit-making enterprise must have at least one constraint that limits the system to achieving its Goal. Every for profit organization will have a constraint in Supply, Operations, or Market. Current constraint may shift, but there cannot be any situation when there is no constraint. Had it been so, its profit would have been Goldratt India infinite!

Theory of Constraints (TOC)

Constraints are neither good nor bad. They are facts of life.

Goldratt India

Theory of Constraints (TOC)

There is really no choice in the matter. Either you manage the constraints or the constraints will manage you. The constraints will determine the output of the system whether they are acknowledged and managed or not.
Goldratt India

Organization as a chain
An organization can be compared to a chain.  The activities that constitute a business are chain of dependent events.  For example we do not dispatch components unless they are packed, and we do not pack parts until they are manufactured.


Goldratt India

Organization as a chain
The output of the organization is achieved through the synchronized efforts of various functions.  The output is limited by the weakest area.  The strength of the chain is determined by the strength of the weakest link.  What should be done to improve the output of an organization?

Goldratt India

Organization as a chain
Should we improve all functions or all links?  Or should we strengthen the weakest function or the weakest link?  It is common sense that unless we improve the weakest link, the organizational output or chain strength would not increase at all.  Is it possible that overall organizational effectiveness is reduced by improving performance in one department ?

Goldratt India

Organization as a chain
The global improvement is not the sum total of all the local improvements.  Often organizations spread their energies thin in all areas in order to improve the output.  In the TOC world optimizing a sub-system would sub-optimize the whole system.


Goldratt India

How does TOC help companies

1.

2.

Focusing improvement efforts where it will have the greatest immediate impact on the bottom line. Providing a reliable process that insures Follow Through

Goldratt India

A process of on going improvement (POOGI)

1. 2. 3. 4. 5.

Identify the constraint. Exploit the constraint Subordinate all policies, decisions and procedures to exploiting the constraint. Elevate the constraint. If we need still more output from the constraint, elevate it. Avoid inertia. If in a previous step constraint shifts, start the cycle once again.
Goldratt India

POOGI: Step 1
Identify the Constraint.  The constraint can be internal or external to your organization. Internal constraint is preferable.  The constraint can be tangible or intangible. For example it could be an equipment or a policy.  Invariably (> 95%) the constraint is a policy.
Goldratt India

POOGI: Step 2
Exploit the Constraint.  Get the most possible out of the existing capacity of the constraint.  Utilization at the constraint is critical.

Goldratt India

POOGI: Step 3
Subordinate all decisions to exploiting the constraint.  All policies and measurements must be designed to get the most out of the constraint.  Utilization and efficiency at the non-constraint resources must not be measured. However this does not imply that there are no measurements for non-constraint resources.  This step is often missed, and thereby the majority of financial benefits of TOC is lost. This is the toughest step.
Goldratt India

Exercise-Profit Maximization
P
$90/U 100 U/week

Q
$100/U 50 U/week

BIC $5/U C 10 min./U

D 15 min./U

D 5 min./U

C 5 min./U

B 15 min./U

Perfect operation (no defects) Same selling price to any clients Fixed market potential Set-up times nil 4 workers (skills are not interchangeable): 1 worker with skill A 1 worker with skill B 1 worker with skill C 1 worker with skill D Each worker is available 5 days a week, 8 hours a day (i.e. 2400 minutes a week) Total operating expenses of the company are $6000 per week (which includes salaries, and everything else)

A 15 min./U

B 15 min./U

A 10 min./U

RM1 $20/U

RM2 $20/U

RM3 $20/U

Goldratt India

POOGI: Step 4
Elevate the constraint.  If more capacity is required after steps 2 &3 to meet the market requirements, increase it through capital investment, outsourcing, or offload the constraint by defining alternative routings, processes or design. Capital investment should not be the first option.  Often times, Exploitation and Subordination are sufficient to reach the needed output. Do not increase the investment too soon.
Goldratt India

POOGI: Step 5
Avoid Inertia.  If in a previous step the constraint is broken, go back to Step 1. Do not let inertia be the system constraint.  Often times when a new constraint is identified, it is necessary to change the policies you have just made!

Goldratt India

POOGI: Step 5
Avoid Inertia.  The long term strategic application of TOC does not call for continuous removal of all constraints.  Rather, the idea is to choose where the constraint should be in order to best exploit the market opportunities, and then keep it there!

