Few years back, while I was employed in a IT MNC, my office commute route involved a stretch of road which had quite a few traffic signals. One of these traffic signal was very nasty. It would sometimes take upto 20-30 minutes just to cross this one. A real bottleneck.
Soon the government decided that there should be a flyover built over this traffic signal. When I heard the news about flyover, I felt that it would solve the bottleneck problem.
3 years and few crore rupees later the flyover was finally ready. But did it solve the problem?
Partially. The bottleneck dissolved at that one particular traffic signal but all that flyover did was shift the bottleneck to the next traffic signal. Overall there was no improvement in my commute time.
This is what happens when you fail to look at a problem in a holistic way. Building the flyover wasn’t the complete solution.
When they thought of building the flyover, authorities were not really addressing the bottleneck, they were focussed on the location of the bottleneck. And in this case the bottleneck was a moving target.
This holistic way of looking at problems is called systems thinking. And Theory of Constraints is an important mental model to assist you in developing systems thinking. It’s the science of looking at the properties of bottlenecks in a system and how they behave.
Theory of constraints says that a system’s performance is constrained by its weakest link.
Peter Bevelin, in his book Seeking Wisdom, writes –
Optimization of one variable may cause the whole system to work less efficiently. Why? The performance of most systems is constrained by the performance of its weakest link. A variable that limits the system from achieving its goal or optimum performance. An increase in production may for example be physically constrained by the production capacity on one of the machines. If one machine in a production line of two machines can produce 100 items and the second 90, the output is physically constrained by the second machine.
When trying to improve the performance of a system, first find out the system’s key constraint(s)- which may be physical(capacity,material,the market) or non- physical (policies, rules, measurements) – and its cause and effect relationship with the system. Maybe the constraint is based on faulty assumptions that can be corrected. Then try to “strengthen” or change the weakest link. Watch out for other effects – wanted or unwanted – that pop up as a consequence. Always consider the effects on the whole system.
Theory of Constraints was made popular by Eliyahu Goldratt. His book The Goal features in the list of few books that Amazon’s CEO Jeff Bezos shares with his top executive. This book was a bible for the team that fixed and optimized Amazon’s fulfilment network.
Sometimes the whole assumption – a bottleneck needs to be removed – may be a wrong one. Instead of removing the bottleneck, you could make the bottleneck itself more efficient and increase the flow through it by introducing clever hacks.
Here’s a very simple experiment to illustrate the idea –
Click here if you can’t watch the video above.
In simple words, TOC provides answers to this one fundamental question – What to change?
Why is it such an important question? It’s important because most of us naively think that we know the answer. Just ask anybody in your organization – what to change – and you will find out that everyone is a real expert in complaining and moaning. And each of these gripes is a suggestion about what to change.
Now Pareto Principle says that 80 percent of results are produced by 20 percent of the problems. As a corollary, 80 percent of the failures are caused by top 20 percent of the problems. Which means if you focus on the top 20 percent of problems you get maximum impact.
Simply put, before jumping on the solution, you first need to identify the right problems and then focus on addressing only those problems. These are the problems which can be called as the constraints which affect the throughput of the system under investigation.
There are times when you discover multiple bottlenecks constraining the system. Then you need to measure the impact of each bottleneck and prioritise.
That’s how you find the right problem to solve. That’s the way to get the maximum bang for the buck.
Goldratt proposes the following framework to identify and address the bottlenecks in a system –
- Articulate the goal of the system i.e. how do we measure the system’s success?
- Identify the constraint. What resource is limiting the system from attaining its goal?
- Exploit the constraint to its fullest. How can we keep the constraining resource as busy as possible, exclusively on what it does best?
- How can we align all processes so they give the constraining resource everything it needs?
- Elevate the constraint. If managing the constraining resource more efficiently does not give us all the improvement we need, then how can we acquire more of the resource?
- Avoid inertia. Has the constraint moved to some other resource as a result of the previous steps? (Like it happened with traffic and flyover problem)
Before one can start working on this framework, it’s important to arrive at right definition of success. You need to know what are the measurable things which can help us determine if the goal has been achieved. Here are few things which one can measure –
Throughput: It’s the rate at which the system generates money through sales. In our example it would be the number of people that pass through the system or from our pre-defined location A to location B.
Inventory: It’s all the money that the system has invested in purchasing things which it intends to sell. This is akin to the investment that government makes for building the infrastructure for facilitating commute e.g. flyovers, broadening the roads, public transport etc.
Operational Expense: It’s all the money the system spends in order to turn inventory into throughput.
To understand it better, let’s ask this question from ourselves. What’s the goal of an organization or a business?
Is it to have motivated employees? Satisfied customers? Or better profit?
You can’t look at it as single problem. The components are connected. So the goal of an organization is actually to keep the customers satisfied, while the employees remain motivated and better profits are achieved at the same time. Any one factor kept ignored will constraint the throughput of the whole system i.e. the organization.
Here’s an example.
Statistics say that 80 percent of the businesses started this year will be out of business within 3 years and many of these businesses will be forced to close down in spite of being profitable. Why? Because they would forget that the real problem to focus on isn’t the accounting profit but the cash flow. Cash becomes an important constraint which, if ignored, causes many profitable businesses to choke and die.
