In this blog article we will show the impact of poor Capacity Management Decisions and the pitfalls that the temptation of reducing Operating Expenses to survive in this Covid-19 crisis may cause to inventory, Due Date Performance and Cash
Many companies impacted by COVID-19 are looking for the latest efficiencies. The paradigm is always the same: focus on efficiency, now more than ever, driven to exasperation by survival instinct.
In order to make correct decisions, it is necessary to have a clear knowledge of the phenomena impacting an Enterprise.
We can think of an Enterprise as a money-making machine. What does this machine do?
It buys "things" (materials, external processing) to make the products/services that will be sold on the market. We call these "things" that are bought, waiting to be transformed, Inventory. Inventory (I) represents the money tied up in the machine in order to make money.
To turn these things into saleable products/services, and to sell them on the market, this machine uses Resources. We can think of these resources as the "petrol that makes the machine work". We call this gasoline the "Operating Expenses". Operating Expenses (OE) is the money that in every period must be paid to make the machine work. They cause thus an "outflow of money".
The products / services obtained are then sold on the market: the difference between the selling price of the products, and the costs to buy these "things" is what we call Throughput Margin (often referred simply as Throughput), that we will indicate with the notation "T".
In this article we will call:
Throughput Margin as the difference from Revenues and True Variable Costs;
Throughput as the speed, the rate at which the machine creates Throughput Margin per unit of time.
Given a certain amount of Operating Expenses (they are capacity costs), then the Throughput Margin is what allow the machine to make money: if the Throughput Margin generated in the unit of time is greater than the Operating Expenses incurred in the same unit of time, then the machine makes money.
So, the time variable and the speed are fundamental in the equation: if the Throughput (the speed, the rate, the pace at which the machine makes money per unit of time), is faster than the pace at which the machine consume Operating Expenses, then the machine makes money.
Based on this equation it seems that in order to improve profit we have to options
Improving Throughput, the speed at which the machine generate Throughput Margin per unit of time;
Reducing the outflow of OE in the same period of time.
What would a manager typically chose?
Operating Expenses are fully in internal control: cutting OE is an internal decision, that is not subject to any risk not to happen. I decide, I do it, it happens.
Increasing Throughput is a decision that lays just partially in the internal boundaries of the Enterprise. If we improve the speed at which the machine release product or services to the market, then we are freeing up capacity that we must sell to the market itself. So it requires a market response: we can influence the market response, but without having 100% confidence that what we plan will happen as planned.
So it is quite obvious that a manager, in the search of predictability of the actions, is naturally pushed to prefer the first option: let's make the machine more fuel-efficient.
To make the machine more fuel-efficient, the natural action is to reduce some of the capacity we have and trying to push resource utilization to the limits.
While planning and implementing those actions, often managers of the machine forget the systemic linkage between Operating Expenses, Inventory and Throughput, and the systemic nature of the machine.
The processes executed by the machine with the resources to obtain the product it sells, are a set of interdependent processes dominated by statistical fluctuation and Murphy.
This systemic linkage are always forgotten when taking the decisions.
What happens when we drain too much capacity and we do not protect our constraints?
It happens what we have depicted in the above graph.
We said that we always have to remember that systems are dominated by statistical fluctuation and Murphy.
Up to an average utilization between 80 to 90%, when Murphy starts to hammer, the system has enough protective capacity to recover from the incidents to limit the impact on lead times and due date performance. This is true if the system is managed wisely: if there is awareness of constraints and the Five Focusing Steps of Theory of Constraints are managed and applied consistently.
If the system is not managed properly, and the presence of constraints and the Five Focusing Steps are ignored, then the mess starts well before the threshold of 80%.
When we are already close to the threshold between 80% to 90% of utilization, then stretching additional Capacity becomes extremely risky. We are close to the threshold of chaos.
Beyond that threshold, lead times extend indefinitely: every time that Murphy hits, the system does not have any ability to recover the problems: they accumulate over and over. By accumulating delays, lead times becomes longer and longer, WIP accumulate and move in waves, thus inventory starts growing exponentially.
Holding inventory in the system absorbs high quantity of cash: the system's cash flow rapidly falls down and become negative. Cash flow as an extremely narrow corridor to stay positive.
By losing quickly cash the system loses its ability to recover the capacity: the Requiem starts.
Our decision to save cash by reducing OE has transformed into the worst decision to burn cash.
What we want to argue is: do not follow the easy way to depict a solution. It may lead to death. Managing the COVID-19 crisis is a huge challenge: on top of our internal constraints it added the disruption of Supply Chains, and availability of material may have become in many cases the constraint itself.
But we shall not be tempted by the sirens of easy gain from just cutting Operating Expenses: we shall find different ways to serve our market, manage better our supplier, moving away from the logic of the unit price. Speed and dependability to sustain Throughput is the Key
Any decision shall be made with a systemic approach, linking the interaction between Throughput, OE, Inventory and Cash.
For sure, the prevalent accounting system adopted by the majority of enterprises (Full Costing) does not help in thus direction.
It's extremely urgent in this situation to move quickly from the costing world of management decision to the Throughput World, adopting Throughput Accounting as a management decision tool to provide information to management, and applying Throughput Economics way of thinking and managing the decision process.
We help manufacturers going beyond their current potential by helping implementing Decision Making and Operations Management Best Practices based on Theory of Constraints to improve flow, speed and cash.