The Theory of Constraints is a management philosophy stating that any system is prevented from achieving its full potential by one or more key constraints.
The Theory of Constraints focuses on constraints in the context of their ability to reduce profits. As a result, the theory focuses on throughput accounting and its core principle of increasing production capacity to generate revenue.
The Theory of Constraints is a five-step, cyclical process that businesses must consistently use to avoid becoming complacent.
The Theory of Constraints was developed in 1984 by business management guru Eliyahu Goldratt in his book The Goal. The Theory of Constraints argues that every system has at least one constraint that hinders high-level performance or profit generation. Fundamentally, the theory advocates identifying constraints and then eliminating them or at the very least, reducing their impact.
Table of Contents
Understanding the Theory of Constraints
The Theory of Constraints was developed in 1984 by business management guru Eliyahu Goldratt in his book The Goal.
In the book, Goldratt uses the chain metaphor to argue that every business system is only as strong as its weakest link. Here, the weakest link is a constraint that limits the extent of profitability. Since there can only be one weakest link, Goldratt suggests that this is where businesses should focus their efforts to institute significant change.
This change is achieved via throughput accounting, which emphasizes selling more of something to generate higher profits. This approach differs from traditional accounting methods that focus on reducing expenses to generate profit.
However, the capacity to reduce expenses is limited once an expense reaches zero. That is, the ability to increase profits is constrained.
Conversely, the emphasis on increasing sales revenue via throughput accounting has no such constraint. This is because – at least in theory – there is no limit to the amount of sales revenue a business can generate.
Throughput accounting is comprised of three parts:
Throughput – or the rate of sales revenue generated by a product or service.
Inventory – or money that is tied up in physical things such as raw materials, equipment, distribution facilities, and goods awaiting sale.
Operating expense – or the money a business spends creating throughput to maintain a desired level of capacity. This may include payroll, depreciation, and utility expenses.
The five steps of the Theory of Constraints
1. Identify the constraint
Which part of the system constitutes the weakest link? Remember, there can only be one.
2. Exploit the constraint
Use available resources to make rapid improvements to the constraint. Reduce or eliminate where possible to avoid expensive wholesale upgrades or process changes.
3. Subordinate the remaining links
The unconstrained (strong) links in a process must be altered so they maximize the output of the weakest link. At this point, the process should be evaluated to determine if the constraint has simply shifted to another location on the chain.
If the constraint has been eliminated, the business can move to step five. Otherwise, they should proceed to step four.
4. Elevate the constraint
If the second and third steps have not been successful, take whatever action necessary to eliminate the constraint. This includes a major overall of an existing system.
5. Beware of inertia
Once a constraint has been removed, avoid becoming complacent.
Understand that the Theory of Constraints is a cyclical process that stresses the importance of improving one constraint and then moving on to the next. Complacency, which Goldratt calls “inertia”, is a significant barrier to profit generation through increased production.
Theory of constraints examples
Steelo
Steelo is a British company that specializes in 3D printing for structural steel fabrication.
The company’s level of client responsiveness is one of the best in the industry, with lead times between order placement and site delivery as short as one day.
Just as impressive is that parts are routinely delivered within a two-hour time window.
According to Steelo founder Michael Krajewski, these impressive numbers are supported by principles of automotive lean manufacturing, a bespoke IT system, and the theory of constraints. “In our theory, you want one department to be working at 100% capacity, and the rest of the business to be under capacity. This is beneficial, because if there’s a problem, it’s likely to be in the department that is working at 100%. So other departments can take up the slack,” Krajewski explained in a 2019 interview with The Construction Index.
Krajewski initially believed welding bays would be the primary source of production bottlenecks, but after deeper analysis, he realized that the company’s delivery system was its most vulnerable point.
While employee overtime or extra resources could compensate for a broken machine, time lost from a late delivery could never be made up.
This was because council restrictions only allowed Steelo to operate between 8 am and 5 pm.
To reduce or avoid irrecoverable time loss, most of the company’s production staff are multi-talented and can be diverted into other roles as necessary.
In the office, for example, designers are trained as estimators and factory floor staff are also trained in a variety of different roles.
The balance of Steelo’s workforce is also somewhat unusual among manufacturers, with 50% of employees based in the office.
Some of these employees are solely tasked with finding ways to improve operations through innovation.
Mazda
At the 11th annual conference for theory of constraints professionals in 2013, powertrain division chief engineer Mitsuo Hitomi explained how the company reached a crisis point after reporting financial losses for the previous four years.
Hitomi noted that Mazda had one chance to reverse its fortunes and survive.
This moment called on the company to develop a car that delivered a superb driving experience with an internal combustion engine that had comparable fuel consumption to a hybrid.
