PRODUCTION DECISIONS

A. INTRODUCTION
WHAT IS OPERATION MANAGEMENT?
It is the management of the production process  production management

Production process: procedure which defines the resources that have to be

used to produce products or services and all the methodology associated to it

The main objectives of production management are:

 Minimize costs of production
 Maximize productivity
 Ensure quality standards
Difference between operations and production management
DECISION MAKING CRITICAL POINTS
The production process includes some critical choices as regards the following
aspects involved in it:
 Type of production process (LESSON 5)
 Quality standards
 Capacity of the facilities
 Plant layout design

 Inventory and storage capacity  warehouse management

 Location of the facilities
 Transport
B. CAPACITY
WHAT IS CAPACITY?
Capacity is not:
 The size of the firm (or the size of the firm´s production plant)
 The actual or realized volume of production in a given time period
Capacity is the maximum amount of goods or services that can be produced
under normal operating conditions in a given period of time

Peak capacity: the maximum amount that can be produced in extraordinary

conditions in a limited time period

Example – car manufacturing company:

 Size of the production facilities  size of the firm
 Number of cars produced last month  actual volume of production
 Max. number of cars produced per month  capacity of the firm
 Max. number of cars produced if working overtime  peak capacity

Determining the productive capacity is a key decision that directly affects

investment decisions and has therefore an impact on the firm success

Inadequate capacity may lead to problems:

  Insufficient capacity  inability to meet demand  lost sales and
damaged brand image
 Excessive capacity  unused resources  storage costs

Capacity should be enough to meet the demand while minimizing investment

and costs
Analyze  Evaluate  Decide
HOW FIRM CAPACITY IS DETERMINED?
 Forecasting the demand
o Estimation of total demand in the industry
o Estimation of the expected market share of the firm
o Collaboration with marketing department (market research) is
crucial
 Determination of necessary capacity
o Based on the estimated demand (looking at competitors´
capacity may help)
o Firms may decide to have more capacity than expected demand
(reserve capacity or “capacity cushion”)
o Need to consider deterioration/obsolescence, as well as learning
effects
 Establishing contingency plans
o If capacity is insufficient: outsourcing, expanding current
facilities, buying new facilities…
o If capacity is excessive: sell some facilities, reduce staff, enter
new markets…
CAPACITY AND ECONOMIES OF SCALE
 Depending on the product nature, economies of scale can be crucial
 Lead to a reduction of average cost due to an increase in the production
volume
 Particularly important when fixed costs are high
In such cases, capacity must be enough so that economies of scale can
be reached
CAPACITY AND BEP
 Break-even point (BEP): number of units the firm needs to sell so that
profit is zero
 Capacity must me enough to produce
the amount of units needed to break –
even

CAPACITY AND OL
 The degree of operating leverage is the
elasticity of EBIT with respect to sales
 OL is always ≥ 1
 o High values  large proportion of fixed costs  increases in
sales lead to big increases in profits  risk is higher
o Large capacity is associated with high degrees of Operating
Leverage
% change∈ EBIT Δ EBIT
OL= =
% change∈ sales Δ Sales
( p−c v) Q Contribution Margin
OL= =
( p−c v ) Q−C F EBIT

C. LOCATION
Location can affect the cost of production and thus the firm´s ability to
compete
Optimal location depends on:
 The type of business
o Location of industrial plants should be based on minimizing
production costs
o Location of service sector firms is based on proximity to clients
to maximize sales
 The degree of differentiation of the product
o Low differentiation  try to find a spatial monopoly
o High differentiation  agglomeration strategy
Agglomeration strategy is based on clusters: many firms are located
together due to proximity to resources, suppliers or customers

Being embedded in a cluster of firms has several advantages:

 Lower costs, due to shared infrastructures (even shared supply or
transportation costs)
 Proximity to firms in related industries can ease transfer of knowledge
(spillovers)
 Allows monitoring the competitors, and reacting faster to their
movements
 Higher visibility (areas with more available alternatives for a product
attract more clients)
Yet, there are also risks:
 Can lead to increased competition for some resources (e.g. labor) and
for customers
 More difficult to keep new technologies secret

Several factors must be considered when determining the optimal site:

 Cost of land
 Cost and supply of labor
 Tax incentives
  Source of demand
 Access to transportation and resources
D. PLANT LAYOUT
Plant layout refers to the arrangement of machinery, equipment, work stations,
stores, offices and even corridors and rest areas within the firm facilities.

