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What Operations Managers Do?

10 OM Strategy Decisions: 10 Decision Areas:


• Design of Goods & Services • service & product design
• Managing Quality • quality management
• Process Strategy • process & capacity design
• location
• Location Strategies
• layout design
• Layout Strategies
• human resources & job design
• Human Resources • supply chain management
• Supply Chain Management • inventory, MRP, and J-I-T
• Inventory Management • intermediate, short-term,
• Scheduling and project scheduling
• Maintenance • maintenance
Scope of Operations Management

 SYSTEM DESIGN – involves decisions


relating to the system capacity, geographic
locations of facilities, arrangement of
departments, layout of equipment, product or
service planning, and acquisition of
equipment.
 SYSTEM OPERATION – involves
management of personnel, inventory planning
& control, scheduling, project management,
and quality assurance
Capacity Decisions
 Most fundamental of all design decisions that operations managers must
make
 With long-term consequences for the organization
 Affect a large portion of fixed cost
 Determine if demand will be met or if facilities will be idle
 Answer basic capacity planning questions on
 What kind of capacity is needed?
 How much is needed?
 When is it needed?
 Made regularly or infrequently (governed by)
 Products/services design
 Stability of demand
 Rate of technological change in equipment
 Competitive factors
Importance of Capacity Decisions

 Real input on the ability of the organization to meet


future demands for products and services
 Effect on operating costs (attempt to balance the
costs of over- and under capacity)
 Major determinant of initial cost
 Long-term commitment of resources
 Effect on competitiveness (barrier to entry by
competition, delivery speed)
 Effect on ease of management
Defining Capacity

 Capacity – the upper limit or ceiling on the load that


an operating unit (plant, department, machine, store,
or worker) can handle
 Capacity Issues – important for all organizations and
at all levels of an organization
 important information for planning purposes :
 to quantify production capability in terms of inputs/outputs
 make other decisions or plans related to those quantities
 The term, “capacity” has different interpretations,
leading to difficulties in measuring capacity
Measuring Capacity
 Important to choose one that does NOT require
updating (ex. dollar amounts)
 Basic measure is UNITS of a product OUTPUT
 ok with single-product operations
 problems with multi-product operations (product mix will
necessitate frequent change in composite index of capacity)
 Alternative : refer capacity to AVAILABILITY of
INPUTS (e.g. no. of hospital beds, m/c hours
available, # of passenger seats)
 “No single measure of capacity will be appropriate in
every situation.” Rather the measure of capacity must
be TAILORED to the SITUATION.
Useful Definitions of Capacity
DESIGN CAPACITY – theoretical maximum
output that can be attained by a system in a given
period (achieved under ideal conditions)
EFFECTIVE CAPACITY – capacity a firm can
expect to achieve given its product mix, methods
of scheduling, m/c maintenance, standards of
quality, and so on
Effective Capacity < Design Capacity
Actual Output < Effective Capacity (due to
realities of m/c breakdowns, absenteeism,
shortages of materials, quality problems
and outside factors)
Measures of System Effectiveness

Efficiency = Actual
Output__
Effective
Actual
Utilization =
Capacity
Output_
Design
Example : Given the information below, compute the efficiency and
utilization of Capacity
the vehicle repair department:
Design capacity= 50 trucks per day
Effective capacity = 40 trucks per day
Actual output = 36 trucks per day
Solution :
Actual 36 trucks per
Efficiency = = = 90%
Output__ day_ 40 trucks
Effective per day
Actual Output_= 36 trucks per = 72%
Utilization = Capacity
Design Capacity day_ 50 trucks
Example : A bakery with 3 process lines for rolls, each
operating 7 days a week and 8 hours per day at 3
shifts. Each line is designed to process 120 rolls per
hour. The facility has an efficiency of 90% and
expected capacity is 80%. What is the anticipated
production?