Critically, the new model also needed to be affordable for most consumers.
The product development cycle at Mazda was cut by half with the Critical Chain Project Management (CCPM) method where the people, equipment, and physical space required to execute tasks are emphasized.
While there were many subsequent benefits to Mazda’s project management processes, there are two which deserve mention. For one, planning transformed from a management-only task to one where developers were involved in building and creating networks.
Mazda also instituted routine reporting and status mechanisms so that problems could be identified before they were too costly to fix later on.
These measures, among others, enabled Mazda to return to profit in 2013 after meeting performance objectives related to customer satisfaction, tech development, and more agile product development.
Key takeaways:
Concept Origin: The Theory of Constraints (TOC) was introduced by Eliyahu Goldratt in his book “The Goal” published in 1984. Goldratt’s ideas revolutionized the field of business management by providing a new perspective on improving organizational performance.
Central Idea – Constraints: The core premise of TOC is that every system, whether it’s a manufacturing process, a project, or an entire business, has at least one constraint that limits its overall performance. Constraints can be physical, operational, or even conceptual barriers that hinder the system’s ability to generate desired outcomes.
Weakest Link Metaphor: Goldratt used the analogy of a chain to explain the importance of constraints. Just as a chain is only as strong as its weakest link, a business system’s effectiveness is limited by its weakest constraint. Identifying and addressing this constraint becomes critical for optimizing performance.
Throughput Accounting: TOC challenges traditional cost-focused accounting methods. Instead of solely cutting expenses, TOC emphasizes increasing throughput, which refers to the rate of sales revenue generated by a product or service. This approach ensures that efforts are directed towards activities that directly contribute to revenue growth.
Five Steps – Constraint Improvement:
Identify the Constraint: Pinpoint the specific aspect within the system that is the constraint limiting performance. It could be a machine, process, or resource.
Exploit the Constraint: Optimize the constraint’s usage to achieve maximum output without additional investment. Focus on increasing its efficiency and reducing downtime.
Subordinate Other Links: Align the rest of the system’s processes and resources to support the constraint. This ensures that the constraint’s output is not wasted due to imbalances elsewhere.
Elevate the Constraint: If the earlier steps don’t yield sufficient improvement, consider investing in expanding or enhancing the constraint’s capacity.
Beware of Inertia: Continuously monitor and improve constraints to prevent complacency and ensure ongoing progress.
Examples – Practical Application:
Steelo: The company identified its delivery system as a constraint rather than the expected welding process. By cross-training employees and optimizing delivery operations, they achieved exceptional responsiveness.
Mazda: Facing financial difficulties, Mazda employed the Theory of Constraints and the Critical Chain Project Management method to transform product development, leading to profitability and enhanced agility.
Goal – Enhancing Profitability: The primary objective of TOC is to improve profitability by identifying, addressing, and ultimately eliminating constraints. By doing so, organizations can enhance their operational efficiency and generate higher revenues.
Cyclical Process: TOC is an ongoing and cyclical process. Constraints can change over time, and even when one constraint is eliminated, new ones may emerge. Continuous improvement and innovation are essential to avoid becoming complacent.
Practical Application: TOC can be applied to various industries, including manufacturing, services, and project management. It provides a framework for optimizing processes, identifying bottlenecks, and making strategic decisions that drive business success.
A failure mode and effects analysis (FMEA) is a structured approach to identifying design failures in a product or process. Developed in the 1950s, the failure mode and effects analysis is one the earliest methodologies of its kind. It enables organizations to anticipate a range of potential failures during the design stage.
Agile Business Analysis (AgileBA) is certification in the form of guidance and training for business analysts seeking to work in agile environments. To support this shift, AgileBA also helps the business analyst relate Agile projects to a wider organizational mission or strategy. To ensure that analysts have the necessary skills and expertise, AgileBA certification was developed.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
A paired comparison analysis is used to rate or rank options where evaluation criteria are subjective by nature. The analysis is particularly useful when there is a lack of clear priorities or objective data to base decisions on. A paired comparison analysis evaluates a range of options by comparing them against each other.
The Monte Carlo analysis is a quantitative risk management technique. The Monte Carlo analysis was developed by nuclear scientist Stanislaw Ulam in 1940 as work progressed on the atom bomb. The analysis first considers the impact of certain risks on project management such as time or budgetary constraints. Then, a computerized mathematical output gives businesses a range of possible outcomes and their probability of occurrence.
A cost-benefit analysis is a process a business can use to analyze decisions according to the costs associated with making that decision. For a cost analysis to be effective it’s important to articulate the project in the simplest terms possible, identify the costs, determine the benefits of project implementation, assess the alternatives.
