Theory of Constraints

Topics: Theory of Constraints, Rate of return, Eliyahu M. Goldratt Pages: 4 (878 words) Published: January 29, 2013
The Theory of Constraints (TOC) is a management philosophy where three financial measures of profit, return on investment (ROI) and cash flow are presented. All three of these measurements are necessary. First, we need an absolute measurement of profit, the amount by which revenues exceed expenses. Second, we need the relative measurement of ROI that compares the amount of money made relative to the amount invested. Finally, we must have enough cash coming in to meet expenses, which is a measure of survival. In order to reach the goal, these three measures should all be positive and increasing. Profit Inventory: the money invested in purchasing things it plans to sell Operating Expense: the money the system spends to turn Inventory into Throughput Throughput (T) is the volume of sales in dollars less the totally variable costs of production, such as the cost of raw materials, subcontracting, and purchasing costs, such as transportation and duties. Investment (formerly Inventory) (I) includes the money invested in equipment, buildings and machine oil. Operating Expense (OE) includes the cost of indirect and direct labor.

The financial measures are calculated as follows:
Net profit = T - OE
Return on Investment = Net Profit/I
Cash flow = Net profit – (Change in I in terms of actual cash outflows and inflows) The goal is achieved by maximizing “T”, while simultaneously minimizing “I” and “OE.” The first priority is to increase “T”, while the second priority is to decrease “I.” Changing “T” is most important because it affects all three financial measures and is not limited in terms of how much it can change. “I” is more important than “OE” because the time-related portion of “I” affects “T” and due to its direct and indirect effects on all three financial measures. “I” directly affects ROI and Cash Flow. “I” also affects “OE” since carrying investments costs money, such as interest charges, storage space costs and material handling costs....
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