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Finance & Measurements, as Taught by Eli Goldratt · Lesson 8 of 8

Changing the scorecard

Make-or-buy rebuilt on the constraint, why sub-contracting the middle of a process invites Murphy, the one-line fix for artificial inventory profits (and who to warn before you apply it), how to measure the people who execute the plan, and the three initiatives that start it all.

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Make or buy, rebuilt

Which measures does a make-or-buy decision change? It depends on one question: does the part use the constraint?

  • If it does, examine ΔT through Δsales and Δraw material: freeing the constraint can sell more, as in Helen’s $125,000 case.
  • If it doesn’t, examine ΔT through Δraw material only: buying the part replaces its material cost with the purchase price.
  • In both cases, check the protective capacity of the resources that cause big holes in the buffer. If it falls, either the buffer (investment) or their capacity (investment and OE) must grow. If it rises, they can shrink.

The best candidates for making in-house: parts whose raw material is much cheaper than their purchase price, and which don’t load the bottleneck or any resource that causes significant holes in the buffer.

A mid-process operation is sub-contracted: parts go out to a vendor and come back for the next steps. What happens to the buffer?

  • Nothing
  • It must grow, because Murphy strikes more often when parts travel
  • It can shrink: the vendor has spare capacity, so parts will come back faster

Splitting a process between two places raises the chance that the constraint is disrupted, so the buffer must grow, which costs investment and lead time. Sometimes it is better to sub-contract the first operations too. Then the vendor’s output is a raw-material buffer for those parts, rather than a bigger buffer for the whole operation, which affects many more parts.

Judging the company as a whole: the simple solution

Financial statements treat inventory as an asset, which creates artificial profits when stock grows and artificial losses when it shrinks. Goldratt didn’t ask anyone to change the structure of the statements. His solution:

Don’t allocate cost to inventory. Value it at what was paid to the outside world for it.

Then turning raw material into work in progress, or work in progress into finished goods, doesn’t change its value. Any change in inventory is matched by exactly the opposite change in cash, so its effect on the bottom line is zero. No artificial profits, no artificial losses.

Goldratt was asked why a nearly finished part should be valued only at its raw material. His answer: a product’s value is only really determined when it changes owner; at every other stage it is a matter of interpretation. A part near the end of the process might sell for less than its raw material if the company liquidates. Since there’s no objective value, use the one that encourages the right decisions.

A warning before you start

Applying the five steps cuts inventory sharply. Even if you don’t report it as a loss, others will: corporate, analysts, banks. Before you start, find out who might see it negatively and explain to them why you are about to do it. Explanations after the fact don’t work: they sound like excuses. And if corporate fears the analysts, go to the analysts first, then go to corporate with them.

Profit centres

The problem with judging profit centres only arises when they buy and sell from other parts of the company: when they are links in an internal supply chain. Goldratt’s conclusion, from his supply chain session: don’t treat a subsystem as a stand-alone business unless it really is one, free to choose whom it buys from and sells to. Stop measuring internal subsystems as profit centres.

Measuring the people who execute

“Isn’t throughput too remote to motivate our employees?” Goldratt agreed it is. T, I and OE are for judging decisions, policies and plans. Most employees execute a given plan; they don’t create it, and they must not be judged on things outside their control. Execution should be judged on two things:

  • Actions that should have been taken were taken: measured by throughput-dollar-days.
  • Actions that shouldn’t have been taken weren’t: measured by inventory-dollar-days.
  • Plus local operating expense: only the expenses under the unit’s own control, with no allocation.

These are explained in depth in the Distribution & Supply Chain course of this series.

Three more questions

“Is it useful to split operating expense into fixed and variable?”

  • Yes, it’s essential, so that managers can see which costs rise with volume
  • No: the useful category is truly variable cost; everything else is OE

Goldratt observed that in many companies “variable” cost stayed flat over years while “fixed” cost doubled, which shows the labels don’t mean what they claim.

“Doesn’t activity-based costing fix the problem?”

  • No: it repeats allocation, with more work to reach wrong decisions
  • Yes: it allocates overhead more accurately, by the activities each product uses

The problem is the concept of allocating, not the accuracy of the allocation.

“Is any of this new to management accountants?”

  • Completely new: management accounting has never considered scarce resources
  • Much echoes long-taught ideas; TOC gives them more weight and uses them

An independent study of TOC implementations, sponsored by the Institute of Management Accountants in the US, reached a similar conclusion.

Only actions change reality

Beware of judging actions and decisions by their local impact. T, I and OE are the compass; the five steps are the guide. Goldratt asked participants to embark on three initiatives:

  1. Reassess existing requests for investment. Most were justified by cost reduction. Re-examine each with ΔT, ΔI and ΔOE: How does it affect the constraint? Sales or raw material? Inventory? Does it really reduce OE?
  2. Reassess your products and services. Identify the internal constraint and find which products give the most throughput per constraint unit. If the constraint is the market, don’t try to grow sales by cutting prices; that is a marketing question, not a price war.
  3. Get consensus to remove added value from inventory. Value work in progress and finished goods at raw material prices, and explain the one-time effect, in advance, to everyone who might misread it.

And above all, embark on the process of ongoing improvement: the five focusing steps.

Check your understanding

Answer all five. Get four right to complete the course.

1. For a part that doesn’t use the constraint, make-or-buy changes T only through…

  • Sales
  • Overhead
  • Raw material versus purchase price
  • Labour

No extra sales are possible.

2. Valuing inventory at raw material price means a change in inventory…

  • Has no effect on the bottom line
  • Raises profit
  • Lowers profit
  • Is ignored

It is matched by the opposite change in cash.

3. When should you explain an inventory reduction to banks and analysts?

  • After the results
  • Never
  • Only if asked
  • Before you start

Afterwards, it sounds like an excuse.

4. People who execute a plan should be measured on…

  • T, I and OE for their own department
  • Throughput-dollar-days, inventory-dollar-days and local operating expense
  • Efficiency
  • Product cost

Never on things outside their control.

5. “T, I and OE are the compass; the five steps are…”

  • The budget
  • The scorecard
  • The guide
  • The audit

Together they replace cost allocation for decisions.