Theory of Constraints and Austrian Economics

Introduction
If anyone has investigated the working of large firms, one will notice a kind of internal
socialism present. The same problems of information, management and resource
allocation that Mises and Hayek described in relation to socialist calculation will crop up.

While many people think that firms exist to make money, in many cases they make
money in order to exist and perpetuate themselves. This is in part because markets permit
organizations that function just well enough to avoid bankruptcy to perpetuate
themselves. Market discipline acts as a check on the expansion of badly managed firms,
but it doesn’t magically guarantee results. That is up to the firm itself.

There are in fact economic fallacies which disrupt firms and cause them to perform less
efficiently. Two examples we’ll encounter in this essay are the labor theory of value and
empiricism / pure induction. The largest problem is that the price system that enables
cooperation in the market place does not always function as effectively as possible within
firms. There is an entrepreneurial opportunity here for people to apply the lessons of
Austrian Economics to firms and enhance their growth. It may also show people how
Austrian Economics helps people understand not just how government policies make
them poorer, but also how Austrian Economics can help directly improve their life.

In short there is a great opportunity here for Austrian Economics to be applied in

business.

In this essay we’ll discuss an approach to making firms more profitable called Theory of
Constraints or TOC. While this is not associated with the Austrian School, it is similar
and parallel to it.

Similarities between Austrian Economics and TOC

Austrian Economics is a unified theory that helps people make sense of a wide variety of
complex social phenomena and explain coordination and distortions in the marketplace.
Theory of Constraints or TOC was designed to help members of firms, especially
manufacturing firms, make sense of their own complex internal social phenomena and
enable coordination and cooperation. TOC has detected certain flaws in the way actors in
firms think, and their fixes for these flaws are congruent with the insights of Austrian
Economics. Similarly the flaws within business thinking appear to be in part confusion
but also erroneous ideas from economics that Austrian Economics and TOC corrects.

Key linkages of Austrian Economics and TOC

What is The Goal?

According to Austrian Economics the goal of market transactions is to make money and
profits. The social function of the price system is to coordinate the different actors in the
economy. According to TOC the goal of an organization is to make money, to profit. This
goal must be used to coordinate the different actors within an organization. The Goal is
also the title of the first book explaining TOC, and was written by Goldratt an Israeli
Physicist.

While one might think that obviously organizations make money, we have to remember
that lots of businesses don’t make money, or very much of it. Many people within an
organization have their own goals which aren’t necessarily aligned with the goal of
making money. The organization just muddles through and often eventually goes out of
business. Internally many organizations are run like bureaucracies or quasi socialist
institutions. The organization needs a system to help coordinate everyone the way that the
price system coordinates the market.

TOC helps an organization align with the goal of making money. Just like the profit
system helps actors in the economy align, TOC and the goal of making money can help
employees in an organization align their efforts. The question is - how to make that
coordination happen?

The price system sends simple and clear signals across the marketplace. The goal of TOC
was to figure out how to do create simple and clear signals for organizations. This would
make coordination possible. The market system helps prevent the cascading effects of
supply and demand variability. Similarly TOC helps prevent these effects within an
organization. Many organizations in fact have serious difficulties meeting demand and
buy excessive raw materials to prevent supply issues and experience cascading
disruptions throughout the organization.

Key Intellectual Errors

Two key intellectual errors Rothbard cites in his history of economic thought are the
Labor Theory of Value and Empiricism / Pure Induction. Similar errors seem to have
infected business thinking in firms. These are also key errors that TOC seeks to address.

Labor Theory of Value

Accounting practice often treats inventory as assets that necessarily have economic value
based on the value of labor input and the value of material. However as we know from
Austrian Economics market value is based on there being a buyer available in the
marketplace. Goods that can’t be sold don’t have value and aren’t an asset. In fact they
destroy value. Inevitably firms who have unsold inventory eventually take a loss and
write off the inventory, despite the inventory being valued as an asset. In the short term
valuing inventory as an asset distorts production

Accounting systems encourage many firms to produce goods at the lowest cost. This is
often done by producing large batches of goods. Because the goods produced are seen as
having some sort of inherent value, firms systems often do not consider whether there is
an immediate buyer. (Individuals at firms of course do see this is an issue, but the firms
system don’t reflect this.) Additionally firms may buy large quantities of raw materials
that can’t be immediately used in order to get a lower per unit cost. The raw material in
inventory ties up scarce capital and may even be written off. In both cases what is in fact
a cost – wasted inventories of raw and finished materials – is often seen as asset or way to
save money. By contrast, TOC helps firms to devote all their production and buying
towards producing for the market and what can be immediately sold.

Empiricism / Pure Induction

As Rothbard pointed out pure induction does not work. One does not simply sift through
all the data to come up with conclusions.

Goldratt, the author of The Goal and creator of TOC, points out that scientists view the
data with the aid of a hypothesis, which is an IF THEN or statement. They don’t just sift
through the data, they use the data to check their hypothesis and see if the data explains
it.

However many management system do not take in to account theory. They assume that
collection of data is sufficient. TOC helps organizations understand what data is
important and relevant.

Accounting Systems
Traditional accounting systems are also set up to deliver historical reporting. They allow
firms to see over all what performance was historically. This is particularly useful for the
state who wishes to collect taxes, and is useful for creditors. However accounting
practices are not focused on helping entrepreneurs make decisions and deal with the
future. These accounting systems think of inventory as assets and try to account for costs.
However entrepreneurs are often dealing with costs that in the short term can be divided
in to sunk costs and variable costs, but accounting system when historically reporting
lump them together. This is explained in much detail in the TOC book The Measurement
Nightmare by Debra Smith.

