In search of "Common Sense"

Jan 6, 2009

Language of Metrics (The bare minimum)(Part 2)

When we start a talk on metrics and measurement, the following is most quoted quote."What gets measured gets done".

Does this mean that everything that needs to be done should be measured? There is a real danger of falling into a trap of thinking 'more the merrier'. There is distinct possibility of thinking that if we have sufficient and more measures than it is safer rather than having less measures and allowing something to slip through the cracks!!! This line of thinking can take the form a guideline which states - discover new measures every-time you face a tough situation. We must keep in mind - "Not everything that counts can be counted and not everything that is counted counts"

We might create a royal mess and keep on digging ourselves in a deeper hole. The above line of thinking belies the systems thinking and 'inherent simplicity' that Goldratt often refers. Inherent Simplicity asserts that whatever complexity that we see on the surface, hides a simple representation - an elegant and simple solution at the heart of any problem.

Then, what is the bare minimum that we need to have in our performance measurement framework, to be confident that reflects our understanding of the 'system' that we are part of as well as an insurance that nothing is being left unaddressed!!

A tall order!!

Following are the category of measures given in "Reaching the Goal – By John Arthur Ricketts".

  1. Financial – To keep focus on the 'purpose' of the business from the key stakeholder, investors' perspective.

  2. Performance – To help take stock of the affairs on a frequent basis on 'how well' the enterprise in doing in the above from the perspective of quantum and efficiency
  3. Resource – To help the managers in taking decisions related to short term product mix, market mix by evaluating the 'exploitation' of the 'constraint' or the bottleneck.

  4. Decision support – To help the managers in decisions related to the longer term product mix, market mix by evaluating the 'elevation' of the constraint or the bottleneck and creating new 'Assets' and deploying initiatives.
  5. Control – To help managers to keep regular business on track by protecting the 'constraint' from the regular and un-predictable disturbances.

This set of five categories of measure help in meeting the two criteria discussed in previous posting.

  1. Financial Measures.

    Any commercial enterprise is created and exists to generate wealth for the stakeholders. The unit of measurement for wealth is the currency in which the business operates.

    These measures irrespective of the type of organization, manufacturing, services, software, should answer the following questions:

  • How much money is generated by the enterprise?
  • How much money is spent to operate it?
  • How much money is captured by it?

We know the answers to above questions from our knowledge of Throughput Accounting

  • Throughput (T),
  • Operating Expense (OE),
  • Inventory/Investment (I).

Throughput Accounting concepts warns us to be very clear of what are "Truly Variable Costs" and not fall prey to phantom of cost accounting measures which considers labour as variable cost and this leads to some very damaging conclusions related to efficiencies, and product / service costing.

Some hints and tips:

  • Throughput is measured in the "goal units" produced by the system.

    • When the goal units are money (for-profit businesses), throughput (T) in the simplest sense is merely:
    • [ Sales revenues (S) ] – [ Cost of the raw materials (RM) ]:

      • T = S - RM
    • Note that T only exists when there is a sale of the product.

      • Producing products that sit in a warehouse does not count toward throughput
    • Throughput is sometimes referred to as "throughput contribution" and has similarities to the concept of "contribution" in other cost accounting methods, which is sales revenues less "variable" costs.

    • But in throughput accounting (TA), the ONLY variable cost is the cost incurred if a product is actually made.

    • Thus for TA, variable costs are primarily raw materials, but can include things like transportation costs and purchased services required to actually build products.

    • In TA, variable costs are only those costs that vary proportionally with the number/amount of product produced, i.e.

      • If you make twice as many widgets,
      • You need twice as many nuts and bolts to assemble the widgets,

      • So you need to spend more money to buy nuts and bolts.

    • For the TA approach, costs such as labor are NOT considered as variable costs.

      • The reasoning is that you don't send people home if the widget making line is down - they are still being paid a wage for the hours they are at work,

      • So at the system level, the labor cost associated with making widgets does not vary with the number of widgets made,

      • Since, you are still paying for the people in any case

  • Investment is all the money tied up the system.

    • This is money associated with inventory, machinery, buildings, and other assets and liabilities.

    • In earlier Theory of Constraints (TOC) documentation, the "I" was interchanged between "Inventory" and "Investment." The preferred term is now only "Investment."

    • Note that TOC recommends inventory be valued strictly on totally variable cost associated with creating the inventory, not with additional cost allocations from overhead.

    • In other words, the value of inventory is only the money
      paid to outside suppliers to purchase the materials put into the inventory.

    • It does not include the money spent by the organization to process the raw materials as they flow through the system.

  • Operating expense is the money the organization spends in generating "goal units" – e.g. products.

    • For physical products, OE includes maintenance, utilities, rent, taxes, payroll, etc., but does not include variable costs, e.g., raw materials.

    • Generally, OE are all expenses that are incurred as a result of the passage of time regardless of how many units are produced.