Solution : Design Capacity = # of lines x # of hours x # of rolls/hr


Anticipated Production = (Design capacity) (Effective capacity)
(Efficiency)
= [(3 lines)(168 hrs)(120
(7 days/wk x 3 shifts x 8 hrs/shift)
rolls/hr/line)](0.80)(0.90) = 43,546 rolls/week
Actual Output < Effective Capacity < Design Capaci
Quality
Utilization Effective Capacity M/C Breakdowns
Training
Benefits of ↑ Utilization are realized Equipment Use
(de-bottleneck)
only when there is demand, otherwise it is
counterproductive Additional variable costs
Inventory carrying costs
Bottleneck conditions ≈ waiting times (WIP)
Determinants of Effective
Capacity
I. FACILITIES
1. Design (size and provision for expansion) 3. Layout (smooth work flow)
2. Location (labor supply, energy sources) 4. Environment (ventilation)
II. PRODUCTS or SERVICES
1. Design (more uniform output ≈ std. mat’ls & methods ≈ greater capacity)
2. Product or Service Mix (different items ≈ different output rates)
III. PROCESSES (Quantity Capabilities : obvious determinant of capacity)
(Quality Capabilities : quality ↓ = output rate ↓ due to inspection)
 HUMAN FACTORS (job content, job design, training & experience,
motivation, compensation, learning rates, absenteeism & turnover)
 OPERATIONAL FACTORS (scheduling, materials management, QA,
maintenance policies and equipment breakdowns)
 EXTERNAL FACTORS
1. Product standards 3. Unions
2. Safety Regulations 4. Pollution control standards
INADEQUATE PLANNING = major limiting determinant of effective capacity
Determining Capacity Requirements

 Capacity Planning Decisions involve


 Long-term considerations (relate to overall level of capacity, e.g.

size)
 Short-term considerations (relate to probable variations in capacity

requirements due to demand fluctuations)


 Link between Marketing and Operations is crucial to a realistic
determination of capacity requirements
 Long-Term Capacity : more on cycles and trends

 Short-Term Capacity : concerned more with seasonal variations or

variations from an average (yearly, monthly, weekly, daily


fluctuations)
 Forecasting Capacity Requirements
 1st phase : future demand is forecast with traditional methods

 2nd phase : forecast is used to determine capacity requirements


Planning for Capacity Addition
Once the rated capacity has been forecast, the next step is to determine the
incremental size of each addition to capacity. There are 3 approaches, namely
(1) one that leads demand, (2) one that lags demand, and (3) an average.

(a) Leading demand with (b) Leading demand with a


an one-step expansion
incremental
New Capacity
expansion New
Demand

Expected Demand
Capacity Expected

Demand
Demand

1 2 3 Time (years) 1 2 3 Time (years)


(d) Attempts to have an average
(c) Capacity lags demand
capacity with incremental
with
expansion
incremental expansion
New New
Capacity Capacity
Expected
Expected
Demand

Demand
Demand
Demand

1 2 3 Time (years) 1 2 3 Time (years)


Managing Demand
Even with good forecasting and facilities built into that forecast,there
may be a poor match between actual demand and available capacity

 Demand Exceeds Capacity When demand exceeds capacity, the


firm may be able to curtail demand by raising prices, scheduling long lead
times, and discouraging marginally profitable business.
 Capacity Exceeds Demand When capacity exceeds demand, the
firm may stimulate demand through price reductions or aggressive
marketing, or accommodate product changes.
 Adjusting to Seasonal Demands A seasonal or cyclical
pattern of demand is another capacity challenge wherein management may
find it helpful to offer products with complementary demand patterns.
Tactics for Matching Capacity to Demand
• Making staffing changes (increase/decrease in no. of employees)
• Adjusting equipment and processes (adding a machine/selling
equipment)
• Improving methods to increase throughput
Developing Capacity Alternatives

 Design flexibility into systems (e.g. provision for future expansion)


 Differentiate between new and mature products or
services
Mature Products ⇒ predictable demand ⇒ capacity requirements
⇒ limited life spans ⇒ find alt. use for additional capacity
New Products ⇒ higher risk in predicting quantity and duration of demand
 Take a “big picture” approach to capacity changes (important
to consider how parts of the system interrelate)
 Prepare to deal with capacity “chunks” (capacity increases are often
acquired in fairly large chunks rather than smooth increments, e.g. required = 55 units/hr
but machine is rated at 40 units/hr)
 Attempt to smooth out capacity requirements
Seasonality Issues ⇒ under/over utilization ⇒ overtime, subcontracting, hedging
7. Identify the optimal operating level
Choice of Capacity ⇔ availability of financial & other resources
Planning Service Capacity
3 Important Factors:
2) Need to be near customers
Convenience – important aspect of service (e.g. hotels)
Capacity & Location – are closely tied
3) Inability to store services
Timing of Demand – must be matched by capacity
Speed of Delivery – major concern in capacity planning
Service Level – brings into issue the cost of maintaining capacity
4) Degree of volatility of demand
Number of individual customers (ex. Banks experiencing days w/
Time to service each customer higher volume of transactions &
varying nature of transactions)
(Peak Periods – extra workers, outsourcing, pricing & promotion)
Evaluating Capacity Alternatives