Key Ideas of TOC related to Austrian Economics

Entrepreneur
The role of management in TOC is similar to that of Mises Entrepreneur. The
Entrepreneur must determine what is the highest present use or investment of the capital
available to him. This investment capital includes a variety of sunk costs as well as
money available for investment. Entrepreneur uses the price system to help rank or value
the different alternative courses of action available to them. TOC similarly helps people
within the firm rank or value the different alternative courses of action available to them.

Marginal Costs and Profits

In order to maximize profits TOC looks for those activities which can increase marginal
profits today and over time. TOC refers to Throughput, which is marginal profit, or the
price of the goods sold minus total variable cost (i.e. raw materials.) This emphasis on
Throughput or marginal profits helps firms avoid activities that aren’t related to market
demand. As we showed above, often companies will act in order to ‘decrease costs’ and
not to increase profits.

Time
Production takes time and passes through various stages, each taking time
This is a key point in Austrian Economics and in TOC. TOC focuses on stages of the
production process and making sure that activities coordinate over time. As a corollary, it
helps individuals understand the highest value action to take at each specific time.

Many production processes are uncoordinated with disruptive shortages and surpluses at
different stages of the production process. Firms are often at a loss as to how to deal with
them because the different stages of the production process are not aligned. TOC helps
firms align themselves.

Profit Maximization and Sunk Costs

A key idea is to maximize profits with the resources available to you. The available
resources include sunk costs, like your machinery, buildings etc. as well as the labor,
overhead, and vendor services which you’re going to pay for anyway at least in the short
term. Your goal is to maximize your return on this investment by making the highest
possible use at any given time. Therefore with TOC you want to maximize the use of
resources, especially labor which you’re going to pay for anyway. It doesn’t help increase
profits to ‘decrease costs’ on paper by using less of your resources on hand, just to
decrease costs. Those resources are still there and their cost isn’t going away just because
they weren’t used. Instead one should maximize the profitable utilization of the resources
on hand. Unfortunately many firms don’t view sunk costs as sunk, and try to save on
those costs, even though the costs are sunk.

Profit Throughput and Opportunity costs

One key idea is to look at your profit throughput per unit resource time. For example if
you have a production line, how much money are you making per day or hour should be
maximized.

Often there is the temptation to reduce the cost of production by inappropriately

minimizing the labor input, when in fact adding labor can sometimes radically increase
the profit throughput. Sometime there is a huge opportunity cost to reducing a cost. In
firms what is seen can trump what is unseen

Profit Throughput also looks at the difference between your marginal cost of producing
an additional good and the sales price of the good.
This helps answer - How do you prioritize production decisions?

Companies who implement Theory of Constraints focus on selling and producing the
highest value items. The highest value items are those items that have a ready buyer and
produce the highest profits per unit of production time. Profit means the difference
between the marginal cost and only the marginal cost of producing an additional good
and the sales price of the good. This has the happy effect of increasing cash flow.

This implies that if easy to produce low margin products have higher profit throughput
than slow to produce high margin products, one should produce the low margin products.
Producing high margin low labor products are not necessarily the best products for a firm
to produce. Yet often companies assume that this is always the case.

The Constraint
TOC points out that in any production process there is a constraint or bottleneck. (Just as
any basketball team always has shortest player.) This constraint limits profit throughput.
Until the constraint moves, the organization must focus on the constraint. This helps
coordinate everyone.

The coordination system is fairly elegant and simple, just like the price system.

Focus on maximizing profit throughput (which creates cash flow.)

If the firms understand what actions and products maximize cash flow, this help
coordinate everyone in the firm.

Find the constraint in the business processes which if not running at peak performance
will disrupt profit throughput. Focus on the constraint. This will help increase profit
throughput.

Don’t worry about other areas unless they’ll prevent from the constraint from running at
peak performance. Other areas by definition aren’t the bottleneck and can pick up the
slack.

When the constraint moves to another place in the business process, focus on the new
constraint.

Conflict Management
Debra Smith points out repeatedly in The Measurement Nightmare that actors within
firms are often in conflict because the system sets up conflicting goals for different
actors. Each person is trying to do the best job they can, but the system has given them
conflicting goals. While the price system helps align firms, the system breaks down
within the firm.
Similarly Mises Liberalism talks about the importance of Liberalism because it is a social
system that aligns the individual and society. Under the Liberal system there is no
structural conflict between the individual and society, and the price system is key part of
Liberalism. Theory of Constraints works to set up a structure or way of thinking within
the firm that aligns individuals and removes conflict.

Further Reading
Hopefully this helps show how applying better and more economic concepts to the firm
can help increase firm performance. This essay is only scratching the surface.

Two book which can help explain Theory of Constraints are

The Goal: A Process of Ongoing Improvement by Eliyahu M. Goldratt and Jeff Cox

The Measurement Nightmare: How the Theory of Constraints Can Resolve Conflicting
Strategies, Policies, and Measures by Debra Smith

The Goal is an easy to read novel which introduces reader to concepts using the Socratic
method. It is the book that started it all. The Measurement Nightmare is a much more
technical and slower work which analyzes the structural issues firms face and the TOC
solution, especially those relating to accounting.