OPERATIONS MANAGEMENT
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Operations Management
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OPERATIONS MANAGEMENT NATURE AND CONTEXT OF OPERATIONS MANAGEMENT......................................................... 4 Production and Operations Management........................................................................................... 4 Benefits of Efficient Production Management................................................................................ 6 Types of Operations........................................................................................................................... 6 Differences between Service and Manufacturing Operations ..................................................... 9 Key Aspects of Operations Management Decision-Making ...................................................... 10 Production and Inventory Strategies ............................................................................................. 11 Globalization of Operations and its Implications ......................................................................... 12 Service Management........................................................................................................................... 13 Service Standards, Plans, and Controls....................................................................................... 14 Service Scheduling .......................................................................................................................... 16 Quality Management............................................................................................................................ 16 Costs of Quality ................................................................................................................................ 18 Quality Control and Quality Assurance ......................................................................................... 21 Total Quality Management.............................................................................................................. 25 Quality Measurement Systems ...................................................................................................... 28 Quality Awards.................................................................................................................................. 30 DESIGN OF PRODUCTION SYSTEMS .............................................................................................. 31 Product and Service Design ............................................................................................................... 31 Production Process Design ................................................................................................................ 31 Strategic Capacity Planning ............................................................................................................... 35 Strategies and Importance of Capacity Decisions ...................................................................... 35 Design Capacity and Effective Capacity Measures .................................................................... 36 Strategic Capacity Planning and Outsourcing Decisions........................................................... 37 PLANNING AND CONTROLLING THE SYSTEM .............................................................................. 39 Supply Chain Management ................................................................................................................ 39 Components and Objectives of Supply Chain Management..................................................... 39 Supply Chain Activities and Processes ........................................................................................ 40 The Strategic Importance of the Supply Chain............................................................................ 41 The Role of Information Technology in Supply Chain Management........................................ 41 © 2011 Certified Management Accountants of Ontario. All rights reserved.
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Types of Supplier Relationships .................................................................................................... 42 Outsourcing and Offshoring............................................................................................................ 42 Quality Problems .............................................................................................................................. 43 Measuring Supply Chain Performance ......................................................................................... 43 Factors Influencing the Supply Chain ............................................................................................... 44 Project Management............................................................................................................................ 45 Project Plan Elements ..................................................................................................................... 45 Project Team and Responsibility Assignment ............................................................................. 46 Project Life Cycle ............................................................................................................................. 46 Project Planning Tools: Gantt Charts, PERT, and CPM ............................................................ 47 Project Budgetary Control............................................................................................................... 54 Resource Planning, Materials Management, and Purchasing ...................................................... 55 Enterprise Resource Planning (ERP)............................................................................................ 55 Material Requirements Planning (MRP) ....................................................................................... 55 Capacity Requirements Planning (CRP) ...................................................................................... 57 Managing Inventory ............................................................................................................................. 58 The Nature and Importance of Inventory...................................................................................... 58 The Costs of Inventory .................................................................................................................... 59 Inventory Control Systems: Periodic, Perpetual/Continuous, and ABC .................................. 59 Models and Systems for Managing Inventories .............................................................................. 63 Lean (Just-in-Time) Systems.............................................................................................................. 68 Goals and Benefits of JIT Systems ............................................................................................... 68 Key Elements of Just-in-Time Systems ........................................................................................ 70 Business Process Re-engineering .................................................................................................... 74 Benefits and Potential Problems of Re-Engineering .................................................................. 74 Activity-Based Management........................................................................................................... 75 BIBLIOGRAPHY OF TEXTBOOKS....................................................................................................... 78
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NATURE AND CONTEXT OF OPERATIONS MANAGEMENT Production and Operations Management Virtually any act of consumption, from the purchase of a burger and fries to the purchase and servicing of a new car, is made possible by the productive capabilities and talents of individuals or teams who invent, organize, and facilitate processes that bring about value-added products and services to satisfy needs. Organizations of all sizes and types employ processes to deliver on the promises they make to customers and other stakeholders such as suppliers and distributors. Operations Management (OM) is a business function that plans, designs, organizes, coordinates, controls, and improves production systems: it transforms inputs into outputs of greater value. Thus, operations management involves the management of:
Inputs, such as raw materials, supplies, employee skills and intellectual capital, facilities, equipment, and monetary capital. Transformation or production processes, such as a manufacturing process or a service process. Outputs, in the form of finished goods and/or completed services.
Operations management systems are also defined in terms of the environment and the mechanisms used for monitoring and control. Figure 1 illustrates a production system with the interrelationships among its components.1
1
Scott M. Shafer and Jack R. Meredith, Introducing Operations Management, (New Jersey: John Wiley & Sons, Inc., 2003), p. 5.
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Figure 1 – Operations Production System
The environment often provides the opportunities and limitations (e.g., government regulation of labour standards) and product characteristics (as reflected in consumer tastes and technological achievements). The monitoring and control functions provide a basis for comparing the system’s performance with the company’s customer-focused strategic goals and objectives. Thus, the objective of OM is to produce the desired product or service using identified methods with optimal utilization of available resources. Simply put, an effective OM system delivers the right goods in the right quantity of the right quality to the right place and at the right price to the right customers. For example, at a plant, it is the transformation of raw materials into iPhones or cars; at an airline, it is the efficient and safe transportation of people and luggage between destinations; at a university, it is organizing the educational environment and resources such as professors and staff to help students attain knowledge; for an accountant, it is performing audits or preparing tax returns.
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Benefits of Efficient Production Management The organization’s various stakeholders and society at large may benefit from efficient production management in the following ways:
Consumers benefit from better productivity and improved product value. Employees receive adequate earnings, improved working conditions, continuous education, and more job security, as well as greater personal and professional satisfaction. Suppliers gain management’s trust with improved forecasts and by ensuring fewer delays in payment and errors in deliveries. Investors receive improved investment security with appropriate market returns. The community receives economic gains and an improved standard of living. The nation may be more prosperous because of increased productivity and a healthy industrial atmosphere.
Types of Operations All transformational processes may be classified using three main categories: intermittent operations, continuous processes, and projects. Intermittent Operations Intermittent operations are used to produce, usually in low volumes, various products that have different processing requirements (e.g., a health care facility, a hair salon, or a small bakery). Resources are usually grouped by function. Workers direct the product through each function and work on it using each resource group as needed (e.g., in an auto repair shop, the car might be moved from computer diagnostics to transmission to brakes to lube-oil-filter). This type of operation requires a skilled workforce and worker discretion, with a small degree of automation. Intermittent operations can be further divided into batch processes and job shop processes. A batch process is designed to produce small or moderate quantities of goods or services. Movie theatres (small groups of people), airlines (groups of passengers), and small corner bakeries are all examples of such operations. Relatively high employee skills are needed for production. A job shop is a small-scale operation intended for a low-volume and high-variety of customized goods or services that have relatively similar processing requirements (e.g., a tool and die shop). These kinds of operations are characterized by skilled workers and flexibility of equipment.
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Repetitive Operations Repetitive operations are designed to produce one or a few standardized products, usually in high volume (e.g., assembly line, commodities extraction and processing, electricity delivery). These capital-intensive, “mass-production” operations tend to organize resources in a line to achieve high efficiency, especially due to the homogeneous or uniform nature of the product. Automation and technological advancement are usually the source of efficiencies and higher productivity.2 Repetitive operations are usually classified into line or assembly processes and continuous processes. Line processes are better suited for production of higher volumes of standardized goods and services with slight flexibility of equipment and relatively low-skilled workers. Examples include cafeteria food services and car manufacturing assembly lines. Continuous processes are common in commodities extraction industries, such as oil refineries, coal mining, and water treatment operations. They are characterized by low equipment flexibility, lack of variety in output, and low skilled labour. Projects The third main process type, the project process, is defined as a large job that is a flexible, non-routine operation with specific deadlines (e.g., dam or aircraft building, consulting projects, or movie production). Table 1 illustrates the distinctions among the various types of processes on a number of dimensions.3
2
R. Dan Reid and Nada R. Sanders, Operations Management: An Integrated Approach, Third Edition, (New Jersey: John Wiley & Sons, Inc., 2007), p. 65. 3
William J. Stevenson and Mehran Hojati, Operations Management, Second Canadian Edition, (Toronto: McGraw‐ Hill‐Ryerson Ltd., 2003), pp. 217‐218.
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Table 1 – Characteristics of Types of Operations Project Type of product
Unique
Type of customer
One at a time
Product demand
Infrequent Project
Batch
Mass / Assembly
Made-to-order
Made-to-stock
Commodity
Mass market
Mass market
Stable
Very stable
Job Shop Made-to-order (customized) A few individual customers Fluctuates
A few individual customers Fluctuates
Job Shop
Batch
Mass / Assembly
Number of different products
Infinite variety
Numerous, varied
Numerous, varied
A few
Primary type of work
Specialized contracts
Fabrication
Fabrication
Assembly
Equipment
Varied
Generalpurpose
Specialpurpose
Worker skills
Experts, craftspeople
Wide range of skills
Generalpurpose Significant range of skills
Custom work, latest technology
Flexibility, quality
Flexibility, quality
Efficiency, speed, low cost
Non-repetitive, small customer base, expensive
Costly (per unit), slow, difficult to manage, plan and schedule
Costly, slow, difficult to manage, moderate scheduling complexity
Large capital investment, lack of responsiveness, high cost of downtime
Cost estimation
Complex
Difficult
Variable costs
High
High
Fixed costs
Varied
Very high
Advantages
Disadvantages
Moderate, somewhat routine
Limited range of skills
Continuous
Continuous Very few
Mixing, treating, refining Highlyautomated Equipment monitors Highly efficient, low cost, easy to control, large capacity Difficult to change, farreaching errors, limited variety, very high cost of downtime
Routine
Routine
Moderate
Low
Very low
Moderate
High
Very high
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Operations Management
Differences between Service and Manufacturing Operations Organizations are usually classified as either manufacturing or service organizations. Manufacturing organizations produce physical, tangible goods that can be stored and inventoried before sale or further processing. Service organizations, on the other hand, offer bundles of benefits in the form of acts, processes, or performances.4 Services possess five characteristics: 1. Intangibility – inability to be seen, touched, heard, tasted, or smelled before purchase. 2. Perishability – inability to be inventoried or stored. 3. Inseparability – production and consumption occur simultaneously. 4. Variability or amorphousness – process and outcome vary due to customer characteristics; i.e., the same style of haircut looks different on two people given the shapes of their faces. 5. Customer participation – customers are directly involved in the process of turning inputs into outputs. Manufacturing and service organizations, thus, possess rather distinct characteristics. Krajewski, Ritzman, and Malhotra5 provide an excellent comparative illustration of their differences in Figure 2. Figure 2 – Continuum of Characteristics of Manufacturing and Service Operations
4
Audrey Gilmore, Services Marketing and Management, (London: Sage Publications, 2003).
5
Lee J. Krajewski, Larry P. Ritzman, and Manoj K. Malhotra, Operations Management: Processes and Supply Chains, Ninth Edition, (New Jersey: Prentice Hall, 2010), p. 6.