 Economic Considerations
Feasibility – payback, useful life
Costs – financing, operations & maintenance
Timing – how soon available
Compatibility with present operations & people
 Public Opinion
Environmental concern, relocation issue, technology upgrade
repercussions such as termination of jobs
 Capacity Evaluation Techniques
 Financial Analysis
 Decision Theory
 Waiting-Line Analysis
 Cost-Volume Analysis
Financial Analysis
 Need to rank investment proposals via F.A. due to
problem of allocating scarce funds
 3 most commonly used methods
 Payback = initial cost ÷ net cash flow
 Present Value = time value of money
 Internal Rate of Return = equivalent interest rate
 2 important terms in financial analysis
 CASH FLOW - refers to the difference between cash
received (from sales and from other sources like sales of
old equipment) and cash outflow for labor, materials,etc.
 PRESENT VALUE – expresses in current value the
sum of all future cash flows of an investment proposal
Net Present Value
A means of determining the discounted value of a
series of future cash receipts
 Consider the time value of money: say investing $100 in a
bank at 5% for 1 year:
$105 = $100(1 + .05)
For the second year:
$110.25 = $105(1 + .05) = $100(1 + .05)2
F
In general, F = P ( 1 + i )N ⇒ P = = FX
(1+i) N

where X = a factor from PV of $1 Table defined as 1/( 1+ i )N


 In situations of where an investment generates an annual
series of uniform and equal cash amounts (called annuity)
The basic relationship is S = RX , where
X = factor from PV of an Annuity of $1 Table
S = present value of a series of uniform annual receipts
R = receipts every year for the life of the investment (the annuity)
Present Value Method
Example No. 1
Your boss, Mr. La Forge, has told you to evaluate the cost of two
machines. After some questioning, you are assured that they have the
following costs. Assume:
 the life of each machine is 3 years, and
 the company thinks it knows how to make 14% on investments no
riskier than this one.
Machine A Machine B
Original cost $ 13,000 $ 20,000

Labor cost per year 2,000 3,000


Floor space per year 500 600
Energy (electricity) per year 1,000 900
Maintenance per year 2,500 500
Total annual cost $ 6,000 $ 5,000
====== ======
Salvage value $2,000 $7,000
Present Value Method
Example No.1 ….con’t
Solution : Determine via the present value method which machine to purchase.

From PV Machine A Machine B


Table of $1 Given P V Given P V
Now Expense 1.000 $13,000 $13,000 $20,000 $20,000
Yr. 1 Expense .877 6,000 5,262 5,000 4,385
Yr. 2 Expense .769 6,000 4,614 5,000 3,845
Yr. 3 Expense .675 6,000 4,050 5,000 3,375
Salvage $26,926 $31,605
Yr.3 Revenue .675 $2,000 -$ 1,350 $7,000 -$ 4,725
$25,576
↵ $26,880
====== ======
Machine A is the low-cost purchase since it has the lower sum of
Present Value Method
Example No.2
Quality Plastics, Inc. is considering two different investment alternatives.
Investment A has an initial cost of $25,000, and investment B has an initial
cost of $26,000. Both investments have a useful life of 4 years. The cash
flows for these investments are shown below. The cost of capital or the
interest rate (i) is 8%.
Present Investment A’s Investment B’s PV of a $1
Year Value Factor Cash Flow PV’s Cash Flow Annuity
PV’s
at 8%
1 .926 $ 10,000 $ 9,260 $ 9,000 $ 8,834
2 .857 9,000 7,713 9,000 $7,713
9,000
3 .794 8,000 6,352 9,000 7,146
x
4 .735 7,000 5,145 9,000 6,615
Totals $28,470 3.312
$29,808
Minus initial investment - 25,000 - 26,000
Net present value $ 3,470 $ 3,808
Based on the NPV criterion, MORE ATTRACTIVE ↑
Decision Theory and
Waiting-Line Analysis
 Decision Theory is helpful for financial comparison of
alternatives under conditions of risk or uncertainty;
applying decision trees to capacity decisions that
maximize the expected value of the alternatives arising
from states of nature (usually future demand or market
favorability) that are assigned probabilities
 Waiting-Line Analysis is often used for designing
service systems and helpful in choosing a capacity
level that is cost-effective through balancing the cost
of having customers wait with the cost of providing
additional capacity; also aids in the determination of
expected costs for various levels of service capacity
Decision Tree
Example

Southern Hospital Supplies, a company that makes hospital gowns, is


considering capacity expansion. Its major alternatives are to do nothing,
build a small plant, build a medium plant, or build a large plant. The new
facility would produce a new type of gown, and currently the potential or
marketability for this product is unknown. If a large plant is built and a
favorable market exists, a profit of $100,000 could be realized. An
unfavorable market would yield a $90,000 loss. However, a medium plant
would earn a $60,000 profit with a favorable market. A $10,000 loss would
result from an unfavorable market. A small plant, on the other hand, would
return $40,000 with favorable market conditions and lose only $5,000 in an
unfavorable market. Of course, there is always the option of doing nothing.
Recent market research indicates that there is a 0.4 probability of a
favorable market, which means that there is also a 0.6 probability of an
unfavorable market. Which alternative is more attractive for Southern?
Decision Tree
Solution: The alternative that will result in the highest
expected monetary value (EMV) can be selected.