Here’s an interesting insight from Prof. Sanjay Bakshi. He mentioned this of cash-rich businesses in his interview with Safal Niveshak –
Let’s say you own a business which has lot of cash on its balance sheet. What are the factors that you should think about while evaluating this situation?
Charlie Munger says that having so much cash is a “high quality problem” and that “excess cash in an advantage, not a disadvantage”. But that’s just one way to look at it and it has certain hidden assumptions.
The metaphor I like here is that of a Tijori (Hindi term for a safety locker for storing valuables). Some of your money is in a Tijori, and it is open, and you don’t have access to it but the fellow who has access to it is a crook.
What’s your money really worth? How much would you expect to fetch for your interest in that Tijori when you sell it to another person in an arms-length transaction?
Well, the owner of a “cash bargain” in a company run by crooks is the functional equivalent of the part-owner of such a Tijori.
Tijori describes the weak link in this system. Your cash’s worth depends on the integrity of the management. So the integrity of the management could become a severe bottleneck and unlocking of business value may not happen at all. A clear value trap.
Similarly, an adequate diversification is a way to protect your portfolio from getting dragged down by one stock which forms a disproportionate part of your portfolio, a bottleneck.
For example, if you have a portfolio of 10 stocks and each stock weights 10%, every time a stock increases to a size of 20% or 25% of your portfolio, you may want to sell a portion of that and rebalance it so that the initial structure, 10% for each stock, gets reinstated.
Charlie Munger, the inimitable partner of Warren Buffett, says, “To a man with hammer, everything looks like a nail.”
Charlie’s observations and conclusions are based on fundamental human nature, basic truths, and core principles from a wide range of disciplines.
Munger suggests that one shouldn’t try to solve problems with the only tool he or she possess. Get more tools. Learn mental models.
What’s a mental model?
A mental model is the representation that a person has in his mind about the object he is interacting with. It is the way the person thinks about what it is they are doing or dealing with. Mental models shape our actions as to how we act or behave in a particular situation. They define what people will pay attention to and how they approach and solve problems.
Mental models are the basic units which construct a person’s world view. So it’s very important to have the right models in your head.
How do you build these models? You don’t have to build them all on your own. A wide array of mental models already exist in form of big and important ideas in every discipline. These big ideas have been developed over past hundreds of years by influential thinkers who have done the hard work of thinking and framing the knowledge in form of these models.
All you have to do is to learn these big ideas and create a scaffolding – a latticework – where you can hang your own experiences. This way of interacting with the world is supremely efficient. It makes you a better thinker, decision maker and gives you a tremendous edge in navigating the world around you.
Paul Graham, founder of YCombinator and a very successful venture capitalist, says –
Studying things from unrelated subjects (multidisciplinary learning) is a lot like yoga for brain. You don’t actually get anywhere when you do yoga. You stand in one place and bend yourself in various shapes. But it makes you more flexible, so when you go out and do walk around, you can walk better.
So build a framework for better thinking – A latticework of mental models.
Take care and keep learning.
Wow…One of your best Anshul. No more words, just cherishing the thoughts………
Anshul Khare says
Thanks for writing this. Constraints are faced by everyone everyday everywhere. It is a very important Mental model with application in just about every aspect of business, investment and life in general as there are Constraints in anything we do…as Time is a resource constraint which is universal. This mental model can help get to better decisions and results and help achieve objectives.
Anshul Khare says
Your observation on “Time being a universal constraint” is spot on.
Lot to learn from this post and the video. Thanks Anshul.!!
Anshul Khare says
You are welcome Prashant. I too learnt something new by writing this post.
Vivek Agrawal says
Awesome post. I have been reading about mental models on farnam Street also. I am interested in this subject since I have Charlie’s almanak. Can you please suggest some good books on this subject. I have already read Peter Bevlin. Keep up the good work. Blogs like this are very important for us, Value Investors.
Anshul Khare says
Apart from PCA and Bevelin’s book, you can find a good compilation of mental models from Psychology in Rolf Dobelli’s book – The Art Of Thinking Clearly.
Varun Tyagi says
Thanks Anshul. I will surely buy and read
Excellent article and I am amazed by your lucid explanation and also the perfect examples. I just shared with my brother who works as a scientist and this is what he wrote.
“Nice article Raja, especially the examples.. the last quote is icing on the cake!
It applies to everything that we do. Interesting.”
Anshul Khare says
I am glad that a scientist liked the article. Safal Niveshak tribe is truly multidisciplinary!
Anup jhunjhunwala says
Can u suggest any books on mental models
Thanks and keep up the great work
Anshul Khare says
Poor Charlie’s Almanack and Peter Bevelin’s Seeking Wisdom are two great books to start with.
Varun Tyagi says
I am reading a wonderful book from PB – lessons from Sherlock Holmes. While reading I came across a line ” I had…come to an entirely erroneous conclusion, which shows,my dear watson, how dangerous it always is to reason from insufficient data”. If I put it in the paralance of investment – what do you think is all necessary data? Where should we stop and how can we conclude on sufficiency of data?
I personally think that adopting a different mental model is easier said than done. There is this thing of overcoming our personal beliefs and mental mindsets. Knowing is good but a little bit of doing is also needed. Might call in for flexibility as well.
Anshul Khare says
True. It’s not supposed to be easy – acquisition of worldly wisdom. It’s a life long process and it’s hard.
Knowledge precedes action but doesn’t guarantee it.