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Profit First and the Theory of Constraints

Profit First and the Theory of Constraints

Author Mike Michalowicz's Profit First book is an application of Eli Goldratt's Theory of Constraints.

If you have spent any time in the manufacturing world -- or spent time with professionals who have worked in the manufacturing world -- you have likely stumbled upon The Goal, by Eli Goldratt. In this classic business novel, Goldratt introduces his "Theory of Constraints", or ToC.

ToC has a number of embodiments or applications. The classic application is the approach of identifying the activity or process where there is an impediment to "throughput". This impediment is often referred to as a Constraint. If we are not mindful of constraints, our entire operation suffers as deadlines are missed and consequently relationships are damaged. Improving areas other than the Constraint have little to no positive impact on our operations.

If we successfully identify the constraint and pace the rest of our operation around the constraint, our overall throughput is more predictable and consequently our relationships are improved as we manage and meet expectations of our trading partners. 

The five focusing steps of ToC are:

  1. Identify the Constraint -- i.e. what is holding things up?
  2. Exploit the Constraint -- are we using the Constraint as best as we can. For example, can we move any activity away from the constraint that does not absolutely need to be serviced by the constraint's resources?
  3. Subordinate everything to the Constraint -- look at the overall process and "pace" things according to the realistic maximum throughput of the constraint
  4. Elevate the Constraint -- after we have implemented steps 2 & 3, we may simply need to invest in "more" of the constrained resource. This might look like hiring new staff or purchasing new equipment, cloud servers, etc.
  5. Rinse and Repeat -- go back and look for new constraints. Be careful that we don't get "comfortable" with our level of improvement.


For a more formal and expanded discussion of the Five Focusing Steps, visit the TOC Institute.

So... what does this have to do with Profit First? In a word, Cash.

Outside of Time, Cash is nearly always the constraint in the typical business, regardless of size. So, let's examine from a high level how the Profit First approach to accounting helps with this cash constraint, which is really a mask for a profit constraint.

Let's identify the problem for most "small business owners": not enough profit.

If there is inadequate profit, the entire enterprise is threatened because you cannot operate a business forever without adequate profit, or margin, or whatever term you prefer.

This lack of margin impacts not just the small business owner, who is typically the primary shareholder, but it impacts the employees of the business. And it impacts the suppliers. And it impacts the down-stream consumers of the business's output. No business operates in a vacuum, so to speak.

There are two general reasons for "not enough profit".

  1. Not enough revenue.
  2. Expenses are too high.

Generally, once the business is out of embryonic start-up mode, these two feed on one another.

The single most relied-upon Key Indicator for a small business owner is their operating bank account balance. Think about it. Is it true for you?

If there are funds in the operating account, we tend to spend it. If the money is not there, we still tend to spend it!

But, what if we "subordinated" the business to Profit?

In really general terms, the Profit First approach recommends taking a percentage of every transaction and setting it aside for profit. Setting aside in this case means actually moving it out of the operating account and into a separate and distinct account -- ideally at a different bank altogether! Make those funds really difficult to access. Similar steps should be taken for setting aside funds for tax obligations. And, for faith concious businesses, consider setting aside funds for important ministry investments also. This is where we get the concept of "first fruits".

If we separate the cash allocated for profits (and taxes and ministry investments), what we have left over is what we use to operate the business. We need to fit the business's expenses into what is left over.

This generally creates what we like to call, a "math problem". The amount left over is simply "not enough". No real surpise here, right? So, what can we do about it?

Now that we know what we need to take *out* of the business in terms of profit, taxes and ministry investments, we subordinate the operations to work with the constrained cash.

  • We right-size our expenditures.
  • We take a sober look at our use of debt. Is it really bringing a return that justifies its cost?
  • We take a sober look at our use of equity partnerships. Are these relationships really bringing a return that justifies the cost?
  • We re-evaluate our pricing model.
    • Are we charging the right amount for our services?
    • Are our client relationships profitable?
    • Can we charge more for our services?
    • Would we have a meaningful uptick in volume if we were to lower our prices? 
  • Are we getting everything we can from our current investments in people, process and technology? 
  • etc.

As we improve the use of the money that is left over, we are in a better position, many times over:

  • We have our profit, tax obligation and ministry investments already set aside. That makes for much less drama.
  • We have paced the business with the amount of cash the business is generating.
  • We have improved the use of the cash that we have today.
  • We have confidence that we can be better managers of any new resources flowing into the business, either through direct operations or from well-thought-out outside investments.

Rinse. And. Repeat.

One final thought. It is tempting to think that we can overcome constraints by just "working harder". Yeah, maybe. A bit.

Before you set your alarm for 3 AM, miss the soccer game, or cancel reading time with the kids tonight, ponder verses 1 and 2 of Psalm 127.

1 Unless the Lord builds the house,
    the builders labor in vain.
Unless the Lord watches over the city,
    the guards stand watch in vain.
2 In vain you rise early
    and stay up late,
toiling for food to eat—
    for he grants sleep to those he loves.

Be diligent. Be a good steward. Trust and Rest in God.

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Posted by encouragework


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