A well-designed plant layout must:

 Help to achieve ideal operating conditions
 Reduce costs (transportation, storage, personnel…)
 Avoid bottlenecks
 Ensure flexibility of the production process
The optimal plan layout depends on the type of production process (batch
production, assembly line, continuous production…)

Main types of plant layouts:

 Process layout or functional layout
o Workers and machines are grouped based on the function they
must perform
o Products circulate around the plant (from function to function)
o Appropriate for low-volume, non-standardized products
o Typical in job-shop and batch production systems

 Product layout or line layout

o Workers and machines are positioned in different spots of the
production line
o Production line is usually arranged in a straight line, U-shape, C-
shape or S-shape
o Appropriate for high-volume, highly standardized products
o Typical in assembly lines and continuous production

 Cellular layout
o Workers and machines are grouped in cells
 o Each cell produces a unique family of components that require
similar processing
o Often, a process layout is arranged within each cells, and cells
are part of a product layout
o Typical in Just-In-Time manufacturing systems

 Fixed-position layout
o Then product remains fixed, and workers and machines are the
ones who move around it
o The materials and equipment that are used more often are
placed closer
o It is typical in very large and heavy products, such as planes,
ships or bridges

PRODUCTION CONTROL
A. INTRODUCTION
PRODUCTION DECISIONS: STRATEGICAL VS TACTICAL
Once the strategic production decisions have been made (plant capacity,
location and layout), the operations manager needs to focus on tactical
decisions. These means short and medium term decisions

These decisions include:

 Operational planning and scheduling
 Productivity control
 Quality control
 Inventory control

B. PRODUCTIVITY CONTROL
MEASUREMENT OF PRODUCTIVITY
Firms strive to increase their productivity:
 Measure of efficiency
 How much a firm produces relative to how many resources it consumes
in the process
Outputs
Productivity =
Inputs
Outputs and inputs are usually measured in units
Firms need continually improve productivity in order to gain a competitive
advantage through the balance between the reduction of costs, the required
quality level and the volume produced.

Some firms evaluate their performance by comparison to a benchmark

productivity: usually the productivity of another firm. This is known as
benchmarking

Firms can improve productivity through several methods:

 Technology
 Economies of scale
 Restructuring
TECHNOLOGY
Firms may improve their productivity by adopting new technology (e.g. new
machinery that can perform tasks more quickly)

Many production processes have become automated:

 Machinery can be less costly than human resources
 Automation may improve production efficiency
 Automation may lead to changes in the production process
 Planning is necessary to understand which technology is more
appropriate
 Correct implementation of technology depends on absorptive capacity
of the firm
 New technology may need reskilling of workers
ECONOMIES OF SCALE
Economies of scale represent a cost advantage that firms experience when they
increase their volume of production

More units produced lead to a smaller average total cost in two ways:
 Spreading fixed costs over more outputs (smaller average fixed cost)
 Boosting efficiency in the production of each unit (smaller average
variable costs)
Total Production Cost ¿ cots+ variable costs
Average total cost= = = Average ¿ cos
Queatity of Units Produced quantity of units produced

DISECONOMIES OF SCALE
 At a certain level of production, average costs begin to increase as output
increases

This can happen for several reasons such as:

 Technical diseconomies  the firm grows too fast and is not able to
adapt the production process, leading to inefficiencies (e.g. scalability
issues, technical difficulties, overcrowding...)
 Organizational diseconomies  more workers and more facilities
makes management more complicated  inefficient management
 Financial diseconomies  expanding the business requires additional
funds, which increases interest expenses and may require hiring new
workers in the finance department
An important part of productivity control lies in analyzing average costs and
finding the optimal levels of production

RESTRUCTURING
Restructuring involves the revision of the production process in an attempt to
improve efficiency
Restructuring can reduce production costs, thereby improving firm´s profits and
firm´s value

Downsizing
 Restructuring can result in a reduction in the number of employees
(downsizing)
 Firms identify job positions that can be eliminated without affecting the
volume or the quality of the products
 Sometimes is accompanied by automation
 Downsizing can help the firm save costs
Downsizing disadvantages
 Costs may arise if remaining workers need to be trained to take
extended responsibilities
 Remaining employees may believe their own jobs might be cut  lower
morale and performance
 Product quality might be affected if remaining workers are too
overloaded with work
 Corporate anorexia: when firms does not have employees to carry out
the activities in normal conditions, often due to extreme downsizing