-$ 14,000 Market favorable (.4)


$100,000

n t
pl a Market unfavorable (.6) -$ 90,000
r ge +$ 18,000
La Market favorable (.4) $ 60,000
? Medium plant
Sm
all Market unfavorable (.6)
pla -$ 10,000
nt
+$ 13,000 Market favorable (.4)
$ 40,000
Do
no
th

Market unfavorable (.6)


in

-$ 5,000
g

$0
Calculating Processing Requirements

 When evaluating capacity alternatives, a necessary piece of information is the


capacity requirements of products that will be processed with a given alternative.
 Required for computation:
 demand forecasts for each product
 standard processing time per unit of each product on each alternative machine
 number of work days per year
 Number of shifts that will be used

Example: A department store works one eight-hour shift, 250 days a year, and has
these figures for usage of a machine that is currently being considered:
Annual Standard Processing Processing Time
Product Demand Time per Unit (Hour) Needed (Hour)
#1 400 5.0 2,000
#2 300 8.0 2,400
#3 700 2.0 1,400
Annual capacity 5,800 =
------- 2.90
= 1 m/c working 8 hrs/shift x 1 shift/day x 250 days/yr = 2,000 machines
Calculating Processing Requirements
Example No. 2
A manager must decide which type of machine to buy, A, B, or C.
Machine costs are: Machine Cost
A $40,000
B $30,000
C $80,000
Product forecasts & processing times on the machines are as follows:
Annual Processing Time (Minutes) per Unit
Product Demand A B C
1 16,000 3 4 2
2 12,000 4 4 3
3 6,000 5 6 4
4 30,000 2 2 1
Assume that only purchasing costs are being considered. Which machine would
have the lowest total cost, and how many of that machine would be needed?
Machines operate 10 hours a day, 250 days a year.
Calculating Processing Requirements
Solution to Example No. 2

Calculate demand in total number of processing minutes per product on


each machine:
Buy 2 machines of B
Product A B C
1 48,000 64,000 32,000
2 48,000 48,000 36,000
3 30,000 36,000 24,000
4 60,000 60,000 30,000
Total Minutes 186,000 208,000 122,000
÷ 60 (in Hours) 3,100 3,467 2,033
÷ annual capacity = 10 hours / day x 250 days / yr = 2,500
No. of Machines 1.24 ≈ 2 1.39 ≈ 2 0.81 ≈ 1
Purchase Cost $80,000 $60,000 $80,000
=======
Cost – Volume Analysis
 Focuses on relationships between COST, REVENUE and VOLUME of
output
 Purpose is to estimate income of an organization under different
operating conditions
 Tool for comparing alternatives under the following ASSUMPTIONS:
1) One product is involved.
2) Everything produced can be sold.
3) The variable cost per unit is the same regardless of volume.
4) Fixed costs do not change with volume changes, or they are step
changes
5) The revenue per unit is the same regardless of volume
6) Revenue per unit exceeds variable cost per unit.
 Provides a conceptual framework for integrating cost, revenue and profit
estimates into CAPACITY DECISIONS
Cost – Volume Analysis
 Fixed Costs – constant, regardless of volume of output (e..g. rental, taxes,
administrative expenses)
 Variable Costs – change directly with volume of output (generally materials
and labor costs); assumes that variable cost per unit (ν ) remains the same
regardless of volume of output (Q )
 Total Cost = Fixed Costs + Variable Costs or TC = FC + VC , where
variable cost, VC = Q x ν
 Total Revenue , TR = Q x SP , where SP = selling price per unit
or TR = Q x R , where R = revenue per unit
 Profit is P = TR – TC
= (Q x SP ) - [ FC + (Q x ν ) ]
P = Q ( SP - ν ) - FC
 required volume to Q = P + FC
generate a specified profit SP - ν
Break – Even Analysis
 Objective : To find the point, in dollars and units, at which
costs equal revenues. TR
 Graphic Approach $ Break-Even Point f it TC
Pro
TR = TC
VC
$ BEP$
VC
i dor
FC Corr
s s
Lo FC
Volume BEPQ
 Algebraic Approach Volume

At BEP, TR = TC Break - even in units , BEPQ = F


Q x SP = F + (Q x ν ) SP - ν
Break – even in dollars, BEP$ = F
1- ν / SP
Break – Even Analysis
Example No. 1 Single-Product Case

Jimmy Stephens, Inc. has fixed costs of $10,000 this period.