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Services may contain both tangible and intangible elements. These differences are not always clear-cut: most manufacturers provide services with their tangible goods (e.g., warranty service or maintenance), and even pure service companies have tangible “back room” components (e.g., kitchen production elements in a fast-food restaurant). Key Aspects of Operations Management Decision-Making Now that the different types of operations have been explored, this section describes some of the most important decisions that are part of OM. OM decision-making flows out of the mission and goals of the organization. In a generic sense, strategies are plans for achieving goals. OM strategies, in particular, deal with the operational areas of the organization and encompass decisions about products, processes, methods, operating resources, quality, costs, capacity, facility layout and location, lead times, scheduling, and forecasting. OM strategies lead to the formation of operational tactics—specific methods and actions used to accomplish strategies—that guide and direct managers’ efforts in daily operations. In order to set viable goals and implement strategies and tactics, managers must recognize the organization’s core competencies, such as skilled employees, flexible manufacturing facilities, excellent service, fast delivery, high quality, access to unique resources such as raw materials, etc. Companies may use these core competencies to strategically position themselves to compete in the marketplace based on cost, time, quality, and flexibility. Cost Competing based on cost suggests providing an economic value at a price lower than that of competitors. This strategy requires cost-cutting in labour, materials, processes, and facilities by reducing waste and operational inefficiencies. This strategy can result in higher profit margins but does not necessarily mean lower quality. Time Time-based strategies attempt to reduce the time needed to accomplish various tasks in order to achieve higher productivity and quality, improved customer service, and shorter introduction times for new products. Companies often compete on rapid delivery (how quickly an order is received) or on-time delivery (how often deliveries are on time, e.g., FedEx).6 Quality Competition based on quality often relies on minimizing defect rates or conforming to design specifications for goods and services. Organizations that compete on this 6
Reid and Sanders, p. 38.
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dimension put customer satisfaction as their top priority and often adopt a “do it right the first time” philosophy (e.g., the legendary service quality of Ritz-Carlton hotels). Flexibility Today’s dynamic business environment, along with rapidly changing customer expectations, forces many companies to focus on designing flexible systems to provide a variety of quickly customizable goods and services and to produce them in small quantities on demand (e.g., a cabinet manufacturer that offers a variety of cupboard styles, finishes, and colours). This strategy may be associated with higher costs and greater demands on the production system. The organization tries to balance unique customer needs with its productive capabilities (e.g., some restaurants permit customers to order off-menu items). It is important to keep in mind trade-offs between different priorities, such as cost and time, or cost and quality. As well, managers may have to make sacrifices in one or more of the organization’s competitive priorities to stay true to the institution’s mission. Production and Inventory Strategies Operations strategies may also be classified based on (1) the amount of product processing required after receiving customer orders and (2) the capacity to store inventory. There are three such strategies: make-to-stock (MTS), make-to-order (MTO), and assemble-to-order (ATO). Table 2 shows the spectrum of these strategies and highlights their features and differences. Table 2 – Production Strategies Spectrum Make-to-stock (MTS)
Assemble-to-order (ATO)
Make-to-order (MTO)
Produces product and stores inventory until receiving customer order
Produces standardized modules in advance and assembles a package after receiving customer order
Starts working on production only upon receipt of customer order
Goods are shipped to distributors or directly to customers
Goods are shipped to distributors or directly to customers
Custom-made goods are shipped according to customer requests
Relies heavily on demand forecasting
Relies less on demand forecasts
Creates additional wait time for customer
Generic output
Standardized options
Customized output / more flexibility
Line and continuous processes
Assembly line
Job or small-batch processes, specialized equipment
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Some operations may incorporate elements of all three strategies. For example, a sandwich shop may assemble and stock the refrigerator with a variety of sandwiches and wraps before the lunch rush for busy clientele (make-to-stock). It might also use previously prepared ingredients to assemble sandwiches in response to special requests from customers who are willing to wait (assemble-to-order). Alternatively, a “party-sub” may require baking a custom-made three-foot long loaf of bread and covering it with unique ingredients requested by the customer (make-to-order). Globalization of Operations and its Implications Globalization, the shift toward a more integrated and interdependent world economy,7 is a powerful force. Organizations operate on the world stage by producing in foreign countries, trading in foreign markets, purchasing from international suppliers, and serving customers with diverse cultural backgrounds. Globalization is driven by declining economic and political barriers (in part due to the fall of the Communist Block), technological advancements, intermodal transportation infrastructure (e.g., containerization accommodates transportation by ship, railway, and trucks), and global mobility of the workforce.8 Globalization exposes companies to four types of risk: 1. Commercial risk – e.g., operational difficulties, market entry and timing, partners that do not fulfil their obligations 2. Country risk – e.g., bureaucracy, economic and political instability, corruption 3. Cross-cultural – e.g., cultural differences, decision-making styles 4. Currency risk – e.g., foreign taxation, exchange rate fluctuations, inflation The degree of risk assumed depends, in part, on the chosen global operations strategy. Heizer and Render identify four possibilities9: 1. International strategy – The organization uses exports and licenses to penetrate foreign markets, thus assuming a minimal level of risk but also limiting the potential for rewards (e.g., Harley Davidson, U.S. Steel). 2. Multidomestic strategy – The organization uses foreign subsidiaries, franchises, or joint ventures. It decentralizes operating decisions to each country in order to enhance responsiveness to local needs but does not achieve cost advantages (e.g., McDonald’s, The Body Shop).
8
Terrance P. Power, International Business: A Canadian Perspective, (Toronto: Nelson Education Ltd., 2008).
9
Jay Heizer and Barry Render, Operations Management, Tenth Edition, (New Jersey: Prentice Hall, 2011), pp. 46‐ 48.
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3. Global strategy – The organization centralizes operating decisions and produces standardized products to achieve economies of scale but does not respond to local needs (e.g., Texas Instruments, Caterpillar). 4. Transnational strategy – The organization combines the benefits of global economies of scale with the benefits of local responsiveness by recognizing the existence of core competencies within various operations around the globe. In other words, each operation around the world specializes in what it does best and serves the global needs of the company (e.g., Coca-Cola, Nestlé). Global operations introduce new operational challenges related to complicated international laws, complex shipping arrangements, and a diverse workforce, etc. Workforce diversity, for example, creates communication challenges and potential conflicts. Furthermore, global environmental issues such as pollution, poverty, and climate change contribute to the challenges and costs of implementing OM strategies on global scale. Managers must demonstrate respect for human rights, indigenous cultures, and the environment when designing and operating processes for competing globally. Service Management The rise of the service segment of the economy is a global phenomenon as more countries diversify their economies. For example, services employ roughly three quarters of Canadians.10 Services are “acts, deeds, performances, or relationships that produce time, place, form, or psychological utilities for consumers.”11 The service design process starts with identification of the service concept, which defines the desired customer experience and outcome, and the target market. Next, the components of the service package intended to meet performance specifications (i.e., customer requirements and outcome expectations) are determined. A service package includes:
Supporting facility – the physical place where the service provider and customer meet to have the service performed. Facilitating goods – tangible products that are purchased or consumed by the customer as part of the service provided.
10
Actual hours worked per week by industry, seasonally adjusted crack", Statistics Canada, http://www40.statcan.gc.ca/l01/cst01/labr68a‐eng.htm, retrieved on May 19, 2011. 11
Roberta S. Russell and Bernard W. Taylor, III, Operations Management: Creating Value along the Supply Chain, Sixth Edition, (New Jersey: John Wiley & Sons, Inc., 2009), p. 185.
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Explicit services – benefits that are readily observable by the senses (seeing, hearing, feeling, tasting). Implicit services – benefits that are felt by the customer emotionally or psychologically (e.g., self-esteem, recognition, accomplishment).
Performance specifications are in turn translated into design specifications that describe activities, skills, and guidelines for service performers (e.g., the number of tables allocated per restaurant server) as well as a description of facilities, location, equipment, and layout needs. Figure 3 illustrates the service design process.12 Figure 3 – Service Design Process
Service Standards, Plans, and Controls While the customer may feel confident about the quality of the service through prior experience or reputation, s/he is unable to evaluate the service prior to purchasing it. Therefore, it is important for the service provider to have in place service standards, plans, and controls to ensure that the service comes as close to the customer’s expectations as possible. 12
Russell and Taylor, p. 188.
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Service standards are more difficult to determine than are standards for products due to the intangible nature of services and their variability. Some standards can be objectively determined, such as the average length of time customers wait for the service, the average length of time to perform the service, or the average number of errors per service encounter. However, even these standards can be difficult to plan, measure, and control. For example, measuring the average number of customers served in a given period is not appropriate if the number of customer arrivals and the average length of service vary considerably. Similarly, the degree of empathy of the service provider towards the customer or the quality of the advice offered by the service provider is difficult to measure. Ultimately, control in a service setting is about matching the delivery of the service package with the promised performance. This is accomplished by the sequential control process, which covers three crucial areas: (1) setting standards, (2) comparing standards with actual performance, and (3) launching corrective action, as depicted in Figure 4. Figure 4 – Services Control Process
Establishment of standards involves describing and communicating performance expectations related to variables that reflect the company’s success (e.g., efficient operation, product quality, fast response to customer inquiries, etc.) to managers and employees (e.g., a customer’s call must be attended to within two minutes of acknowledgement). Then evaluative criteria are established to provide a means for comparing standards with actual performance. This step includes determining who will review actual results against standards, how it will be done, and the timing of these evaluations. For example, statistical quality control criteria such as means or ranges may be used to assess service quality (e.g., delivery within three to five business days). The standards may measure cost, time, quality, quantity, behaviours, attitudes, facilities, and other variables. The comparison stage allows managers to compare the actual performance with the desired standards by means of critical incident and problem reports, inspection checklists, employee interviews, status reports, personal observation, and operational audits.
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Finally, in the case of discrepancy between the standard and the actual performance, corrective action is necessary, such as a change in the number of service providers or the priority of their responsibilities. Alternatively, managers may determine that the original objectives were unattainable and make needed adjustments to the standards. Service Scheduling The unique nature of services creates numerous operational challenges, especially in scheduling. Many of these techniques will be described in later sections as they pertain to both service and production operations. This section examines scheduling for pure services (e.g., banking, universities, hospitals, and airlines). The challenge here is to appropriately schedule one or numerous input resources and to schedule employees, equipment, materials, and facilities to match as closely as possible the anticipated arrivals of customers or jobs. This requires accurate demand forecasts. The purpose is to minimize the number of customers turned away, as well as to optimize the usage of available resources and improve productivity (i.e., number of outputs per unit of input). Managers may use overtime and part-time help during busy periods as well as rely on additional leased equipment and facilities. For instance, a catering company may hire additional staff and rent extra service equipment during the busy June wedding season. Companies may also promote and offer price incentives for off-peak consumption to regulate demand (e.g., a pizzeria offering a Tuesday night special). Other demand management techniques include inventorying demand by using reservations systems (commonly used by doctors and dentists) or queuing systems such as first-come, first-served (used in banking and other call centres). For queuing systems, or waiting lines, the goal is to determine the maximum allowable wait-time per customer and to create an environment that is pleasant and efficient. Quality Management The American Society for Quality (ASQ) defines quality as a “subjective term for which each person has his or her own definition. In technical usage, quality can have two meanings: (1) The characteristics of a product or service that bear on its ability to satisfy stated or implied needs and (2) a product or service that is free of deficiencies.”13 Thus, quality is “in the eye of the beholder.” Some definitions of quality, such as fitness for use, evaluate how well the product or service performs according to its intended use. For example, both a regular and a fly13
American Society of Quality (ASQ). http://asq.org/glossary/q.html retrieved on May 19, 2011.
