It took me a lot of time to understand the sources of disagreement and gap in understanding approaches to cash flow evaluation in decision making. I couldn’t realize why formula CF=T-OE-∆I is not obvious.
Now I realize that it’s not used in TOC. What a surprise to me! Let me explain why.
I started studying TOC in 2011 from the Russian edition of William Detmer’s book “Goldratt’s Theory of Constraints. A system Approach to Continuous Improvement” not from the “Goal”. In the chapter devoted to T, OE and I concept there was a footnote about relations between T, OE and I with the above formula. The formula is so natural and obvious to anybody who is related with financial accounting, it’s so simple, logical, practical and graceful if we are speaking about the goal “to make money now and in the future” that I even didn’t mentioned that the footnote was written by scientific editor not by author and focused on T/CU concept admiring and enjoying simplicity and usability. The formula is taken from The Complete Guide to CQM (Quality America, 2000).
When I started my discussion about the purpose not to consider material costs as a TVC in some cases I was sure that the formula is usual in TOC (because it’s obvious as I thought) and when you didn’t understand me I was puzzled. So, I took all my books were is this issue: William Detmer’s I’ve mentioned above , Thomas Corbett’s “Throughput Accounting” and found the reason.
Thus, let start from the very beginning.
First, let’s agree about the goal. It’s generally accepted that the goal of any commercial organization is to get profit. But is it a goal of owner? Will any owner be satisfied when his organization has profit but can’t give him any cash? “Common sense is not common” What is profit? It’s just a figure in accountant’s books. It can be related with your money in bank or in cash or it may be dissipated in inventories, investments and deferred client’s payment. I didn’t see correct Goldratt’s quotation but I clearly know that “make money now and in the future” and “make profit now and in the future” is not the same. And the vast majority of entrepreneurs and owners I’m acquainted with will prefer to have more money with less profit than the reverse. And if it’s so that the top-level measurement is cash-free. There are different definitions of FCF (Free Cash Flow), I prefer to define it like “money which owner can use to any projects and purposes without any harm to organization functionality, liabilities and development plans”. Profit is necessary condition to make money in future but it’s not sufficient.
TOC solutions for supply chain management do not only improve ROI but also free money from the stock from surpluses. Let say we have about 20% increasing of T due to better availability ($20 000 – for example) and decreasing stock minus 30% ($10 000). In this case we have increased cash-free for $30 000 – not bad to invest in entrepreneurs experiment.
When we make any decision it impacts on all three elements. For example, we sell product for $100, TVC is $50, ∆OE for one sale is zero. If we use buffer management and replenish according to consumption ∆I is to be zero: when we sell it decreases for $50 and we replenish it for $50. What we’ll see in CF? Throughput is $50, ∆OE = 0, NP = $50, CF=$50-0-($50-$50)=50. No difference between NP and CF. But what happens when we sell to deferred payment? Where would we see accounts receivable? I think it’s investment in client’s relationship, so we have to account it ∆I.
And here is a question which sum we have to account? Usually it is revenue but… We have invested our own money only equal to TVC. To my mind ∆I is (-$50) (decreasing by shipping goods) plus replenishment for $50 plus $50 (money invested in accounts receivable) = ($50)+$50+$50=$50.
So NP didn’t changed, it’s $50 but CF = $0. Now we have profit but have no money. Good business!
Of course, we have to look it not only in short time but and in long time interval. May be we have to buffer accounts receivable, who knows? We make buffers for our clients accounts receivable in two dimensions: time and money.
That’s why I’m torturing you with questions.
You say that it may take a lot of time between the moment we buy the material and the moment we decide to stop its production. Yes, it’s obvious but the formula is working at any time interval not only for single sale but for whole organization slightly modified.
All variables are sum for T, OE and I for the whole organization. If we are making decision for some scenarios we should use Deltas.
It’s not something special. It’s trivial calculation of cash flow indirect way from P&L and BS report. It links Net Profit with changes in Balance sheet. Usually it is used to check cash flow accounting in order to be sure that every movement of cash is accounted and nothing left unaccounted. So , there are different approaches what to consider as “I” – it may be total assets, current assets if we are talking about all money stuck in organization or net assets (I’m not sure it is correct translation: it means total assets minus all debts in liabilities) if we are talking about our own money. So the impact of TOC supply chain logistics application on a cash flow was obvious from the very beginning.