    • OE is the price the organization pays to maintain its current capacity to produce products, regardless of whether or not products are produced.
    • Specifically, it includes all employee time, regardless of what they are (or are not) doing.
  1. Performance Measures

These measures quantify progress towards an organization's goal. These measures can be calculated at the overall organization level as well as self contained business units, projects, process etc levels to align behavior and decision making at local level in accordance with the global good.

  • Net Profit = Throughput – Operating Expense

  • Return on Investment = Net Profit / Investment

  • Productivity = Throughput / Operating Expense

On the face of it, the above measures look conventional but since there is a subtle difference in underlying Financial Measures, hence the resulting performance measures are different.

The basic thumb-rule while evaluating the performance of a sub-unit using these measures is to consider T, I and OE which are in direct control of the sub-unit owner / leader. The allocation of the unit / head-office cost etc should not be done. The decision to improve local performance based on these measures lead to improvement of the global performance.

  1. Resource Measures

Although, measuring efficiency or resource utilization to ensure 100% utilization is not what is advocated in Throughput Accounting, still in service organizations, resources form an important component of the I and OE.

Resource measures being local efficiency measures should not be used for behavior influence. The resource measures at the constraint / bottleneck help in deciding the product / service mix for maximizing throughput.

  • Totally Variable Cost (TVC) for each specific sale transaction – this includes subcontractor fees, commissions, travel and living expenses, and so on.

  • Throughput per Constraint Unit: T/ CU – this measure is used to prioritize use of the constraint by selecting the product mix that maximizes throughput.

  • Utilization: U = Time a resource spends producing / Time available to produce
  1. Decision Support Measures

    Organization Management needs to take decision related to capital investments, addressing new markets – geographies, segments, introducing new products / services, improving processes, etc. The defining characteristics of such decisions is that it impacts the "Asset Creation" for the business and putting these 'Assets' to specific markets, offerings etc.
    These decisions also have the potential to shift the constraint or require the enterprise to forfeit some T on some existing product / services to gain more T on new product / services. In stable constraint and existing product / services the resource measure T/CU is adequate but for other cases following measures give an appropriate direction

  • Change in Net Profit: ∆NP = ∆T - ∆OE

  • Payback: PB = ∆NP / ∆I

Here ∆ is the symbol for Delta or the difference between two alternatives or before/after scenarios being compared. These measures can also throw light on the initiatives being taken in different times. E.g. a proposed cost cutting initiative that slashes OE and requires no ∆I will look a lot less appealing if it also jeopardizes T to the point that ∆NP is significant or erratic. Conversely, an investment proposal with only ∆NP can look quite appealing if its ∆I is trivial and resources are readily available or ∆OE is zero.

  1. Control Measures

    These set of measures are unique contribution of Goldratt and Throughput Accounting. These measures deal with a new concept of time-money. When we think of investment evaluation we know of common terms of Net Present Value (NPV) or payback period. These terms deal with either money (NPV) or time (Payback), at a time but not both at the same time. These are obtained by multiplying the two and getting measures called 'Dollar Days'.

    Throughput Dollar Days (TDD): This measure is used in production as well as in supply chain to evaluate the performance of supplying units against the due date of shipment. It is calculated for lost sales/ delay of shipment beyond the committed date by multiplying the sale value of the order with the number of days delayed. This is accumulated for the units / departments which are responsible for the delay and results in negative light on the department. This influences the right kind of behavior as it increases very quickly with each passing day and is more damaging for the larger orders. It also helps in ensuring that people complete a task right first time as any return of material creates a significant addition of TDD on the department which needs to contribute rework.

    Inventory Dollar Days (IDD): This measure is used to in production as well in supply chain to evaluate the performance of the receiving units against the utilization of 'Inventory' retained by the supplying unit to ensure no stock out. It also ensures that the sales team sells what is available in stock and ensures that the old inventory does not pile up and clog the pipeline and lock up the precious working capital. It is calculated by multiplying the inventory value over the buffer stock agreed upon with the number of days it stays above the agreed upon level.

    Project or Process Dollar per Day (PDD): This measure is used for projects and processes. This is the rate at which a project or a process produces Net Profit. PDD = NP / Days (Duration of the project), (NP = T- OE). This promotes on time delivery of the project against the negotiated duration. When a project is late, i.e Denominator increases, the throughput expected from the project remains same whereas the Operating Expense increases i.e the Net Profit i.e. the numerator goes down. The combined effect is shrinking of PDD. In general, the higher the value of PDD, the better. PDD can be negative for unprofitable projects. PDD is calculated based on NP rather than T to encourage delivery within budget as well as on time. PDD can measure individual projects / contracts or a set of projects / contracts, for a specific duration or their entire duration, can be used to compare completed, active or planned projects / contracts.

    Resource Dollar per Day (RDD): This measure is used for projects and processes. This is the rate at which excess resources erode the NP by generating OE without the corresponding T and which cannot be considered as an I (Investment). Like IDD it discourages unnecessary investment in resources.

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