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fishing rod will catch fish; however, the fly-fishing rod is more suited for the intended purpose of catching a trout on a fly. Other definitions of quality, such as value for price, are based on economic or price considerations of the product with customers choosing the cheaper offer when faced with equivalent options. Psychological factors may also affect perceptions of quality, such as the environment, aesthetics, other patrons (e.g., in a restaurant), and the product or service provider’s reputation (e.g., Ralph Lauren.) It is useful to distinguish the dimensions of quality from the customer’s point of view, for both manufactured products and services. Table 3 highlights some differences.14
Dimensions of quality
Table 3 – Quality Dimensions for Goods and Services Manufactured goods
Services
Performance – basic operating characteristics, e.g., PC processor speed
Time and timeliness – customer wait time before service is provided, and its completion on time
Features – “extra” items added to the basic model, e.g., built-in camera on a laptop
Completeness – delivering the order according to the customer’s expectations
Reliability – probability of a product performing properly in expected timeframe
Courtesy – proper treatment from employees
Conformance to specifications – extent to which a product meets specified standards determined by designers
Consistency – uniform level of service provided to each customer during every service encounter
Durability – the product’s life span before replacement
Accessibility and convenience – ease of obtaining the service
Serviceability – ease, speed, and cost of repairing the product
Accuracy – service performed right every time
Aesthetics – how a product looks, sounds, feels, tastes, or smells
Responsiveness – agility to react to unusual service circumstances
Safety – probability of a customer suffering an injury or harm from the product Other subjective perceptions such as opinions of family members, brand name, advertising, etc. Customers evaluate and weigh these quality characteristics in relation to the associated costs when they compare alternatives and make purchase decisions. Therefore, managers should be mindful that the consequences of poor quality are loss of business, lower productivity, a poor company reputation, and increased liability. 14
Adapted from Russell and Taylor, p. 53.
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Costs of Quality The costs of quality are the costs incurred to prevent the production of a poor quality product or service and the costs to rectify the situation when poor quality does occur. Cost Classification There are four major categories of costs of quality: 1. Prevention costs – costs to prevent defective products or services, e.g., training, design engineering, supplier evaluations, preventive equipment maintenance, materials testing. 2. Appraisal costs – costs to detect defective products or services, e.g., inspection of parts, processes, and products; product testing. 3. Internal failure costs – costs for defects detected before products and services are delivered to customers, e.g., scrap, spoilage, rework, and downtime. 4. External failure costs – costs for defects detected after products and services are delivered to customers, e.g., handling complaints, product returns, warranty claims, product liability, loss of customers or goodwill. The first two categories together are referred to as conformance costs, and the last two categories are referred to as non-conformance costs. Cost Calculation A costs of quality report attempts to measure and report the four types of costs of quality outlined above. Some items, such as employee training or rework, are easy to measure. Other costs are difficult to quantify. For that reason, the costs in a typical cost of quality report do not include opportunity costs in the form of lost contribution margin. Poor quality can reduce contribution margin in three ways: lost sales due to customer "badwill," lost sales due to capacity squandered on spoiled or reworked units, and the need to charge lower prices. Such opportunity costs can be as large as or larger than the costs typically recorded in accounting systems. In general, a trade-off exists between conformance costs and non-conformance costs. Increasing conformance costs will result in lower non-conformance costs as fewer lowquality items are produced or received by the customer. Example 1 below illustrates how spending more money “up front” on conformance costs can reduce the overall costs of quality.
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Example 1 – Costs of Quality Report Capron Company has accumulated the following cost information related to its operations over the past two years. Develop a Cost of Quality Statement, based on the conformance (prevention and appraisal) and non-conformance (internal failure and external failure) costs for each of the two years and give the implications of your analysis.
ITEM
2005
2006
Sales
$125,000,000
$136,000,000
Final Product Inspection
105,000
45,000
Customer Complaints Line
600,000
500,000
Rework
254,000
201,000
Employee Training
50,000
560,000
Voluntary Repair Costs
560,000
480,000
Repair Costs
345,000
267,000
Raw Materials Inspection
165,000
24,000
Product Liability Insurance
10,000,000
8,000,000
Supplier Certification
5,000
357,000
Scrap
256,000
198,000
Machine Downtime
56,000
25,000
Warranty Costs
4,560,700
4,300,000
Production Sampling Costs
98,500
55,000
Process Improvement
150,000
250,000
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Solution to Capron
2005
2006
ITEM
Amount ($)
%
Amount ($)
%
Sales
125,000,000
100
136,000,000
100
Employee Training
50,000
0.04
560,000
0.41
Supplier Certification
5,000
0.00
357,000
0.26
Process Improvement
150,000
0.12
250,000
0.18
Total Prevention Costs
205,000
0.16
1,167,000
0.86
Raw Materials Inspection
165,000
0.13
24,000
0.02
Production Sampling Costs
98,500
0.08
55,000
0.04
Final Product Inspection
105,000
0.08
45,000
0.03
Total Appraisal Costs
368,500
0.29
124,000
0.09
Scrap
256,000
0.20
198,000
0.15
Repair
345,000
0.28
267,000
0.20
Rework
254,000
0.20
201,000
0.15
Machine Downtime
56,000
0.04
25,000
0.02
Total Internal Failure Costs
911,000
0.73
691,000
0.51
Warranty Costs
4,456,700
3.60
4,300,000
3.16
Voluntary Repair Costs
560,500
0.45
480,000
0.35
Customer Complaints Line
600,000
0.48
500,000
0.37
Product Liability Insurance
10,000,000
8.00
8,000,000
5.88
Total External Failure Costs
15,721,200
12.58
13,280,000
9.76
Total Quality Costs
17,205,700
13.76
15,262,000
11.22
Prevention Costs
Appraisal Costs
Internal Failure Costs
External Failure Costs
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The above calculations indicate that spending almost $1 million more upfront on prevention of poor quality results in an overall decrease in total quality costs of almost $2 million. In percentage terms, spending more on preventing poor quality in the first place reduced the overall cost of poor quality from 13.76% of product costs to 11.22%. Most companies can expect to see a similar pattern: spending more to prevent poor quality will ultimately reduce appraisal, internal failure, and external failure costs, ultimately reducing total quality costs. In general, spending more on conformance costs, either prevention or appraisal, should result in a more than commensurate reduction in non-conformance costs. Quality Control and Quality Assurance A variety of quality tools are available to help managers ensure high standards of quality. This section describes such tools and provides guidance on their application in OM. Process Flowcharts A process flowchart is a schematic diagram of the sequence of steps in a job, operation, or process. It is a visual tool that allows managers and workers to identify and solve quality problems, and to understand the interrelationship between various departments and processes related to the problem. Figure 5 illustrates a process flowchart.
Figure 5 – Process Flowchart
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Cause-and-Effect Diagrams A cause-and-effect or Ishikawa diagram, also called a “fishbone” diagram, is a graphical representation of the relationships between elements—causes and effects—of quality problems (see Figure 6).15 The “head” of the fish is the problem, such as a faulty power button on an iPod music player. The causes are represented by the “spine” and the “bones” of the diagram, such as machinery, materials, or employee actions that need correction. Figure 6 – Cause and Effect Diagram
Checklist A checklist is a list of common defects or errors and the number of their occurrences in the process. This tool allows managers to monitor the number of defects in terms of location and time, such as the number of errors per shift, employee, or machine. Figure 7 provides an illustration of a checklist for a bicycle. Figure 7 – Checklist Defect
Number of Defects
Broken chain
5
Missing mirror
3
Tear in seat
26
Poor lubrication
12
15
The cause‐and‐effect diagram is adapted and made using a trial copy of SmartDraw software , available at www.smartdraw.com.
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Control Chart Control charts graphically represent process data over time and show the upper control limit (UCL) and lower control limit (LCL) of the process under managerial control. The limits correspond to predetermined values of performance parameters (e.g., weight, height, volume, temperature, number of defective units, and percentage of defective units). The results of small samples (versus individual units) produced by a process are plotted onto a control chart to check for conformity with the predetermined limits, as shown in Figure 8. As long as the sample results remain within the LCL and UCL, the process is in control. Control charts will be discussed in more detail later. Figure 8 – Control Chart
Pareto Analysis This quality tool is based on the Pareto principle or the so-called 80/20 rule. Studies show that most defects (i.e., 80%) are due to a few causes that when eliminated may result in significant cost reductions. Managers can count the number of defects for each potential area of poor quality and present them in the Pareto chart format shown in Figure 9.
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Figure 9 – Pareto Analysis
Scatter Diagrams Scatter diagrams graphically show how two quality variables are interrelated. For example, during testing, the speed at which a car is travelling should result in a particular level of fuel consumption and represents one data point on the graph (see Figure 10). If the data points form a tight band, the car has the expected fuel efficiency. If not, there may be problems with the vehicle that cause erratic consumption of fuel. Figure 10 – Scatter Diagram
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Total Quality Management Total quality management (TQM) refers to an approach to quality improvement that permeates the entire organization, including employees, suppliers, and customers. Rather than simply trying to reduce overall quality costs by spending more money upfront on conformance costs, TQM aims to achieve zero defects. Some of the hallmarks of TQM are designing a quality product or service; ensuring that procedures and processes can deliver the promised quality the first time; ensuring continuous improvement of both products and processes by benchmarking against best practices; providing employee training and empowerment; working in teams; and using various statistical quality tools. TQM implementation in organizations varies due to, for instance, the organizational culture and the nature of the industry. However, general approaches have been developed. Figure 11 illustrates such an approach.
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Figure 11 – TQM Implementation Model
The TQM philosophy is overwhelmingly customer-centric. The end goal is satisfaction of the customer’s needs. Customer satisfaction is achieved using significant employee involvement in the production or service delivery process. This requires changes in organizational culture, such as taking ownership of checking quality at the source and using teams of empowered employees.
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Continuous Improvement – Kaizen The cornerstone of TQM is continuous improvement, which is based on a Japanese concept called kaizen. This philosophy involves identifying benchmarks of excellent practice and implementing a never-ending process of continuous improvement of people, equipment, materials, suppliers, and operational procedures and policies. Plan-Do-Check-Act (PDCA), a circular model developed by Walter Shewhart, is a popular tool that describes a four-step process of continuous improvement, as depicted in Figure 12.
Figure 12 – Plan‐Do‐Check‐Act Model
Another important quality assurance option is inspection, which involves measuring, observing, tasting, testing, and touching the product to identify the defective elements or processes. Using inspection successfully involves answering the following questions: (a) when to inspect? (e.g., at what point in the process? how often? before costly or irreversible processes?) and (b) where to inspect? (e.g., at the supplier’s plant, at the production facility, at the point of customer contact). Inspections may be combined with checklists and fail-safe devices called poka-yokes (a Japanese term), such as electronic chips installed in cotton swabs used in surgery that signal doctors to remove them before completion of the surgery, or diesel gas pump nozzles that do not fit into regular gas tanks to avoid errors in fuel consumption. © 2011 Certified Management Accountants of Ontario. All rights reserved.
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TQM in Services Applying TQM in services is more challenging because of the intangible components that play an important role in determining customer satisfaction from the service encounter. Indeed, in addition to the list of quality dimensions in Table 3, Parasuraman, Zeithaml, and Berry suggest other service quality determinants, such as reliability, competence and courtesy of service staff, credibility (trustworthiness and honesty), security (freedom from danger or doubt), and empathy,16 which are related mostly to the service process. Thus, operations managers need to design service processes in accordance with these attributes and use quality tools to ensure adherence and proper delivery. Continuous improvement of company service policies based on benchmarking is crucial for quality service delivery, as is ongoing employee training. Quality Measurement Systems Quality measurement tools were introduced to OM from the field of statistics. A statistical quality control (SQC) system consists of tools that are classified into: (1) descriptive statistics (such as mean, standard deviation, range); (2) statistical processes control (SPC), which entails examining a random sample of the output and checking its conformity with a predetermined range; and (3) acceptance sampling, which includes inspecting a sample and deciding whether to accept or reject the entire production batch.17 Quality Control Chart A quality control chart is a graph that shows shifts in the mean value of a process and is used to determine whether the sample data falls within a normal range of variation. A mean control chart (or x-bar chart) tracks changes in a process mean. A range control chart (or R-chart) tracks the range, or dispersion, within a sample. An attributes chart tracks whether the sample is defective or non-defective. P-charts measure the percent defective in a sample, whereas c-charts count the number of defects. As long as the distribution (pattern formed by the values) is within the specified limits, the process is in control, and natural variations, or expected variations that affect every production process to some degree, are tolerated. When the distribution is out of control, the cause of assignable variations must be investigated. Possible causes include equipment that requires maintenance or recalibration, faulty materials, or untrained workers. Figure 13 presents a mean control chart showing product characteristics that fall out of control, or out of the range of the acceptable quality values, and need management’s attention. 16
A. Parasuraman, Valerie A. Zeithaml, and Leonard L. Berry, “Conceptual Model of Service Quality and its Implications for Future Research,” Journal of Marketing, 1994, vol. 58, no. 1. pp. 111‐125. 17
Reid and Sanders, pp. 172‐173.