Direct labor is $1.50 per unit and material is $0.75 per unit.
The selling price is $4.00 per unit. Determine the break-
even point in dollars and units.

Solution:
ν = DL + material = 1.50 + .75 = $2.25

BEP$ = F = $10,000 = $22,857.14


1 - 1 - (2.25 /
ν / SP =
BEP F 4.00) = $10,000
Q = 5,714 units
SP - ν 4.00 -
Break – Even Analysis
Example No. 2 Single-Product Case

The owner of Old Fashioned Berry Pies, S. Simon, is contemplating


adding a new machine line of pies, which will require leasing new
equipment for a monthly payment of $6,000. Variable costs would be
$2 per pie, and pies would retail for $7 each.
a. How many pies must be sold in order to break even?
b. What would the profit (loss) be if 1,000 pies are made and sold
in a month?
c. How many pies must be sold to realize a profit of $4,000?
Solution:
a) BEPQ = FC = $6,000 = 1,200 pies / month
SP - ν $7 - $2
a) At Q = 1,000 pies, P = Q ( SP - ν ) - FC
= 1000($7 – $2) - $6,000 = -$ 1,000 (loss)
c) To make a profit (P) of $4,000 , Q = P + FC = 4,000 + 6,000 = 2,000
SP - ν 7 -2 pies
Break – Even Analysis
Example No. 3 Step Costs / Multiple B-E Points

A manager has the option of purchasing one, two, or three machines. Fixed
costs and potential volume are as follows:
Number of Total Annual Corresponding
Machines Fixed Costs Range of Output
1 $ 9,600 0 to 300
2 15,000 301 to 600
3 20,000 601 to 900
Variable cost is $10 per unit, and revenue is $40 per unit.
a) Determine the break-even point for each range.
b) If projected annual demand is between 580 and 660 units, how many
machines should the manager purchase?
Solution: Compute B-E for each range and compare with projected range of demand.
BEPQ(1 m/c) = FC / (R - ν ) = $9,600 / $ (40 –10)/unit = 320 units
[ not in the range, so there is no BEP ]
BEPQ(2 m/c) = $15,000 / $(40 – 10)/unit = 500 units [∴ Buy 2 machines ]
BEPQ(3 m/c) = $20,000 / $(40 – 10)/unit = 667 units [ not in the range ≈ loss ]
Break – Even Analysis
Example No. 4 Multi-Product Case

 Firms offering a variety of products that have different selling prices and variable
costs, the break-even point is
where, BEP$ = F
V = variable cost per unit ∑ [ ( 1 – Vi / Pi ) x
P = price per unit (Wi) ]
F = fixed cost
W = percent each product is of total dollar sales
i = each product
 Illustration: Information for Le Bistro, a French-style deli, follows. Fixed costs
are $3,500 per month. Annual Forecasted
Item Price Cost Sales Units
Sandwich $2.95 $1.25 7,000
Soft drink .80 .30 7,000
Baked potato 1.55 .47 5,000
Tea .75 .25 5,000
Salad bar 2.85 1.00 3,000
Break – Even Analysis
Example No. 4 Multi-Product Case (con’t)
Solution :
Annual [1-(V/P)]xW=
Selling Variable Forecasted Wi = Weighted
Item (i) Price (P) Cost (V) (V / P) 1 - (V/P) Sales ($) % of Sales Contribution
SW $2.95 $1.25 .42 .58 $ 20,650 .446 .259
SD .80 .30 .38 .62 5,600 .121 .075
BP 1.55 .47 .30 .70 7,750 .167 .117
T .75 .25 .33 .67 3,750 .081 .054
SB 2.85 1.00 .35 .65 8,550 .185 .120
$46,300 1.000 .625
BEP$ = F = $3,500/mo. X 12 mos. = $67,200
∑ [ ( 1 – Vi / Pi ) x (Wi) ] .625
If there are 52 weeks at 6 work days each, determine (a) the total daily sales to
break even, and (b) the number of sandwiches that must be sold each day.
(a) BEP$ (daily) = $67,200 = $215.38 (b) No. of = .446 x $215.38 = 32.5 or
Sandwiches $2.95 33 each day
312 days