The most inefficient factory is the one where every machine and worker operates at full capacity…
Yes, it’s counterintuitive. A stopped machine or idle worker should logically signal inefficient use of resources…
But as the well-tested Theory of Constraints (ToC) teaches, reality is quite the opposite.

ToC is discussed in all academic literature on operations management, but I particularly liked the business novel The Goal by Eliyahu M. Goldratt. It presents both the core challenges and solutions from a practical point of view.

The theory defines three key indicators for evaluating a manufacturing business, and focusing on improving these provides the basis for sound decision-making. While the terms are traditional, ToC gives them a new and powerful meaning:

  • Throughput – the rate at which the system generates money through sales.
  • Inventory – the money invested in purchasing raw materials.
  • Operating Expense – the money spent to convert inventory into throughput.

These three indicators are based on the understanding that the true goal of business is creating value, which is ultimately measured by the money it generates (Cash is King).
The goal is not to reduce costs, produce more, grow sales, employ more people, or anything else… A factory exists to generate money.

Maximizing Throughput means management should stop focusing on improving local efficiencies and instead prioritize the overall efficiency of the system (which, in practice, is often neglected).
Overall efficiency depends on the system’s bottleneck – the weakest link in the chain.

Any optimization, new equipment, additional professionals, or increased capacity beyond the bottleneck is wasted effort…
These decisions don’t increase sales (since the speed of final product output doesn’t change) and instead lead to excess work-in-progress inventory.

So the essence of successful management lies in focusing on the bottlenecks and adapting to changing demand.
This means:

  • Ensuring uninterrupted flow at the bottleneck by creating material and time buffers before it, and
  • Synchronizing all other production processes to avoid overproduction and inventory buildup.

All of these: Lean, Just-in-Time, Kanban, Drum-Buffer-Rope – are based on one fundamental idea, just applied in different contexts.

Goldratt’s article on this, “Standing on the Shoulders of Giants – Production Concepts versus Production Applications”, especially the Hitachi Tool Engineering example, is highly recommended.

Now, as for why direct labor and other production expenses are not included in Inventory and are instead classified as Operating Expenses:

Capitalizing direct production costs into inventory creates the illusion of profit in financial statements.
ToC warns that this approach incentivizes the overproduction of unnecessary work-in-progress.
Management must realize that producing for the future is like loaning money to the future with zero interest…
Excess inventory should be seen as a liability, not an asset.

And what happens when the system’s bottleneck has more capacity than market demand? That is, when there is no actual internal bottleneck?

This often occurs after expanding capacity during an economic boom, only to face overcapacity in a downturn.
In such cases, the bottleneck lies outside the system, so the focus must shift outward – to sales, marketing, pricing strategy, or new markets.

In conclusion, every important decision in manufacturing management should be evaluated in light of these three indicators.
Improving one indicator doesn’t automatically mean improvement overall.
Reducing operating expenses means nothing if inventory grows.
Likewise, reducing inventory is pointless if it hurts sales.

Source:

The Goal by Eliyahu Goldratt & Jeff Cox