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Figure 13 – Quality Control Chart
Six Sigma Quality The six sigma quality management initiative (developed by Motorola Corporation) is based on a data-driven, methodological approach to quality control. Its mission is to eliminate defects to reach six standard deviations from the desired target of quality. Six standard deviations means 3.4 defects per million, which translates, for example, to only 3.4 pieces of mail lost with one million pieces processed correctly. A six sigma comprehensive program is designed to lower the organization’s costs, save time, and improve customer satisfaction. The five-step six sigma improvement process, often called DMAIC, is presented below: 1. Define the project’s purpose, scope, and critical outputs; identify gaps for improvement with customer’s quality definition in mind. 2. Measure the work and collect process data. 3. Analyze the data; check for reliability and duplicability of results. 4. Improve the process; modify and redesign existing procedures. 5. Control the new process to make sure new performance is maintained.18 The implementation of a six sigma program involves collaboration and teamwork across the organization, input from six sigma experts, and the use of quality control tools (such as fish-bone diagrams or scatter diagrams). 18
Heizer and Render, pp. 196‐197.
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Quality Awards Three prestigious awards recognize management efforts for integrating quality in operations: the Malcolm Baldrige Award (U.S.), the Demming Prize (Japan), and the Canada Awards for Excellence. The Baldrige Award recognizes quality achievements of U.S. companies and is intended to stimulate efforts in quality improvement as well as promotion of successful programs and best practices. The award’s mission is to “improve the competitiveness and performance of U.S. organizations.”19 Applicants are evaluated in seven areas: leadership; strategic planning; operations focus; customer focus; workforce focus; measurement, analysis, and knowledge management; and results. 20 The Demming Prize, named in honour of the late W. Edwards Demming, is typically awarded to a Japanese company for achieving high quality standards, usually with a focus on statistical quality control. The award is given to companies, business units, or individuals who champion quality. The Canada Award for Excellence is awarded by the National Quality Institute (NQI), an independent non-profit organization, to organizations that adhere to a developed set of criteria similar to those of the Baldrige Award, as shown in Figure 14.21 Figure 14 – Canadian Framework for Business Excellence
19
National Institute of Standards and Quality, http://www.nist.gov/baldrige/, retrieved on May 24, 2011.
20
National Institute of Standards and Quality, http://www.nist.gov/baldrige/publications/criteria.cfm, retrieved on May 24, 2011.
21
Canadian Framework for Business Excellence, National Quality Institute, http://nqi.ca/nqistore/product_details.aspx?ID=61, retrieved on May 24, 2011.
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DESIGN OF PRODUCTION SYSTEMS Product and Service Design Product design refers to the procedures to design or redesign a product or service to increase its market potential and/or to improve the efficiency of the processes that create it. Product design is important because the design of goods and services directly affects their marketability, cost, profitability, quality, serviceability, and ease of production. Some techniques of product and service design and development are discussed below. Concurrent engineering refers to the joint design of products and processes by individuals from various functions, such as design engineers, manufacturing specialists, marketing personnel, buyers, and quality specialists. Reverse engineering refers to dismantling and inspecting a competitor’s product to discover design ideas, product improvements, and materials and processes used. Value analysis refers to the analysis of a product/service to improve its design and reduce its cost, typically by reducing the number of parts/steps of which it consists by eliminating those that do not add value in the customer’s mind. Modular design uses parts that can be pre-assembled into modules or subassemblies. The entire module is then inserted into the final product during assembly. This reduces the number of parts that final assembly must deal with, simplifying purchasing, assembly, and handling, as well as design. Robust design refers to designing the product so that small variations in the production process or operating environment do not adversely affect the performance of the product. Quality Function Deployment (QFD) is a team-based, structured approach to product/service design that focuses on customer requirements at all stages of design and manufacturing. QFD is primarily a set of graphically oriented planning matrices used for decision-making throughout the product development process. This technique forces the design team to focus on customer requirements by beginning with a list of what product features the customer wants or expects in a product. Production Process Design A process is a series of steps that converts inputs into finished goods and services. Efficient and effective processes are crucial to meeting customer needs, maintaining a competitive advantage, and achieving organizational goals.
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An organization's process strategy refers to the overall approach of the organization to how goods and services are physically be produced. Process design (or process selection) refers to the selection of inputs, operations, work flows, and methods used in producing goods and services. Processes are directly linked to corporate strategy, product and service design, and capacity planning. For example, an organization that competes on flexibility will require a low-volume process, often with high labour involvement and less automation. Conversely, an organization that competes on efficiency will often rely on highly automated processes. As well, the design of a product must be congruent with the process that makes it. For example, products that are highly complex or highly customized may make automation of the process difficult. In turn, the complexity of a process or ability of a process to be automated will influence the maximum output, i.e., capacity, of the process. Process design also considers what steps add value for the customer and what steps do not, seeking to minimize or eliminate the latter. Another factor is the organization’s expertise and whether some steps in the production of the product or service should be outsourced to another organization.
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Process Mapping Designing production systems requires identification of the activities and resources necessary for the production/operation process. Managers use process mapping—a graphic representation of the activities of the entire process and their interrelationships—to identify the sequence of activities to be performed, their timing, and decisionmaking events. Traditionally, in process mapping (also called process flow chart) the symbols in Figure 15 are used. Figure 15 – Process Flow Chart Symbols start and end of the process activity decision point delivered product or service direction of the flow Figure 16 represents a sample process map for a restaurant, from the moment when the customer enters the restaurant to the moment the customer leaves.
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Figure 16 – Process Map for a Restaurant
A clear understanding of the depicted process helps the management team to redesign activities, develop new products, or improve quality. For example, the Integrated DEFinition (IDEF)22 method uses a hierarchical top-down approach to decompose the process elements to the desired level of detail and then uses team brainstorming sessions to continuously improve the processes. Theory of Constraints The theory of constraints (TOC) is a “systematic management approach that focuses on actively managing those constraints that impede a firm’s progress toward its goals of maximizing profits and effectively using its resources.”23 According to this theory, three kinds of constraints determine a system’s output: 1. An internal resource constraint is determined by its bottleneck, which is the longest task in the process and which limits the system’s output. 22
Stevenson and Hojati, p. 225.
23
Krajewski, Ritzman and Malhotra, p. 264.
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2. A market constraint occurs when production capacity exceeds market demand, which may result in excess inventory. 3. A policy constraint is put in place to dictate the production rate according to a company policy (e.g., no overtime, or policies related to batch-size). A five-step process has been developed to deal with such limitations:24 1. Identify the constraints or bottlenecks. 2. Develop a plan to overcome the constraint. 3. Assemble and focus resources to implement the plan (Step 2) and subordinate all other decisions to Step 2. 4. Rearrange and reschedule work or expand capacity to mitigate the effects of the constraints. 5. Proceed to Step 1 once the identified set of constraints is solved. Production system improvements based on this process can be measured financially (e.g., net profit, cash flow) and operationally (e.g., inventory, operating expenses, wait times). Strategic Capacity Planning Strategies and Importance of Capacity Decisions Capacity is the maximum rate of output of a system or a process: the number of units a facility can receive, hold, process, or produce. Capacity decisions need to match the organization’s strategic goals and meet its current and future demand. They determine the capital requirements and are often made in view of three time horizons: long, intermediate, and short. Figure 17 shows the interrelationships between those horizons.25 When making capacity decisions, the organization should also consider the predicted economic growth, market demand variability, plant operating and maintenance costs, environmental impact, technological innovation, relationships with suppliers and customers, competitors’ reactions, and the effects of globalization.
24
Heizer and Render, p. 291.
25
Adapted from Heizer and Render, p. 283.
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Figure 17 – Capacity Planning Time Horizons
Design Capacity and Effective Capacity Measures Design capacity is the maximum theoretical output or rate of output of the system under ideal conditions in a given period of time. In contrast, effective capacity is the maximum output rate that a system can sustain under normal conditions. For example, a bank teller serves 70 customers per day (effective capacity), but may end up serving 90 customers on Fridays and at month-end. System performance can be measured two ways. Utilization is the percentage of design capacity actually achieved, and efficiency is the percentage of effective capacity actually achieved. Another useful capacity measure is the capacity cushion, the amount by which the average utilization rate falls below 100% (i.e., 100% – utilization %). A cushion is added to the needed capacity to provide greater flexibility. These equations help managers and marketers to estimate outputs during periods of expansion and growth and to match them meaningfully with increased customer demand.
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Example 2 – Design Capacity Patell Toymaker produced 126,000 stuffed animals last week. The effective capacity is 138,000. The factory operates six days per week with two 8-hour shifts per day. The assembly line was designed to produce animals at a rate of 1,500 per hour. Calculate design capacity, utilization, efficiency, and capacity cushion. Design capacity = (6 days x 8 hours x 2 shifts) x (1,500 animals per hour) = 144,000 Utilization = actual output / design capacity = 126,000 / 144,000 = 87.5% Efficiency = actual output / effective capacity = 126,000 / 138,000 = 91.3% Capacity cushion = 100 – 87.5% = 12.5% This information indicates that Patell is running close to its effective capacity, at 91.3% efficiency. If demand increases by 10%, the company will be at its effective capacity. Therefore, depending on demand projections for the next year, Patell will have to add a third shift or add to its factory space. This decision-making process is discussed in more detail below, in generic terms. Strategic Capacity Planning and Outsourcing Decisions Capacity planning follows a detailed four-step procedure: 1. Identify capacity requirements, both now and in the future. When identifying capacity requirements, managers need to forecast future demand, add capacity cushions, and consider strategic goals and the mission of the organization. 2. Develop capacity alternatives that enable the company to meet its capacity needs in the future. Capacity modification options often fall into one of the following categories: (1) do nothing, (2) expand large now, and (3) expand small now, with the intent to add capacity later. 3. Evaluate capacity alternatives. One of the most commonly used tools for evaluating alternatives is a decision tree. Decision trees (see Figure 18) are graphic models of various alternatives and their consequences, often expressed in monetary terms. For example, the expected monetary value (EMV) is calculated as the product of an alternative’s monetary payout and the probability of its occurrence (e.g., the chance of high demand for the company’s product). 4. Select and implement the best alternative that meets the company’s goals. Implementation often involves an audit and comparison of actual results with the desired objectives.