That’s why I even didn’t pay any attention that it’s not Detmer’s or Goldratt’s formula so obvious it was if we are talking about money. I even admired how easy physician understood the nature of money management without any complexity just taking out the core of it. All thoughts in Haystack Syndrom, all definitions of T, OE and I never caused me doubt that this calculation of cash flow is obvious to everyone.
That’s why I claim that it’s no reason don’t to treat material costs as TVC because if we don’t replenish it even selling below TVC have positive impact on our goal units – money. And in regular cases it have negative impact due to replenishment.
Let’s see: selling price is $40, TVC – $50, and we replenish (OE we put out of consideration). CF = 40 (TS) – 50 (TVC) – (50-50) (∆I) = (10) – minus ten dollars – bad decision.
But if we don’t replenish situation changes: CF = TS – TVC – ∆I = 40 – 50 – (-50) = 40. Good decision in spite of negative NP.
That’s why I don’t see any reason to multiply entities. Let’s use Occam’s razor. We already have all necessary data to make good enough decision if we’ll not substitute the goal – make MONEY now and in the future. “Information is an answer to the question” if I’m not mistaken.
The article is devoted to the approach to performance assessment of systems and first of all business systems. In Russian “эффективность” is used as term for “performance”, “effectiveness” and “efficiency”. In English (as far as I know) this words also sometimes are used like a synonyms.
If you’ll ask any manager, what does he want from the organization, with the probability of 80% you’ll get the answer: “It must be efficient”. In Russian it’ll sound like “Организация должна быть эффективной” and does he mean effective, efficient or high level of performance you’ll never understand if you’ll not specify what does he mean.
Efficiency is one of the most used demands for the performance of a system. Efficiency is defined by the formula:
Ef – efficiency measurement;
R – result measurement;
C – resource consumption measurement.
So, lets agree that the efficiency is main feature of a system performance for some time and simulate some simple situation.
There is some department which result is defined like the increasing of profit volume for $10 million. It’ll be our result measurement. After we’ve planned our activity, calculated necessary resources management assigned the department budget – $2 million. So, for $1 we must get $5 result, our Ef=0,2.
After the end of the period we measure the result. And we see that the increasing of profit is only $1 million but the budget consumption is $200 thousand. So, Ef=0,2! We are efficient!! If the efficiency is main measurement of performance – we have high level of performance. But…
Why my boss isn’t happy? His intuition says that the performance is low, because we’ve got only 10% of demanding result. Who cares about good efficiency when the effectiveness is low?
Does a system have required performance if spaceship falls in Pacific ocean instead of getting Mars orbit even if the consumption of resources is in proportion to distance?
Intuitively and logically it’s obvious that efficiency is necessary but not sufficient for appreciation of system performance.
Required performance demands simultaneous attainment of required efficiency and effectiveness.
The efficiency is defined:
Absolute value of efficiency often has no sense. Most of all the assessment of efficiency is related with the comparison of expected and actual efficiency.
Ec – efficiency measurement;
Ecf – actual efficiency measurement;
Ecp – expected efficiency measurement.
The effectiveness if defined:
R – effectiveness measurement;
Rf – actual result measurement;
Rp – expected result measurement
Lets add one more entity – the resource consumption:
C – resource consumption measurement;
Cf – actual resource consumption;
Cp – expected resource consumption.
By the (2), (3), (4), (5), efficiency is:
Lets return to performance measurement. Our definition is:
performance is a way of functioning of system that provides necessary efficiency and simultaneously required level of effectiveness.
Ergo, performance is directly proportional to effectiveness (high measurement of effectiveness (4) means high performance) and inversely proportional to efficiency measurement according to (6) (low efficiency measurement (6) – high performance).
Ergo, performance is defined:
where: k – proportion constant.
The special case of the performance formula tested by author in real business practice may look like:
The described approach to the performance assessment allows to get integral evaluation without taking into account relation of intermediate results, actions and resources. Undoubtedly, it is only high level measurement.