The CATWOE analysis is a problem-solving strategy that asks businesses to look at an issue from six different perspectives. The CATWOE analysis is an in-depth and holistic approach to problem-solving because it enables businesses to consider all perspectives. This often forces management out of habitual ways of thinking that would otherwise hinder growth and profitability. Most importantly, the CATWOE analysis allows businesses to combine multiple perspectives into a single, unifying solution.
It’s possible to identify the key players that overlap with a company’s business model with a competitor analysis. This overlapping can be analyzed in terms of key customers, technologies, distribution, and financial models. When all those elements are analyzed, it is possible to map all the facets of competition for a tech business model to understand better where a business stands in the marketplace and its possible future developments.
The Pareto Analysis is a statistical analysis used in business decision making that identifies a certain number of input factors that have the greatest impact on income. It is based on the similarly named Pareto Principle, which states that 80% of the effect of something can be attributed to just 20% of the drivers.
A comparable company analysis is a process that enables the identification of similar organizations to be used as a comparison to understand the business and financial performance of the target company. To find comparables you can look at two key profiles: the business and financial profile. From the comparable company analysis it is possible to understand the competitive landscape of the target organization.
A SWOT Analysis is a framework used for evaluating the business’s Strengths, Weaknesses, Opportunities, and Threats. It can aid in identifying the problematic areas of your business so that you can maximize your opportunities. It will also alert you to the challenges your organization might face in the future.
The PESTEL analysis is a framework that can help marketers assess whether macro-economic factors are affecting an organization. This is a critical step that helps organizations identify potential threats and weaknesses that can be used in other frameworks such as SWOT or to gain a broader and better understanding of the overall marketing environment.
Business analysis is a research discipline that helps driving change within an organization by identifying the key elements and processes that drive value. Business analysis can also be used in Identifying new business opportunities or how to take advantage of existing business opportunities to grow your business in the marketplace.
In corporate finance, the financial structure is how corporations finance their assets (usually either through debt or equity). For the sake of reverse engineering businesses, we want to look at three critical elements to determine the model used to sustain its assets: cost structure, profitability, and cash flow generation.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Value investing is an investment philosophy that looks at companies’ fundamentals, to discover those companies whose intrinsic value is higher than what the market is currently pricing, in short value investing tries to evaluate a business by starting by its fundamentals.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Financial accounting is a subdiscipline within accounting that helps organizations provide reporting related to three critical areas of a business: its assets and liabilities (balance sheet), its revenues and expenses (income statement), and its cash flows (cash flow statement). Together those areas can be used for internal and external purposes.
Post-mortem analyses review projects from start to finish to determine process improvements and ensure that inefficiencies are not repeated in the future. In the Project Management Book of Knowledge (PMBOK), this process is referred to as “lessons learned”.
Retrospective analyses are held after a project to determine what worked well and what did not. They are also conducted at the end of an iteration in Agile project management. Agile practitioners call these meetings retrospectives or retros. They are an effective way to check the pulse of a project team, reflect on the work performed to date, and reach a consensus on how to tackle the next sprint cycle.
In essence, a root cause analysis involves the identification of problem root causes to devise the most effective solutions. Note that the root cause is an underlying factor that sets the problem in motion or causes a particular situation such as non-conformance.
A break-even analysis is commonly used to determine the point at which a new product or service will become profitable. The analysis is a financial calculation that tells the business how many products it must sell to cover its production costs. A break-even analysis is a small business accounting process that tells the business what it needs to do to break even or recoup its initial investment.
Stanford University Professor Ronald A. Howard first defined decision analysis as a profession in 1964. Over the ensuing decades, Howard has supervised many doctoral theses on the subject across topics including nuclear waste disposal, investment planning, hurricane seeding, and research strategy. Decision analysis (DA) is a systematic, visual, and quantitative decision-making approach where all aspects of a decision are evaluated before making an optimal choice.
A DESTEP analysis is a framework used by businesses to understand their external environment and the issues which may impact them. The DESTEP analysis is an extension of the popular PEST analysis created by Harvard Business School professor Francis J. Aguilar. The DESTEP analysis groups external factors into six categories: demographic, economic, socio-cultural, technological, ecological, and political.
The STEEP analysis is a tool used to map the external factors that impact an organization. STEEP stands for the five key areas on which the analysis focuses: socio-cultural, technological, economic, environmental/ecological, and political. Usually, the STEEP analysis is complementary or alternative to other methods such as SWOT or PESTEL analyses.
The STEEPLE analysis is a variation of the STEEP analysis. Where the step analysis comprises socio-cultural, technological, economic, environmental/ecological, and political factors as the base of the analysis. The STEEPLE analysis adds other two factors such as Legal and Ethical.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