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Figure 18 – Decision Tree for Plant Expansion
Capacity expansion often involves making decisions about whether to outsource some functions of the production system to external suppliers or to maintain them in-house. The outsourced functions include purchasing, research and development, logistics, finance and accounting, sales and marketing, etc. These make-or-buy decisions allow the company to appropriately allocate productive resources and attain the lowest possible cost. When making make-or-buy decisions, the total cost (TC) of buying the item is compared with the costs of making it. TCbuy = FCbuy + (VCbuy X Q) TCmake = FCmake + (VCmake X Q) where Q = quantity of items demanded FC = fixed costs VC = variable costs At what quantity do the total costs of these two alternatives equal each other? FCbuy + (VCbuy X Q) = FCmake + (VCmake X Q) The solution arrives at the indifference point, which is the number of items to buy or sell while keeping the TC equal. It is more economically attractive to the organization to outsource when TCbuy < TCmake.
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Example 3 – Make‐or‐Buy Decision Ana and Michael have decided to open a submarine sandwich shop in Hamilton. One of their first decisions is whether they should bake the buns on-site or buy them from a local supplier. If they buy from the local supplier, they will need transportation/storage containers at a fixed cost of $3,500 annually. They can buy the buns for $0.80 each. If they make the buns in-house they will need a small kitchen at a fixed cost of $52,500 annually. Making the buns in-house will cost $0.32 each. They believe they will sell 110,000 subs. Should they produce the buns in-house or outsource? FCbuy + (VCbuy X Q) = FCmake + (VCmake X Q) $3,500 + ($0.80 x Q) = $52,500 + ($0.32 x Q) Q = 102,084 subs This is the indifference point. Alternatively TCbuy @ 110,000= 91,500 vs TCmake @ 110,000 = 88,000 $3,500 + ($0.80 x 110,000) > $52,500 + ($0.32 x 110,000) $88,000 > $35,500 Since the costs are equal at 102,084 subs and Ana and Michael expect to sell 110,000 subs, they should bake the buns in-house. Of course, the decision to outsource depends on more than just cost considerations. The quality and reliability of the supplier are important, as is the flexibility to accommodate changes in demand. These qualitative considerations are discussed in more detail in the subsequent section on supply chain management.
PLANNING AND CONTROLLING THE SYSTEM Supply Chain Management Components and Objectives of Supply Chain Management A supply chain (SC) is a network of activities that allows a company to acquire raw materials, transform inputs into outputs, and deliver those outputs to its customers. The supplier network is comprised of the group of internal and external suppliers that provide goods and services to the organization. Supply chain management (SCM) is a business function that coordinates, controls, and manages SC activities and relations between suppliers, transporters, and other stakeholders to achieve a strategic advantage.
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Organizations need SCM to improve operations, control transportation costs, generate competitive advantage, resist competitive forces, improve purchasing and inventory management practices, and improve the company’s long-term prospective in the global marketplace. Effective SCM benefits include lower inventories and costs, reduced lead time, faster delivery times, and improved operational flexibility and profitability. Unexpected fluctuations in demand, supply disruptions due to supplier bankruptcies or partners going out of business, natural disasters (e.g., the earthquake and tsunami in Japan in 2011), labour and land disputes, economic and financial instability, and cyber terrorism attacks (e.g., hacking of the Sony Playstation gaming website in 2011) contribute to the complexity and costs of SCM.
Supply Chain Activities and Processes Key supply chain activities and processes are discussed below. Forecasting activities enable managers to predict the quantity and timing of consumer demand. There are both qualitative and quantitative approaches to forecasting. Qualitative methods include relying on the opinion of experts (managers), using a composite of salespersons’ estimates, and surveying consumers. Quantitative methods include time-series models, which assume that the past is a good predictor of the future, and associative or causal models, such as linear regression, which incorporate variables or factors that affect demand (e.g., weather, advertising, and competitors’ prices). Product and service design activities include matching the needs and wants of customers with operations capabilities of the organization. More will be said about this in a subsequent section. Purchasing activities include the acquisition of necessary goods and services at optimum prices from competent and reliable sources to serve customers’ needs. This process also involves the selection of suppliers. Vendor selection is a complicated process that considers many factors: price; quality; the supplier’s competence, reputation, and reliability; the availability of add-on services such as warranties and post-purchase service; location, flexibility, lead times, on-time delivery, financial security and stability, and integrity; supplier certification; and references from other users. Inventory management activities include efficient management of the flow of materials: recording and tracking the materials based on quantity and value. A separate section is devoted to inventory management later in this document. Logistics involves the movement of materials, which includes the selection of transportation modes (highway, rail, water, pipeline, air) based on trade-offs between holding costs and shipping costs.
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Warehousing activities include storage (e.g., receive, identify, and inspect goods; dispatch goods to storage), maintenance (e.g., monitor and control goods in storage), and preparation (e.g., organize and dispatch the shipment) of the inventory for the next step in the supply chain. The Strategic Importance of the Supply Chain It is important that the supply chain supports the organization’s operations management strategy, which in turn supports the organization’s overall strategy. A low-cost strategy requires different things from a supply chain than a differentiation strategy. For instance, a low-cost strategy involves the design of low-cost products, selection of low-cost suppliers, and holding of minimal levels of inventory to avoid costs. In comparison, a differentiation strategy requires more attention to design, the selection of innovative suppliers, and efforts to ensure that inventory does not become obsolete. The Role of Information Technology in Supply Chain Management Information technology has been playing an increasingly important role in SCM, including developments in the following areas:
Internet and E-commerce (both business-to-business (B2B) and business-tocustomer (B2C) forms) – refers to commercial transactions (i.e., exchange of value and payment) that take place on the Internet. Benefits include lower-cost information, 24/7 availability, reduced paper-processing costs, faster delivery, and increased flexibility of locations. Potential disadvantages include lack of system security and reliability, lack of privacy, difficulty integrating E-commerce software with existing software and databases, and lack of trust in the integrity of those on the other end and in the transaction itself. Intranets (networks that are internal to an organization) and extranets (which connect the company’s intranets to the Internet to provide access to suppliers and customers) create opportunities to reduce costs and delivery times. Electronic data interchange (EDI) – a standardized data-transmitting format that facilitates electronic communications between companies. It allows organizations to place orders, track inventory and shipment records, and perform other SCM functions. Point-of-sale (POS) systems, assisted by bar codes, electronically record and transmit sales data for use in forecasting and inventory management.
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Types of Supplier Relationships Supply chain strategies can involve different types of supplier relationships. Heizer and Render identify five different types, as discussed below.26 In a many-suppliers strategy, the organization negotiates with many suppliers, each of whom completes a request for quotation. The order usually goes to the lowest bidder. This type of supplier relationship is best suited for commodities. In a few-suppliers strategy, the goal is to develop long-term partnerships with a few dedicated suppliers who can then develop a good understanding of the needs of the buyer and its end customer. This type of supplier relationship is also typical for organizations that are using a just-in-time system or a philosophy of continuous improvement. A third type of supplier relationship is vertical integration, where the organization actually buys the supplier. Provided that the organization has the necessary capital and managerial expertise, there are often opportunities for significant cost reductions as well as improved quality and reliability. A keiretsu network uses a coalition of suppliers that provide technical expertise and stable quality production to the manufacturer in return for financial capital, in the form of ownership or loans. Virtual companies use suppliers on an as-needed basis. The relationships may be short-term or long-term, and range from subcontracting to partnerships. The advantages of this approach are low capital investment, flexibility, and access to specialized expertise. In general, supplier relationships are enhanced when there are common goals, mutual trust and respect, and compatible organizational cultures. Outsourcing and Offshoring Outsourcing refers to the transfer of activities that traditionally have been performed internally to external providers. The overall goal of outsourcing is to gain efficiencies by having these activities performed by experts, thereby allowing the organization to focus on its core competencies. Offshoring refers to the use of overseas service providers for outsourced activities. Table 4 outlines some of the more commonly considered advantages and disadvantages of outsourcing. There are also hidden costs of outsourcing, such as the costs of internal transition and retraining, and deteriorating inter-organizational 26
Heizer and Render, pp. 425‐427.
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communication. As well, there are numerous ethical challenges such as potential harm to human health or the environment, the livelihood needs of the local people, compliance with various labour laws, and human rights issues. Political and economic risks further complicate offshoring decisions. Table 4 – Advantages and Disadvantages of Outsourcing Advantages
Disadvantages
Cost savings
Loss of control
Improved operations and service
Larger transportation costs
Learning from outside expertise
Stress and negative effects on employees
Focusing on core competencies
Threat of creating future new competition
Gaining outside technology and know-how
Lack of customer focus
Operational and staff flexibility and control
Quality problems
Risk-sharing
Poor publicity and ill-will
Measuring Supply Chain Performance The Supply Chain Council has developed the SCOR (Supply Chain Operations Reference) model that identifies five SC performance dimensions: reliability, responsiveness, agility, costs, and asset management.27 Table 5 contains examples of metrics for each dimension. The goal of the SC performance system is to build and align the organization’s supply chain with its strategic goals. The model also focuses on processes, practices, and people performance. Furthermore, it incorporates the interests of the company’s customers and suppliers.
27
Source: http://supply‐chain.org/f/SCOR‐Overview‐Web.pdf, retrieved on June 1, 2011.
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Table 5 – SCOR Model Performance Measures SCOR Dimension
Performance Metric
Reliability relates to the ability to perform tasks as expected
Percentage of orders filled perfectly, percentage of on-time shipments, number of defective products
Responsiveness refers to the speed of performance
Production cycle time, order fulfilment cycle time
Agility is the ability to change and respond to external environmental factors
Flexibility in terms of order sizes, adaptability to changes in tastes or technology
SCOR Dimension
Performance Metric
Costs (labour, material, transportation, storage)
Cost per shipment, cost per warehouse delivery, cost of goods sold
Asset management
Inventory turnover, receivables turnover, return on assists
Factors Influencing the Supply Chain Numerous factors affect the supply chains of companies. Developments in information technology (i.e., the Internet, EDI) have been discussed in a previous section. Some of the internal factors that influence the supply chain are the nature of the product, the firm’s strategy (as discussed earlier), and the expertise of the organization (i.e., firms with less expertise rely more heavily on partnership relationships). In terms of external factors, the supply chain strategies of competitors, industry practices, and the product life-cycle stage must be considered (e.g., in a mature industry, backward integration may be used to achieve the necessary reductions in cost). As well, the diversity and complexity of supply chains attract new government regulation (e.g., eco-efficiency and waste reduction policies), which influence customer-company interactions on a global scale. Globalization itself is having a profound impact on supply chain efficiencies as the chains stretch geographically and managers adjust to working in different cultural environments. Furthermore, international business risks (e.g., currency exchange risk, political instability risk, inadequate infrastructure) often negatively impact supply chain decisions.
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Project Management Project Plan Elements A project is a one-time, unique set of operations or activities designed to achieve specific objectives within a specified time period (e.g., the merger of two companies, the launch of a new iPad, or the introduction of a new school curriculum). Project management, therefore, includes planning, scheduling, and controlling activities to develop and implement the project in a timely manner. Table 6 includes the basic elements of a project plan. Table 6 – Project Plan Elements
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Project Team and Responsibility Assignment The project team usually consists of individuals of different levels from various departments of the organization or invited outside experts. For example, implementation of a computer network acquisition project may involve managers, IT personnel, and end users. The team members should possess several characteristics to meaningfully participate and contribute to the project: technical competence, project-related experience, sensitivity (toward interpersonal conflicts), and commitment (to get the project done). Project team members report to the project manager. The project manager coordinates activities with other departments and reports to the top manager. The project manager assumes responsibility for the success of the project, i.e., s/he ensures that all activities are finished in the right order, on time, of the expected quality, and within budget. Thus, the project manager plays various roles, such as those of a facilitator, communicator, and decision-maker. Project-related responsibilities, albeit temporary, may sometimes deviate from a team member’s regular job and create negative consequences, such as reluctance to return to regular duties after working on an exciting project. Furthermore, global projects introduce new challenges and needs such as the need to provide cultural diversity training, to reconcile terminology differences, to note discrepancies in calendars and holiday celebrations, and to acknowledge differences in management style and practice. Project Life Cycle A project life cycle describes a five-phase sequence of activities, presented in Figure 19.
