operations management - CMA

Transcription

OPERATIONS
MANAGEMENT
© 2011 Certified Management Accountants of Ontario. All rights reserved.
Operations Management
Page |2
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.
Page |3
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 © 2011 Certified Management Accountants of Ontario. All rights reserved.
Page |4
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
Page |5
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.
Page |6
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.
Page |7
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
Page |8
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
Page |9
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 10
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 11
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
P a g e | 12
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 13
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.


P a g e | 14
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 15
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.
P a g e | 16
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 17
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 18
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.
P a g e | 19
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
$136,000,000
Final Product Inspection
105,000
45,000
Customer Complaints Line
600,000
500,000
Rework
254,000
201,000
Employee Training
50,000
560,000
Voluntary Repair Costs
560,000
480,000
Repair Costs
345,000
267,000
Raw Materials Inspection
165,000
24,000
Product Liability Insurance
10,000,000
8,000,000
Supplier Certification
5,000
357,000
Scrap
256,000
198,000
Machine Downtime
56,000
25,000
Warranty Costs
4,560,700
4,300,000
Production Sampling Costs
98,500
55,000
Process Improvement
150,000
250,000
P a g e | 20
Solution to Capron
2005
2006
ITEM
Amount ($)
%
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
P a g e | 21
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
P a g e | 22
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 23
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.
P a g e | 24
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
P a g e | 25
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.
P a g e | 26
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.
P a g e | 27
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.
P a g e | 28
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 29
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 30
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 31
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.
P a g e | 32
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.
P a g e | 33
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.
P a g e | 34
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 35
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 36
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.
P a g e | 37
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.
P a g e | 38
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.
P a g e | 39
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.
P a g e | 40
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.
P a g e | 41
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.
P a g e | 42
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 43
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 44
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.
P a g e | 45
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
P a g e | 46
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
P a g e | 47
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.
P a g e | 48
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.
P a g e | 49
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
P a g e | 50
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
P a g e | 51
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.
P a g e | 52
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.
P a g e | 53
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
P a g e | 54
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
P a g e | 55
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
P a g e | 56
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).
P a g e | 57
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.
P a g e | 58
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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 59
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.
P a g e | 60
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.
P a g e | 61
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
P a g e | 62
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
P a g e | 63
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.
P a g e | 64
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.
P a g e | 65
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.
P a g e | 66
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
H1  
 p
 d
IMAX  Q1  
 p
P a g e | 67
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.
P a g e | 68
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 
.501 

 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. © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 69
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
P a g e | 70
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
P a g e | 71
Figure 27 – Process Design Elements of JIT
P a g e | 72
Figure 28 – Organizational Design Elements of JIT © 2011 Certified Management Accountants of Ontario. All rights reserved.
P a g e | 73
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.
P a g e | 74
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.
P a g e | 75
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
P a g e | 76
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.
P a g e | 77
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.
P a g e | 78
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.

operations management - CMA

Transcription

Similar documents

Lake Manitouwabing

What is CribMaster? - Groves Industrial Supply

Inventory Management Savings.key

Customer Service Representative

TBDHU.COM/CAREERS

poolplayers.ca - CPA Southern Ontario

landscape industry show - California Landscape Contractor`s

Explore your options at ontariocolleges.ca

Smoke-Free Ontario Poster

Gibson School is a 1914 Collegiate Gothic Schoolhouse named