Application of formula (7) has some important limitations:
First, it concerns time like a resource which has the same importance like any other. But, every manager knows that time is the most deficit resource and it is very difficult to manage. Time couldn’t be added or accumulated in stock. That is why the formula (7) is valid to the cases of system performance assessment in fixed and comparable time intervals.
Second, formula (7) does not consider result dependence of composition and quality of resources used to it delivery. It’s generally not true in real life and real systems.
Classic managerial task is to balance a triangle “Time-limit – Quality (result scope) – Resource consumption” There is old managerial joke: “Cheap, qualitatively, within time-limit – you may choose any two of it”.
The reality shows that the answer is – “No”. If this assumptions were valid creators of new technologies would get immediate superiority in performance and deliver better results. But in real market environment technological innovators themselves rarely wins, more frequent the winners are those who came second or third. Those followers often get more success and show more performance.Most often delivered result is an effect of a presence, quality and availability of resource in needed quantity and proper sequence. In this case resources are means of production or any other fixed assets, materials, information, people etc., except for the time available. Other words, every resource has some contribution to the result, i.e. result is an integral function of resource availability:
The essence of function f(c) is a characteristic of system’s efficiency which is, first of all, determined by technologies used. Any technological innovations, implemented in system, should look toward increasing return on needed resources.
The attention of the vast majority of managers who are preoccupied with the issues of performance is focused at this function. But this attention misses the very important aspect. Can the increasing of result be supported by the existing capacity of resources or adding resources? Is technological superiority the only basis for performance increasing?
The reason is simple: existing system is NOT ABLE to pass through itself proper volume of resources in available time-limit. Meanwhile, the delivery of the result in due time is very often is the main way to assess performance. Nobody sharpen the axes after the time they are needed!!!
For example. Olympic facilities in Sochi must be totally ready to 2014. If they will not be ready – no efficiency does matter in delivery of the result because the effectiveness rate will be zero (4). They must not be almost ready, they must be totally ready or the performance will be zero no matter how many resources were saved during the delivery.
Winners main advantage usually is the ability to pass through themselves more resources in order to deliver result in the same time as losers.
Company’s capability to provide itself with necessary resources may be described like further:
Here function ᵠ(t) is characteristic of resource permeability per unit of time.
Thus, the effectiveness of system is defined:
Effectiveness is function of system’s technological efficiency determined by the resource quality and availability and resource permeability in existing time-limits.
Technological efficiency in business and social systems is in the focus of attention of entrepreneurs, most of decision makers are focused on this issue while resource permeability is often out of focus area. Meanwhile, it is one of the most important parameters that determines competitiveness and performance of a system. To author’s opinion in is critically undervalued.
When we design any system, we formulate hypothesis about nature and profile of functions f(c) and ᵠ(t), based on retrospective analysis, intuition or expert evaluation or any other methods of decision making. According to this hypothesis we plan the expected performance of the system.
After finishing of a project or system starting we get actual measurements and can assess reliability of plan. So, formula (7) can be used for the assessment of reliability of our forecasts.
- Definition of performance as a way of functioning of system that provides necessary efficiency and simultaneously required level of effectiveness, allows to design a tool of quantitative assessment of performance (formula (7)).
- In real systems effectiveness is determined, from one hand, resource composition, its quality and availability, when it’s necessary, and, from the other hand, resource permeability, i.e. system capability deliver resource in tame-limit.
- Resource permeability management often is undervalued while finding ways to increase system performance.
- Technological efficiency and resource permeability management is the basis ways of increasing performance of a system
What is functional purpose og management? Why is it basically needed?
Adizes says that the function of management is to provide effectiveness end efficiency of a company. But why we can’t go without professional management? Why we can not write an algorithm and exclude management superstructure?
The reason is that real activity always hapens in a sequence of choises from alternatives which often are in conflicts.
Management is necessary to eliminate system conflicts, to solve dilemmas of choise.
Conflicts, antagonisms, dilemmas are the source and basis of a management existence. If there were no conflicts, delemmas or antaginisms – there were no necessity in management. Algorithms would be enough.