Figure 19 – Project Life Cycle
The phases can overlap, and work may continue on different stages simultaneously. In the conception phase, the project team may, for example, work on defining a new product or service as well determine the budgets and estimate the risks of undertaking the project. The feasibility stage allows team members to evaluate the technical and economic feasibility of the concept using various criteria. The planning phase consists of identification and assignment of tasks and resources as well as risk analysis and the © 2011 Certified Management Accountants of Ontario. All rights reserved.
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selection of criteria for measuring success on the deliverables. The execution phase of the life cycle usually takes the greatest amount of effort to complete and requires most of the resources. The closeout or termination phase introduces the deliverables, reassigns the involved personnel, and handles the remaining resources. Project Planning Tools: Gantt Charts, PERT, and CPM Project managers have a number of resources to assist them in managing activities in the project life cycle. Gantt Charts Gantt charts (see Figure 20) show the timeline for each project activity. These charts are useful in production and employee scheduling, new product development, or marketing campaign management. However, Gantt charts do not directly identify the precedence of the activities. Figure 20 – Gantt Chart Time in months 0
1
2
3
4
5
6
7
8
Task 1 Task 2 Task 3 Task 4 Task 5 Task 6
PERT and CPM Both program evaluation and review technique (PERT) and critical path method (CPM) show project activities as a network of precedence relationships. Thus, managers can determine the sequence of the activities and see which ones can occur independently of each another. These tools are especially useful to analyze the time needed to complete each project task and to identify the minimum time needed to complete the entire project. As originally conceived, CPM assumed that activity times were known with certainty. In contrast, PERT acknowledged uncertainty and used probabilistic time estimates of the activities—optimistic, most likely, and pessimistic. Another difference between the two techniques was that CPM made use of a dual perspective, both time and cost. The distinctions between PERT and CPM have blurred as both techniques have evolved over time. © 2011 Certified Management Accountants of Ontario. All rights reserved.
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Figure 21 presents a sample PERT/CPM chart. Each node represents an activity and the arrows show the order in which activities must be completed. In this illustration, both activities A and B must be completed before activity D can be started; activity D, in turn, has to be completed before activity F can be started. Figure 21 – Sample PERT/CPM Chart
PERT and CPM network diagrams do not explicitly consider costs and assume that sufficient resources will be available when required. Resource limitations, however, may restrict the possibility of performing two or more activities simultaneously. CPM/PERT project planning steps include: Identify the individual activities. Determine the sequence of the activities. Draw a relational diagram. Estimate the completion time for each activity (as noted above, for PERT, three estimates are made). 5. Determine the longest path through the network. This is known as the critical path since delays in the completion of activities on this path will delay the whole project. 6. Update the CPM diagram during the project’s life to schedule, monitor, and control the project. 1. 2. 3. 4.
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Working one’s way forward through the relational diagram, one can calculate the earliest start time (ES) for an activity, assuming all preceding activities are started at their earliest start time (i.e., the best-case scenario) and the earliest finish time (EF) for an activity, which is equal to ES plus the estimated time (t) for the activity. Working one’s way backward through the relational diagram, one can calculate the latest finish time (LF) for an activity (i.e., the latest it can be finished without delaying the whole project) and the latest start time for an activity (LS = LF – t). Then the amount of slack time (LF – EF) can be calculated for each activity. Activities on the critical path have no slack time. Both PERT and CPM offer these benefits:
Provide a graphical display of the project activities. Estimate the time needed to complete the project. Show the activities that are critical to maintaining the project’s schedule. Show how long a task can be delayed without delaying the entire project (known as slack time).
The following example illustrates CPM. Example 4 – CPM Example for Organizing a Soccer Tournament The activities and precedence of steps and times required to organize a soccer tournament are shown in the table below. Activity
Code
Predecessor
Time
Finalize location contract
A
-
2
Contact players
B
-
8
Plan promotion
C
A
3
Locate officials
D
C
2
Send invitations
E
C
10
Buy trophies
F
B&C
4
Finalize player contracts
G
D
4
Finalize catering contract
H
E&F
1
Set up location
I
E&G
3
Run tournament
J
H&I
2
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Questions: 1. What is the minimum time needed to organize the tournament? 2. What tasks must be completed on time in order to finish the project on time? 3. What tasks can be completed late and still allow the project to finish on time? 4. What is the earliest time a task can be started? What is the latest time a task can be completed?
Step 1: Draw the CPM Chart
CPM chart notation: ES = earliest start time EF = earliest finish time LS = latest start time LF = latest finish time TS = total slack = LF – EF = LS – ES
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Step 2: Calculate ES and EF for Each Step from the Start (Forward Pass)
Note: Activity I cannot begin before Activity E is complete. See below.
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The completed forward pass is presented below:
Step 3: Calculate LF, LS, and TS for Each Activity from J Towards the Start (Backward Pass) To begin, LF is set to EF = 20 for Task J.
Note that similar to the forward pass, for activities such as C and E, the smallest LS from the completed activities become the LF of the step involved.
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Step 4: Critical Path is the Sequence of Activities with TS = 0, A-E-C-I J.
Activity
Code
Predecessor
Time
Slack
Location contract
A
-
2
0
Contact players
B
-
8
5
Plan promotion
C
A
3
0
Code
Predecessor
Time
Slack
Locate Officials
D
C
2
4
Send Invites
E
C
10
0
Buy trophies
F
B&C
4
5
Player Contracts
G
D
4
6
Catering Contract
H
E&F
1
2
Set-up Location
I
E&G
3
0
Run tournament
J
H&I
2
0
Activity
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Answers to Questions: 1. The minimum time needed to organize the tournament is 20 days. 2. A, C, E, I, and J must be completed on time; these are critical activities, i.e., the critical path, and must be started and completed sequentially and on time. 3. B, D, F, G, and H can be finished late (see slack above), and the project will still be completed on time. For example, B (contacting players) can be delayed for up to five days without delaying the tournament. 4. The earliest start and finish times can be read from the completed CPM chart. Project Budgetary Control Project managers are not only concerned with the time required to complete a project— they are also concerned about the cost to do so. Predicting project cash flows requires these steps: 1. Estimate the cost of each work package, which is the smallest element in the work breakdown structure (WBS). A WBS is a breakdown of the project into major tasks, then minor tasks, then subtasks and, finally, work packages. 2. Use PERT/CPM to find the critical path for the project. 3. Calculate monthly project expenditures assuming each activity starts at its earliest possible start time (given prior precedence relationships). 4. Calculate monthly project expenditures assuming each activity starts at its latest possible time (to ensure that subsequent activities are started early enough to still complete the project on time). 5. Calculate the range of monthly cash flows based on Steps 3 and 4. Based on this information, the project manager can then decide whether to allocate additional resources to activities on the critical path at any point during the project in order to expedite those activities and keep the project on schedule. Time-cost trade-off models enable the project manager to determine the minimum cost for the project and to control expenditures during the project. Such models are based on the assumption that there is a relationship between activity completion time and project cost. Expediting an activity costs money yet, at the same time, costs are incurred when projects are delayed. Activity direct costs are costs incurred to expedite activities, such as paying overtime, hiring more employees, and leasing or buying more equipment. Project indirect costs are costs incurred when the project is not completed on time. They include additional facilities and overhead costs as well as the opportunity costs of not having resources © 2011 Certified Management Accountants of Ontario. All rights reserved.
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freed up for other projects. They may also include penalty costs or lost incentive payments. For the project manager, the goal is to find the project duration that minimizes the sum of these two offsetting types of costs, that is, to find the optimum time-cost trade-off. Resource Planning, Materials Management, and Purchasing Enterprise Resource Planning (ERP) Enterprise resource planning (ERP) is a system—usually supported by software— designed to organize and manage operations planning and control processes, purchasing, inventory, product distribution, human resources, and finances. It allows managers to integrate standardized recordkeeping and information sharing across the organization. For example, ERP software combines the various systems used by the finance, marketing, purchasing, and warehouse departments into one cohesive and transparent computerized system with a single database designed for simple access and navigation. Successful ERP implementation provides numerous benefits to the organization such as improved efficiency and accuracy, lower costs, fewer required personnel, improved information flow, better management control, and faster decision-making. However, the system also comes with higher software costs, more expensive training and maintenance (e.g., data conversion and analysis costs), less operational flexibility, and adverse effects on employee performance while employees learn to deal with the new operational environment. Despite its shortcomings, ERP continues to be a productive tool in the OM toolbox. Material Requirements Planning (MRP) Material requirements planning (MRP) is an information system designed to coordinate and manage the ordering and scheduling of resources (e.g., raw materials, parts, components, subassemblies). The original MRP planned only materials. MRP II, which stands for manufacturing resource planning, also plans resource requirements, such as labour and machine time. Today, MRP controls the entire production system, including order entry, scheduling, inventory control (regular and just-in-time), finance, accounting, and computer integrated manufacturing (CIM). CIM, an automated manufacturing process, combines computer-aided design (CAD) to design products, computer-aided process planning (CAPP) to design manufacturing processes, and automated manufacturing planning and control systems (MP&CS) to plan, schedule, and monitor manufacturing processes. As illustrated in Figure 22, MRP begins with the master production schedule (MPS), a timetable of what is to be produced and when. It also uses bills of materials, which © 2011 Certified Management Accountants of Ontario. All rights reserved.
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contain descriptions of all components of a product, as well as inventory records (including lead times). Beginning with the end product, the gross requirements are calculated based on total demand for the product. On-hand inventory and scheduled receipts are then subtracted to arrive at net requirements. The planned order receipt is the order amount required to meet net requirements in the period. The planned order release is the planned order receipt date less the required lead time. Planned order changes include revisions of order quantities and due dates. After starting with the final product, MRP works backwards through the same process for each component, part, and resource to determine what quantity is needed when. MRP specifies when production and purchase orders must be placed. The goal is to ensure availability of materials during the production process and to attain the lowest inventory level. Most MRP systems also allocate production capacity to each order. This is called capacity requirements planning (CRP) and is discussed in the next section. MRP also produces a number of secondary reports:
Planning reports for forecasting future inventory requirements. Exception reports, which highlight various deviations and discrepancies (e.g., in quantities or due dates). Performance-control reports, which measure deviations from plans (e.g., missed due dates or stockouts).
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Figure 22 – MRP Overview
Capacity Requirements Planning (CRP) Capacity requirements planning (CRP) is the process that determines short-range capacity requirements along with the equipment and labour resources needed to complete orders generated by MRP. It is designed to assign proper workloads and to estimate their feasibility for operations (i.e., capability of completing orders with existing resources). When the CRP system detects discrepancies (i.e., overloads or underloads) at a work centre, managers may, for example, compensate by modifying lot sizes, rescheduling work, or contracting out.
