We are continuing our series based on The Goal by Eliyahu M Goldratt and the Theory of Constraints. {This series was co-written with Brad Stillahn.}

To make managing a complex organization easier, we break organizations into pieces. Many of the current measurements have the purpose of measuring local performance, under the erroneous assumption that the overall performance of the organization will be maximized if each department maximizes its performance.

The role of measurements is to induce the parts to do what’s good for the organization as a whole. What’s good for the organization as a whole is achieving the three objectives stated above.

In previous articles, we’ve referred to some of the measurements used by TOC practitioners:

  • Throughput (T) is rate at which the system generates money through sales.
  • Inventory (I) is the money invested in purchasing things which it intends to sell.
  • Operating Expense (OE) is the money the system spends to turn Inventory into Throughput.

To determine Throughput, subtract truly variable costs (TVC) from Sales dollars. Truly variable costs include raw materials, outsourcing, freight, and sales commission. Throughput is most similar to Gross Profit, except that direct labor is considered an Operating Expense in Theory of Constraints (TOC). It’s not that direct labor does not vary, but it is a period expense and does not necessarily need to vary with sales. Dramatic improvements in Net Profit can be gained when Throughput increases without a proportionate increase in Operating Expense.

…to be continued.

Here’s to maximizing YOUR profits!
Dr Lisa Lang

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