Practical Ecommerce

Theory of Constraints, for ecommerce companies

Two or three years ago, in October, I left the office in the middle of the day and went to Starbucks to have a cup of coffee and think about our company. We had fairly good year up to that point and our growth rate was respectable. But I was not pleased. I wanted more, much more. Since we are not VC funded, we did not have large amounts of cash to throw at experimental ways to grow. This made me look for a system of growth that we can implement without much cost and without much risk.

My research took me to a hybrid system combining “Theory of Constraints” (TOC) with the “One-Page Strategic Plan.” TOC was developed by Dr. Eliyahu Goldratt, a physicist and management consultant. TOC has been mostly used and written about for large companies, mostly in manufacturing. One-Page Strategic Plan was developed by Verne Harnish, an entrepreneur and educator, and is mostly applied to growing businesses. Both systems focus on profitable growth, which is what I was looking for.

I mostly used One-Page Strategic Plan as an information tool, however. So most of this post (and the next few posts) will be about TOC and how we applied it at overstockArt.com to help us grow profitably.

I’ll start by explaining the basics of TOC and why it was so attractive to me. TOC is a commonsense approach to continuous improvement. It has been compared to “lean manufacturing” — there are similarities. There are also some major differences. The big difference is that TOC does not look to improve every step in your company’s process. It focuses on the constraint. The claim of TOC is that every system has a constraint or a bottleneck that controls the throughput of the system. In a business, throughput equals sales that are fulfilled to customers.

The real power of the system is the realization that not everything has to be improved. You must focus only on the constraint — i.e., the real problem of your organization. Many managers, when looking for increases in a company’s performance, create many improvements and they can’t understand why these many small improvements do not translate into real bottom line results. The reason is that they are focusing on optimizing a single resource but not the system as a whole. According to TOC, the throughput of the system as a whole is dependent on the constraint.

While TOC uses a commonsense approach, it is not common practice. As a matter of fact, many of the solutions proposed by TOC initially feel wrong to most people, because the solutions require a company to operate differently than it did in the past. Unfortunately, change is not easy for people. But if your company does not change, it will not grow.

Basics of TOC

TOC simplifies the way you look at the financial numbers of your company. There are only three financial metrics to consider, according to TOC.

  • Throughput. “The rate at which a system generates money through sales.” Most commonly this is considered sales or gross margin, depending on the specifics of the business.
  • Inventory. “The money the system has invested in purchasing things that it intends to sell.”
  • Operational Expense. “All the money the system spends in order to turn inventory into throughput.”

Many companies, when they want to improve, focus on one of these metrics. For example, if a company is losing money a manager may attempt to cut operating expense by firing employees. But, in doing so, the manager only affected one aspect positively (reduced costs), but, in doing so, he may have decreased throughput. To achieve the best level of operation, a company must focus on all three measurements: You want to increase throughput while reducing inventory and operational expense, or at least not increasing the last two factors by as much.

To apply TOC successfully, Dr. Goldratt developed five steps.

  1. Identify the system constraint. This can be looked at in a department or your entire organization. We started by looking at our production department and searched for the bottleneck in our production (or, order fulfillment) department.
  2. Decide how to exploit the constraint. The constraint controls your organization’s entire throughput. An improvement to the constraint is an improvement to the entire system. An improvement to other areas is not a real improvement to throughput.
  3. Subordinate everything to the constraint. Since the constraint controls your throughput, everything must be subordinated to this decision.
  4. If necessary or possible, elevate the constraint. In this step a company must evaluate the flow and performance of the constraint and consider what investments are possible.
  5. If in the previous steps the constraint has been broken, go back to step one, but don’t allow inertia to cause a system constraint. This step I consider as the loop step that makes this a continuous improvement methodology. Once a constraint is broken or conditions change, you must continuously search using the focusing steps for ways to attain better performance for the entire organization.

Again, TOC does not look to improve only parts of your organization, but the output as a whole.

In his book The Goal, Dr. Goldratt starts by asking, “What is the goal of a company?” I’ll finish this article by asking the readers this same question. Please write your answer to that question, and other comments, below. In my next post, I will offer more details for the application of TOC.

See the next installment of David Sasson’s “Theory of Constraints” series, at “Applying Theory of Constraints to our packaging process.”

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  1. Jule Marcantoni September 9, 2014 Reply

    Goal: To make money on a continuing basis

  2. David Sasson September 9, 2014 Reply

    Jule, Hi, thanks for the nice comment. Very well written and true.

  3. Carlos Rivera September 11, 2014 Reply

    I love methodologies like this! I’m looking forward to part 2.

    My answer to your question would be: High sales with low-overhead.

    • David Sasson September 12, 2014 Reply

      Carlos,

      Thanks for the nice comment. I like how you stated the goal. Part 2 is coming soon. It will be less theory and more practice.

  4. Anthony Masaba September 11, 2014 Reply

    Thanks for this good analysis. I personally has been wondering why organizations fail to target the right decisions in management but rather resort to firing employees only to manifest farther decline in operations

    • David Sasson September 12, 2014 Reply

      Anthony, you are very perceptive. I think the main reason for this activity is that they are not looking or trying to solve the root cause of their problems. They are looking at symptoms. And in many cases, especially when all a manager does is analyze the financials, it seems that if cost is reduced by X% they will be profitable. However, even if they turn a profit next quarter, cutting cost is not enough. After all, the goal of a company is not only to cut cost. Thanks for the nice comment.

  5. James La Trobe-Bateman October 26, 2014 Reply

    To make more money now and in the future…

    I recently saw an alleged quote from W Buffet that he focuses on the top 5 improvements. Why not just the top 1?

    • David Sasson November 13, 2014 Reply

      James, thanks for the interesting comment. It is so true. Focus creates success. And in this area less is more!