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Managing Inventory The Nature and Importance of Inventory An inventory is a stock of goods a company keeps for sale or use in the future. These include (1) raw materials to be transformed into products; (2) components, which are parts assembled into final output; (3) work-in-process, which are items throughout the plant waiting to be processed or worked on; and (4) finished goods, which are products ready for sale. Inventory management is an important tool in OM because inventory levels and variety affect customer service and satisfaction, and capital and debt management, as well as the efficient and effective operation of the organization. Meredith and Shafer describe five types of inventory, classified by function:28 1. Transit inventories or pipeline inventories occur during the transportation of goods or parts between various locations. 2. Buffer inventories or safety stocks are used to protect the organization against variation in product demand and fluctuations in supply (e.g., due to stockouts experienced by suppliers, lost orders, or incorrect shipments). 3. Anticipation inventories are kept to compensate for seasonal fluctuations in demand, disruptions caused by labour disputes or other disruptions, or changes in prices (e.g., fuel inventories). 4. Decoupling inventories serve as cushions between stages in the manufacturing and distribution processes, and allow a plant to operate smoothly at a reasonably uniform rate even in the event of equipment breakdowns. 5. Cycle inventories or lot-size inventories result from the stipulations of ordering systems for parts or other supplies, such as when managers are forced to order in batches or limited quantities set by suppliers or when they can take advantage of quantity discounts. Decoupling inventories also allow various workstations or departments to maintain a measure of independence since problems in one part of the plant will not immediately cause problems elsewhere. They provide flexibility in production scheduling, allowing for larger production runs and lower setup costs. Finally, decoupling inventories provide a buffer against fluctuations in demand, thereby ensuring that customers have an adequate selection of goods.
28
Shafer and Meredith, p. 367.
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The Costs of Inventory Inventory management is a primary concern for managers because carrying either inadequate or excessive levels of inventory is costly. Decisions about inventory levels are affected by these costs:
Ordering costs – managerial and administrative costs to prepare purchase or production orders. Examples include employee time spent placing orders, the fixed-cost portion of shipping costs, and employee time spent receiving and inspecting goods. These costs are usually a fixed dollar amount and vary little with the order size.
Set-up (or production change) costs – costs of preparing machines or processes for production, such as time and labour to clean tools or change computer instructions.
Holding or carrying costs – expenses associated with physically keeping items in storage. These costs grow with the amount of inventory in storage and have three components: o Storage costs – costs of space (e.g., warehouse rent, utilities, and security), equipment (e.g., forklifts), and employees. o Capital costs – cost of the company’s capital (interest rate paid for the tied-up capital) or opportunity cost (rate of return forgone to hold the inventory instead of investing the capital elsewhere). o Risk costs – inventory insurance, obsolescence, breakage, spoilage, and pilferage.
Shortage or stockout costs – costs incurred when customer demand outpaces the available inventory, resulting in lost sales, damage to the corporate reputation, back order processing time and effort, as well as possible late charges.
Some of these costs (e.g., loss of reputation costs or capital costs) are more difficult to measure than others and may have a profound impact on operations. Managers implement inventory control systems to determine what, how much, and when to order to maintain efficient and effective operations. Inventory Control Systems: Periodic, Perpetual/Continuous, and ABC Achieving the desired level of customer service and maintaining efficiency in purchasing and production are the two major objectives of an inventory control system. OM managers limit understocking to accomplish the customer service objective; they prevent overstocking to be efficient. The following sections describe the various inventory control systems. © 2011 Certified Management Accountants of Ontario. All rights reserved.
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Periodic Review System The periodic review system allows managers to account for inventory and reorder at predetermined time intervals (e.g., bi-weekly or on the last Wednesday of the month). The target inventory (TI) level is achieved by placing orders that replenish stock. TI is calculated as follows: TI = [d * (RP + L)] + SS where: d = average period demand (units per day, week, month, etc.) RP = review period (time between reviews of stock) L = lead time (amount of time between order placement and item arrival) SS = safety stock The safety stock is calculated as follows: SS = z*σRP+L where: z = number of standard deviations. For example, a 95% service-cycle level corresponds to z = 1.645 and means that there would only be a 5% chance of a stockout. Z-values are derived from a table of the Standard Normal Distribution available in statistics textbooks. σRP+L = standard deviation of demand during the period and lead time σRP+L =
σ
t
RP L
where: σt = standard deviation of demand during interval t Figure 23 illustrates desired service level and corresponding risk of stockout using a normal distribution of z-values.
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Figure 23 – Service Level
The following formula is used to calculate the replenishment order quantity (QR): QR = TI – OH where: OH = on-hand quantity (including items on order)
Example 5 – Periodic Review Order Quantity Sahak Autoparts Manufacturing produces gearboxes. The company’s records indicate that the daily demand for the boxes is 120 units with a standard deviation of 9 units. The lead time is 21 days and the review period is 30 days. The company also has 40 units in inventory at the beginning of this review period. Sahak’s goal is to maintain a 95% cycle-service level (i.e., probability of having items in stock). What is the periodic review order quantity? Order quantity = [d * (RP + L)] + SS – OH = [(120)*(30+21)] + (1.65)*(9)* 30 21 - 40 = 6120 + 106 – 40 = 6186 units.
Perpetual or Continuous Inventory System A continuous inventory system (also called a perpetual system) continuously keeps track of item removals from inventory. Therefore, this system alerts managers to the current level of inventory for each item in stock. When the system detects levels of
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inventory below a predetermined level (the reorder point), a fixed quantity of items is ordered, thus avoiding shortages. If demand is not seasonal and the optimal order quantity can be determined, a continuous system provides the benefit of fixed order quantities. Furthermore, a continuous review system requires less safety stock than a periodic review system because unexpected increases in demand can be noticed and responded to promptly. ABC Inventory System The ABC inventory system classifies inventory items based on predetermined importance indicators. Often it groups items according to their annual dollar value. Other criteria, such as high unit cost, quality problems, delivery problems, expected engineering changes, and the impact of stockouts may warrant upgrading items to a higher classification. As shown in Figure 24, an ABC inventory system creates three groups (the percentages shown below are not hard and fast rules): 1. Class A inventory usually represents about 20% of the items or stock-keeping units (SKUs) but makes up close to 80% of the annual dollar value of inventory purchased. 2. Class B items make up close to 30% of the inventory. 3. Class C SKUs account for 50% of the items but less than 5% of the annual dollar value of inventory purchased. Figure 24 – ABC Analysis Chart
100 —
Clas s C
Class B
90 — Class A 80 —
e lu av r all o d f o e g at n e cr e P
70 — 60 — 50 — 40 — 30 — 20 — 10 — 0 — 10
20
30
40
50
60
70
80
90 100
Percentage of SKUs
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The classification is done using the following procedure: 1. 2. 3. 4.
Determine the annual dollar value usage for each SKU. Rank items in descending order based on that value. Calculate the cumulative annual dollar value. Group items into ABC categories.
The goal of ABC analysis is to focus most of the resources on monitoring a few critical inventory parts instead of many insignificant ones. Thus, different policies and controls will be established for each class. For example, relative to the other classes, Class A items may warrant more attention to supplier relationships, tighter physical inventory controls, more frequent verification of the accuracy of inventory records, and more sophisticated demand forecasting methods. Application of ABC analysis requires careful and accurate recordkeeping. The benefits include reduction of the average order lot size, and improved monitoring of inventory turnover and deliveries from suppliers. Models and Systems for Managing Inventories Economic Order Quantity (EOQ) The economic order quantity (EOQ) model is a widely used technique for inventory control when demand is independent of the demand for other items. The objective is to minimize total costs (holding costs and setup/order costs). The model, illustrated in Figure 25, determines the time of order placement and order quantity. It is a robust model, which means that changes in setup costs, holding costs, or even the EOQ will have only a modest effect on total costs.
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The basic EOQ model uses these assumptions:
Product demand is known and constant. There are no constraints on order lot size. Lead time is known and constant. Independent decisions are made for each inventory category. Ordering and setup costs are known and constant. The ordered quantity arrives instantaneously. All units cost the same regardless of order size, i.e., no quantity discounts. No back orders are allowed.
Figure 25 – EOQ Model Time between orders (order cycle) = Q / D Usage rate
Order quantity = Q (maximum inventory le level) ve l yr o tn e vn I
Average inventory on hand Q 2
reorder point
0 Minimum inventory
Time Place order
L = 1 wk Receive order
Replenishment order cycle
The basic model can be refined by relaxing some of the assumptions, such as allowing for time between placing and receiving an order or incorporating quantity discounts. The reorder point (R) is the product of lead time and demand, as shown below: R = dL where: d = average daily demand L = lead time (days) A receipt of Q units begins each inventory cycle (when the inventory reaches the reorder point). A constant demand rate, (d), is used to order the same quantity (Q).The company places the order (Q) at the reorder point (R) when the available inventory barely covers demand during the lead time (L), creating no shortages over time. © 2011 Certified Management Accountants of Ontario. All rights reserved.
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For the basic EOQ model, total annual inventory cost is based on this formula: D Q TCQ S H Q 2 Q
2DS H
where: TC = total annual cost D = annual demand S = ordering or setup costs Q = order quantity H = annual holding costs D S annual inventory ordering cost Q Q H annual inventory holding cost 2
The EOQ occurs where annual ordering and holding costs are equal, as shown in Example 6.
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Example 6 – Basic EOQ Model Annual demand for Brasiliana Coffee Ltd. is 12,000 units. The company orders 400 units at a time. The cost to place an order is $50 and the annual cost of holding each item is $7.50. The purchasing lead time is seven days. What is the EOQ? What are the total annual costs of inventory? What is the reorder point?
Q
2DS H
2 * 12,000 * $50 400 units $7.5
R Daily Demand x Lead Time
12,000 * 7 days 280 units 300 days
400 12,000 TC $7.50 $1,500 $1,500 $3,000 $50 2 400 Economic Production Quantity (EPQ) Another commonly used system is the economic production quantity (EPQ). In cases where production capacity exceeds demand rate for an item, batch production modes are common. The EPQ accommodates this nuance of accumulating inventory while production occurs. The EPQ assumptions are similar to those of EOQ; however, inventory units are delivered incrementally throughout the production period instead of as a single delivery. The company’s inventory accumulates during the production period and reaches its maximum (Imax) at a rate equal to the difference between production and usage rates. The inventory levels drop when production stops. The production cycle restarts again when inventory on hand is used up. The formulae for the EPQ model are as follows:
EPQ
2DS d H1 p
d IMAX Q1 p
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Under the EPQ model, there are no ordering costs; however, setup costs exist that are independent of lot size. Total annual costs under this model are presented by the following formula: TC = annual setup costs + annual holding costs D I TCEPQ S MAX H Q 2 where:
D = annual demand Q = quantity ordered H = annual holding cost S = setup costs Thus, the EPQ formula is used to find the “optimal” batch size to minimize the total setup and inventory costs. As is the case with EOQ, this occurs where setup and holding costs are equal.
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Example 7 – EPQ
Tiger Foods Ltd. (TFL) produces premium plant food. The annual demand is 60,000 bags. The packaging department can fill bags with food at a rate of 200 bags per week. They operate 50 weeks each year, and TFL can produce 600 bags per week. The setup cost is $100, and the annual holding cost rate is $.50 per lb. The lead time is 14 days. Calculate the EPQ. Determine the maximum inventory level. Calculate the total cost of using the EPQ policy. What is the reorder point? EPQ
2(60,000 )(100 ) 6,000bags 600 .501 400
IMAX 6,000 1 200 4 , 000 bags 600
60,000 4,000 TC 100 .50 1,000 1,000 $2,000 2 6,000
Reorder point R = d * L = 300 bags /5 days in week * 14 days = 840 Thus, this policy tells us to order 6,000 bags when the inventory hits 840 bags. Lean (Just-in-Time) Systems Goals and Benefits of JIT Systems A Just-In-Time (JIT) or lean production system (developed at the Toyota Motor Company) is “an integrated set of activities designed to achieve high volume production using minimal inventories of raw materials, work-in-process, and finished goods. Parts arrive at the next workstation ‘just in time’ and are completed and move through the operation quickly.”29 JIT is also a pull system in that production is pulled through the system by customer demand. Nothing is produced until it is needed, which also makes JIT a lean system.