Goldratt India

Case study 1: Capital goods manufacturer



Background

Capital goods manufacturer for refractory equipment It was losing money for 2.5 years Owner has decided to close the plant in six months Constraint: cash / Goal achievement level 1

Actions
Stopped measuring machine utilization Stopped measuring local performance parameters to prevent

bad multi tasking Focus on cash generation Weekly review

Goldratt India

Case study 1: Capital goods manufacturer



Results
Turned around in 100 days Turnover increases by 30 times in 5 years Current profit > 3 times turnover in 2000

Goldratt India

Case study 2: Auto component manufacturer



Background manufacturer of automotive gears Losing money for last 5 years Action initiated for divestment Constraint: Operational policies / Goal achievement level 2 Actions Stopped measuring Tons All functional heads Key Result Areas (KRAs) abolished Started measuring OTIF (On time in full) Focus on throughput instead of sales Weekly review
Goldratt India

Case study 2: Auto component manufacturer



Results Throughput increases by 70% within 2 years

Goldratt India

Case study 3: Refractory manufacturer



Background manufacturer of refractories for steel and cement industry Inconsistent profits Constraint: Orders / Goal achievement level 3 Actions Stopped measuring Tons Started measuring Throughput loss Focus on throughput instead of sales Weekly review Results Throughput increases by 25% within 3 months
Goldratt India

Constraints: Identification
 Every system will

always have only one weakest link at any given timeConstraint  Constraint is in market if market share > 50% of world market  Constraint is orders if On Time in Full (OTIF) > 95%
Goldratt India

Constraints: Identification


Supply is constraint if material availability < 95% despite payments being on time Suppliers if consumption is > 50% of world consumption Supplier policies if consumption < 50% of world consumption

Goldratt India

Constraints: Identification


Constraint is operations when OTIF < 95%, and material availability > 95% Equipment if OEE (Overall Equipment Effectiveness) for at least one equipment >95% on 24X7 basis Operational policies if OEE < 95%

Goldratt India

Cash Constraint
There is Cash Constraint only and only if there are  sufficient orders i.e. OTIF < 95%  manufacturing capacity i.e. OEE < 95% for all equipments  right suppliers  there are raw material shortages as suppliers are refusing to supply unless paid upfront  additional cash cannot be easily arranged  Cash shortage does not necessarily imply cash constraint.  However if cash shortage is not managed properly, it will lead to cash constraint
Goldratt India

Cash Constraint: definitions

Cash to cash cycle time is the total time it takes from taking cash outflow to cash inflow (n) periods Throughput rate (T) is defined as the contribution per unit of constraint resource over one period of time When constraint is cash, it is defined as the contribution in $ per unit of time per $ of cash available T = ((s/tvc)^(1/n) -1) per unit of cash for one period of time where s is the unit selling price and tvc is the unit totally variable cost
Goldratt India

Cash Constraint: Throughput calculation example

Parameter Selling price per unit (s) in $ Totally Variable Cost per unit (tvc) in $ Manufacturing lead time in weeks Credit period in weeks Total cash to cash time (n) T / Week ={(s / tvc )^(1/n)}-1
Goldratt India

P 100 50 2 4 6 0.12

Q 80 50 2 1 3 0.17

Cash Constraint: definitions contd..

 

  

Throughput ratio (t) = s / tvc Survival Time: This is the time the organization can run with current cash. Survival time = Cash in hand / OE (Operating Expenses) Minimal cash required for survival = n*OE Adequate survival cash = n*OE*{t/(t-1)} Sufficient survival cash = n*(OE + Cash required for full capacity utilization for one period)

Goldratt India

Cash Constraint calculations

Parameter Throughput ratio (t) ~ s/tvc Total cash to cash time (n) OE / week in $ Cash available in $ Survival time in weeks Survival cash requirement: n*O.E. Adequate cash requirement: n*OE*{t/(t-1)} Cash required / week for full capacity Sufficient cash requirement: n*(OE+1000)
Goldratt India

P 2 6 500 2000 4 3000 6000 1000 9000

Q 1.6 3 500 2000 4 1500 4000 1000 4500

Cash Constraint: Issues

Cash constraint is the worst constraint  Cash shortage does not necessarily imply cash constraint  Exploiting and subordinating cash constraint also elevates cash constraint  Cash constraint impacts throughput nonlinearly  Cash Constraint is the fastest constraint to shift!


Goldratt India

Cash Constraint: Some Common nonsense

    

Purchase more than immediate requirement to take advantage of quantity discount Combine supplies to get freight advantage Produce more than immediate requirement for better capacity utilization Batch dispatches to reduce freight cost Not selling obsolete material below purchase price / book value
Goldratt India

Guiding Principles


Eli Goldratt: Measurements Drive Behaviors Warren Buffett: Take a few right decisions provided you do not make too many wrong decisions Responding to a question for recipe for success at the Berkshire Hathaway AGM 2003 Eliminating current wrong practices is more important than initiating new right actionsRavi Gilani
Goldratt India

Exploiting and subordinating Cash constraint: Measurements



Remove wrong measurements

Sales, profit, market share, gross margin, net

margin (some times even throughput!) ROI, productivity, capacity utilization



Monitoring right measurements

Survival time, cash available, adequate cash

requirement, overdue payments

Goldratt India

Exploiting and subordinating: Increasing cash to cash velocity



Cash to cash cycle time (n) reduction has huge nonlinear impact on throughput, cash availability, survival time, adequate cash requirement etc. For product P, reducing cash to cash cycle time from 6 weeks to 3 weeks, throughput / week increases by more than 100% Reduce cash to cash cycle time by shrinking Customer payment time - get money immediately even at deep discount of 20-40% Manufacturing lead time (Choke release of work) Supplier lead time (offer 5-10% price increase for immediate delivery)
Goldratt India