29
Richard B. Chase, F. Robert Jacobs, and Nicholas J. Aquilano, Operations Management for Competitive Advantage, Tenth Edition, (New York: McGraw‐Hill/Irwin, 2004), pp. 426‐427.
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JIT is also lean because it attempts to eliminate disruptions and to use resources in the best possible way. Anything that does not contribute to the value of the product is considered waste. This includes:
Product defects – costs of rework and likely lost sales Processing waste – scrap and unnecessary production procedures Inventory – an idle resource Unnecessary transporting – work-in-process inventory Waiting time
JIT offers a number of advantages over traditional manufacturing systems, as shown in Table 7.
Table 7 – Advantages of JIT Advantages Reduced inventory investment Reduced manufacturing lead time Increased productivity and equipment utilization Greater flexibility Reduced planning and recordkeeping Increased participation by workforce Fewer defects / Increased product quality Smaller capital investment
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Key Elements of Just-in-Time Systems The key design elements of just-in-time systems in terms of product, process, organization, and manufacturing planning and control are outlined in Figures 26, 27, 28, and 29, respectively.
Figure 26 – Product Design Elements of JIT
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Figure 27 – Process Design Elements of JIT
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Figure 28 – Organizational Design Elements of JIT
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Figure 29 – Manufacturing and Control Design Elements of JIT
A successful JIT implementation requires careful planning and buy-in across the organization. There are a number of requirements and considerations when converting from a traditional production system to a just-in-time approach: 1. Obtain top management’s commitment to JIT: they must recognize the expected time, costs, and results of the conversion. 2. Study operations carefully before conversion, since some processes will require more effort than others, and not all will benefit from being done just-in-time. 3. Inform employees about JIT implementation to obtain their support and cooperation. Provide adequate training in setups, equipment maintenance, cooperation, and problem-solving. Furthermore, enlist their help in identifying and eliminating problems. Assure workers that their jobs are secure, and cross-train them on different operations. 4. Begin by reducing setup times while maintaining the current system.
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5. Convert operations gradually; start at the end of a process and work backwards to the beginning. Ensure each operation has been successfully converted before starting to convert the next one. Do not reduce inventories until the conversion process is complete and functioning properly. 6. Convert suppliers to JIT. Reduce the number of suppliers, favouring the most reliable and high quality partnerships. Establish long-term commitments with these suppliers, and be prepared to work closely with them. 7. Prepare to encounter obstacles to JIT conversion, including:
Lack of commitment by top management. Lack of cooperation between management and workers: management may resent giving workers more responsibility, while workers may resist taking on the added responsibility. Lack of supplier support, due to: o Unease about entering into long-term commitments. o Difficulty in making frequent, small-quantity deliveries, especially if the supplier has other customers using a traditional approach or if the supplier is located some distance away. o Unwillingness to adopt a JIT approach to supply. o Unwillingness to assume greater responsibility for monitoring and maintaining quality.
A successful conversion process often demands a spirit of cooperation and a strong organizational culture that is committed to the JIT philosophy.
Business Process Re-engineering Benefits and Potential Problems of Re-Engineering Business process re-engineering (BPR) involves a complete rethinking and redesign of an organization’s business processes. The goals are to achieve dramatic improvements in performance and to produce results that will attain the organization’s strategy. BPR often involves reorganizing value chain activities that are fragmented across various functional departments, and creating process departments or cross-functional work groups to perform all of the steps required to produce the desired result. For example, a new-product development team may assemble people from R&D, engineering, purchasing, manufacturing, and sales and marketing to bring new products to market more quickly.
Cost management supports BPR by providing managers with relevant information about costs for each activity on the value chain, as well as information about productivity, quality, and performance on key success factors, etc. © 2011 Certified Management Accountants of Ontario. All rights reserved.
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BPR can be used as a tool to help achieve an organization’s new strategy. Because it examines all assumptions about how and why the organization is doing what it is doing, BPR also helps an organization change with the changing times, as competition evolves, technology improves, new materials become available, and customers demand more. BPR can also be used to create or enhance an organization’s competitive advantage. It can result in cost savings and efficiencies since jobs are often modified, combined, or eliminated. Of course, making such changes to people’s jobs creates disadvantages, as the firm may need to downsize and/or people may need to acquire new skills. BPR is also a time-consuming process because it involves radical change, and people are often resistant to change. BPR can also become problematic if it is not viewed correctly as a strategic tool, and if redesigned processes do not help to achieve the organization’s strategy. Activity-Based Management Activity-based management (ABM) is another tool designed to make positive improvements to the processes within an organization. It is an extension of activitybased costing (ABC), which differs from traditional costing systems in that ABC uses many homogeneous indirect cost pools (small cost pools composed of similar costs that are caused by, or driven by, a single activity) with indirect cost allocation bases that are likely to be cost drivers. These allocation bases are often non-financial variables, such as number of purchase orders, number of parts, number of setups, and number of hours. ABM and Process Improvement/Cost Management
ABM builds on ABC by identifying activities as value-added or non-value-added. Valueadded activities enhance the value of products and services in the eyes of customers; the goal is to build on and improve these activities. Non-value-added activities do not add to customer perceptions about product/service value and therefore waste resources. The goal of process improvement is to reduce or eliminate the latter. By doing so, an organization can identify and implement reductions in cost and improvements in efficiency and quality. For example, for the new-car purchaser, inspections to detect manufacturing defects and steps taken to correct those defects are not value-added activities. Instead, the customer values activities that build quality into the vehicle in the first place. Therefore, dedicating more resources to the former will enhance the car manufacturer’s reputation for quality and will reduce the need for the latter. Similarly, costs incurred to move parts inventory throughout the manufacturing plant and inventory storage costs are nonvalue-added—the customer does not want to pay more for a car simply to cover such costs. Process improvement might focus on ensuring that parts are delivered to the
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correct location on a just-in-time basis, thereby minimizing the costs of inventory management. ABM and process improvement can also be combined with target costing and kaizen costing. Target costing is a cost control method by which products and their manufacturing processes are designed to meet specific target costs based on expected selling prices. To attain the necessary reduction in cost, the product might be redesigned to require the insertion of fewer parts and to be simpler to assemble. Making these modifications to the product will reduce the number of incoming parts to inspect (a non-value-added activity from the customer’s perspective), the number of hours required to assemble the product and, possibly, other non-value-added activities such as testing and rework. Kaizen costing is a continuous-improvement approach to reducing costs and improving quality. ABM is, once again, used to identify that activities do not add value in the minds of customers so that these activities can be gradually eliminated or reduced. In turn, value-added activities can be further enhanced. ABM and Customer Profitability
ABM can also be used to manage customer profitability by analyzing how customers, or groups of customers, differ in their profitability. The 80/20 rule often applies, i.e., 20% of customers generate 80% of the profits. ABM identifies activities and characteristics that cause some customers to be more costly than others. The interests of customers who order high-margin products but have low service requirements can then be given high priority. Another use is to focus on ways of making future business with the remaining customers more profitable by changing the pricing and/or service structure to encourage customer behaviours that will enhance profitability and discourage those that reduce profitability (e.g., require customers to pay for delivery or institute a minimum order quantity). Finally, when focused on activities, customer profitability analysis can be used to take internal actions to reduce the costs of specific activity areas. This last application may involve process improvement or a complete business process reengineering. For the purpose of customer profitability analysis, it is helpful to distinguish between five different levels of activity costs: 1.
Customer output unit-level costs – costs of activities related to individual units sold to a customer, e.g., direct labour and material costs.
2.
Customer batch-level costs – costs of activities related to a group of units sold to a customer, e.g., shipping costs, production line setup costs.
3.
Customer-sustaining costs – costs of activities to support a customer regardless of the number of units or batches sold to that customer, e.g., salary of customer representative, special tools for a customer’s particular type of order.
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4.
Distribution channel costs – costs of activities related to a particular distribution channel but not to individual customers, e.g., costs of developing and maintaining relationships with wholesalers or retailers, costs of restocking shelves.
5.
Corporate sustaining costs – costs of activities not traceable to individual customers or distribution channels, e.g., administrative salaries, information system costs.
Decisions to allocate resources across customers and, potentially, to cease to do business with unprofitable customers require sound management judgment. The lifetime value of the customer should be considered, including short- and long-run profitability prospects and opportunities for cross-selling (selling new or complementary items to existing customers). All avenues should first be explored to turn an unprofitable customer into a profitable one. As well, customers may be retained because they are loyal customers who are not always looking for the best prices. The impact on other customers of dropping a customer (e.g., loss of potential referrals, negative word-of-mouth consequences) and the ability to learn from a customer (e.g., about new products or sales tactics) are also considerations. The loss of customers will also mean that existing fixed costs have to be absorbed by the remaining costs, thereby altering the profitability of those customers. Finally, despite low profitability, service to some customers may be continued because abandoning such customers would be inconsistent with the organization’s mission and values. Other Applications of ABM
ABM can be used to determine and manage the costs of quality: prevention costs (e.g. maintenance), appraisal costs (e.g., inspection), internal failure costs (e.g., rework), and external failure costs (e.g., warranty repairs). ABM can be used to identify each product’s or service’s use of constrained resources and, consequently, the best way to relax constraints (e.g., by making more employees available for a particular activity or by seeking out additional suppliers of materials). Finally, ABM can be used as a performance measurement tool, whereby information about activities (e.g., number of components, number of inspection hours used, number of setups) and costs (materials handling costs, inspection costs) can be benchmarked against budgetary targets, the competition, and industry standards. Balanced scorecards often make use of ABC cost information to evaluate the organization’s performance. Both ABC and ABM are covered in more detail in the management accounting material.
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BIBLIOGRAPHY OF TEXTBOOKS In addition to specific sources cited in the footnotes, use of the following textbooks is acknowledged: Chase, Richard B., F. Robert Jacobs, and Nicholas J. Aquilano, 2004, Operations Management for a Competitive Advantage, Tenth Edition, New York: McGraw-Hill/Irwin, an imprint of The McGraw-Hill Companies, Inc. Heizer, Jay and Barry Render, 2011, Operations Management, Tenth Edition, New Jersey: Prentice Hall, an imprint of Pearson Education, Inc. Horngren, Charles T., George Foster, Srikant M. Datar, and Maureen P. Gowing, 2010, Cost Accounting: A Managerial Emphasis, Fifth Canadian Edition, Toronto: Pearson Education Canada, a division of Pearson Canada Inc. Krajewski, Lee J., Larry P. Ritzman, and Manoj K. Malhotra, 2010, Operations Management: Processes and Supply Chains, Ninth Edition, New Jersey: Prentice Hall, an imprint of Pearson Education, Inc. Markland, Robert E., Shawnee K. Vickery, and Robert A. Davis, 1998, Operations Management: Concepts in Manufacturing and Service, Second Edition, Ohio: SouthWestern College Publishing. Power, Terrance P., 2008, International Business: A Canadian Perspective, Toronto: Nelson Education Ltd. Reid, R. Dan and Nada R. Sanders, 2007, Operations Management: An Integrated Approach, Third Edition, New Jersey: John Wiley & Sons, Inc. Russell, Roberta S. and Bernard W. Taylor, III, 2009, Operations Management: Creating Value Along the Supply Chain, Sixth Edition, New Jersey: John Wiley & Sons, Inc. Shafer, Scott M. and Jack R. Meredith, 2003, Introducing Operations Management, New Jersey: John Wiley & Sons, Inc. Stevenson, William J. and Mehran Hojati, 2003, Operations Management, Second Canadian Edition, Toronto: McGraw-Hill Ryerson Ltd.
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