Exploiting and subordinating: Selling obsolete material

 

Often organizations do not sell obsolete material at below purchase price/ book value In most cases selling unwanted stock even at a discount of 80-90% of purchase price is the right decision. (negative throughput!) For product Q, selling obsolete material even at 85% discount will generate cash > purchase price in just 13 weeks! (Apart from the fact that it also increases chances of survival ) Any addition in cash increases survival time immediately
Goldratt India

Elevating Cash Constraint: Additional Cash induction



 

Cash constraint organizations do have difficulty in organizing loans even at high interest rates of 18-24% per year However even these organizations, cash may be available at 1-4% per week! For a cash constrained organization selling product P, borrowing even at 4% per week makes sense as P generates T @ 12% per week (Q even better @ 17% per week) Interest cost control is not the Goal of the organization!
Goldratt India

Managing Cash Constraint

Example
Value 2 6 500 2000 2550 12 Q 1-4%

Parameter Throughput ratio (t)~ (s/tvc) Cash to Cash cycle time in weeks (n) OE / week Cash in hand Current customer receivables over 6 weeks Time in weeks for bankruptcy Alternative product Interest rate / week at which money could be available
Goldratt India

Managing Cash Constraint Substituting Q for P

Parameter Throughput ratio (t)~ (s/tvc) Cash to Cash cycle time in weeks (n) OE / week Cash in hand Current customer receivables over 6 weeks Time in weeks for shifting cash constraint to capacity
Goldratt India

Value 1.6 3 500 2000 2550 10

Managing Cash Constraint Borrowing cash @ 4% per week

Parameter Throughput ratio (t)~ (s/tvc) Cash to Cash cycle time in weeks (n) OE / week Cash in hand Current customer receivables over 6 weeks Cash inducted @ 4% week interest Time in weeks for shifting cash constraint to capacity Time in weeks to return borrowed cash
Goldratt India

Value 2 6 500 2000 2550 4000 13 27-29

Cash Constraint-case study Constraint       

A mass manufacturing organization in electrical industry, had a constraint in cash Material cost ~ 40% of sales Manufacturing lead time ~ 3 days Collection time ~ 60 days Capacity utilization ~ 30% OTIF < 10% Suppliers were willing to provide material off the shelf provided they could get payment upfront The constraint shifted from cash to orders within 13 weeks by shrinking collection time at 50% discount!
Goldratt India

Cash Constraint-case study

Data elements Selling price per unit (s) in $ Totally Variable Cost per unit (tvc) in $ Throughput ratio (t=s/tvc) Manufacturing lead time in days Credit period in days Total cash to cash time (n) in days T / week ={(s/tvc)^(1/n)}-1
Goldratt India

Existing 100 40 2.5 3 60 63 10.7%

New 50 40 1.25 3 4 7 25%

Next step after cash constraint is broken

Current crisis in the world is not due shortage of cash  Currently it is due to slowing down of money rotation. We have very severe shortage of trust!  What can we do? Increase the money flow!  Offer early payment to your suppliers with cash constraint with or without price discount!

Goldratt India

Summary
A company must know its Goal.  All the players in the organization must understand how is the scoring done  Then it must identify the Constraint(s) that is limiting the level of achievement of that Goal.  The Theory of Constraints is about

Focus on global improvement in place of local

improvements everywhere. Process of On Going Improvement.

Goldratt India

Process of On Going Improvement

1. 2. 3. 4. 5.

TOC Summary:

Identify the constraint. Exploit it. Subordinate all other decisions to the necessity of exploiting the constraint. If after # 2 & # 3 more capacity is needed to meet market demand Elevate the constraint. Go back to # 1, but do not let inertia become the systems constraint. Choose your constraint.
Goldratt India

Summary


You have Cash Constraint only and only if there are sufficient orders i.e. OTIF < 95%, sufficient manufacturing capacity i.e. OEE <95% for all equipments, right suppliers, and supplies are suffering as suppliers have not been paid on time due to cash crunch

Goldratt India

Summary
Exploiting and subordinating cash constraint also elevates cash constraint  Cash constraint impacts throughput nonlinearly  Cash Constraint is the fastest constraint to shift!  Eliminate wrong measures and implement right measures

Goldratt India

Summary
Shrinking cash to cash cycle time has the most immediate impact on cash  Elevating cash by selling obsolete material even at very low price impacts cash significantly  Borrowing cash at very high interest could also be an option during the duration of cash constraint situation  In most cases cash constraint can be shifted within 13 weeks!

Goldratt India

Summary
Once we have adequate cash, offer to construct Win-Win with your cash constrained suppliers.  We cannot live in an island of prosperity surrounded by a sea of misery!


Goldratt India

This is not the End. It is not even the beginning of the End. It is perhaps the End of the beginning!

THANK YOU!
Ravi Gilani ravigilani@goldrattindia.com

Goldratt India