C. QUALITY CONTROL
WHAT IS QUALITY?
Quality can be defined as the degree to which a product or service satisfies a
customer´s requirements or expectations

Firms have come to understand that:

 Quality is one of the main drivers of customer satisfaction and brand
loyalty
 Quality not only comes from the product, but also from customer
service
 Satisfied customers are more likely to buy more products from the same
firm
 Retaining existing customers is as important as attracting new ones and
it is less costly
Therefore, quality is crucial for current and future firm performance
Quality control is a process that involves:
 Determining whether the quality of a product or a service meets the
desired level
 Assessing the various characteristics that enhance customer satisfaction
 Identifying improvements that need to be made in the production
process
Total quality management:
 Product quality is dependent on the overall quality of the
organization, including planning, management and control processes
 Provide managers and employees with the training they need to
excel in their jobs
 Encourage employees to take responsibility and to provide
leadership
 Encourage all employees to search for ways to improve the
production process
 Continually monitor activities and evaluate the methods used to
measure quality
QUALITY ASSESSMENT
1. Control by technology: use technology to assess quality and to identify
improvement venues
2. Control by employees: employees can assess the quality of the products
and offer suggestions
3. Control by sampling: randomly select some of the products and test
them
4. After sales control: monitor complaints and share of returned products
5. Correct deficiencies: identify source of the problem (e.g. quality of
materials, workers or machinery) and correct it

GLOBAL QUALITY STANDARDS

 Firms that conduct international business may attempt to satisfy a set of global
quality standards
The more common is established by the International Standards Organization
(ISO)
 ISO 9000 sets standards for production quality (ISO 14000 for
environmental effects)
 Independent auditors review the firm´s operations and decide whether
standards are met
 Focus on the design, manufacturing process, installation and service of a
product
 Meeting these standards is voluntary (it costs over $20.000)
 Firms that meet them can become certified  more credibility
D. INVENTORY CONTROL
CONCEPTS
Inventory: is a set of items which remain stored and are readily available to be
used in the production process (raw material) or to be sold (finished product)

Main types of inventories:

 Raw materials
 Work-in-progress (semi-finished goods)
 Finished goods
Inventory control: is the process of managing inventory at a level that
minimizes costs while avoiding the risk of lacking enough stock to meet the
demand

In general, inventory management involves making decisions concerning how

much (quantity) and when (time) to order from the suppliers

The answer to when and how much to order depends on several factors:
 Nature of the demand
o Demand can be treated as certain or as a random variable with a
given probability distribution (e.g. a normal distribution)
o Demand of an item can be independent (if it does not depend on
the demand of another item) or dependent (e.g. wheel on a
bicycle)
 Lead time
o The time between the moment when the order is placed and the
moment when the order is received
o Can also be treated as certain or as a random variable

 Inventory costs:
 o Purchase costs (PC): the cost of acquiring (purchasing) an
amount of items at a given price
o Holding costs (HC) or carrying/storage costs: the costs
originated from storing items and the cost of having such
resources unused, which means the profitability that such items
could bring if they were not unused
o Ordering costs (OC): the fixed cost of making an order (e.g.
shipping cost)
 Shortage costs:
o Those that arise when the firm cannot meet the demand due to
insufficient stock (lost sales, brand image…)
ECONOMIC ORDER QUANTITY – EOQ
EOQ is the optimal quantity (Q) that a firm should purchase every time it places
an order with the aim of minimizing total inventory costs:
Q SD
T C =PC + H C +OC =DP + ( H +iP ) +
2 Q
 D = the annual demand of the product
 P = the purchase cost per unit
 H = the annual holding cost per unit
 i = the interest rate
 Q/2 = the average quantity in stock
 S = the cost of placing an order
 Q = the quantity purchased per order
Underlying assumptions:
 The ordering cost (S) is constant
 The (D) is known, and spread evenly throughout the year
 The purchase price (P) is constant and independent of Q
(no discounts are applicable)
 The lead time is fixed
 The replenishment is made instantaneously, the whole
batch is delivered at once
 Only one product is involved

Q SD
T C =DP+ ( H +iP ) +
2 Q
In order to find the order quantity (Q) that minimized the total
cost, we take the first partial derivative with respect to Q and
make it equal to zero (first order condition)
δ C T ( H+ iP ) SD
δQ
=
2
− 2 =0→ Q =
Q
2 2 SD
( H +iP ) √
→Q=
2 SD
¿¿
¿

Q=
√
2 SD
¿¿
¿
Based on that, we can also know the following elements:
Optimal number of orders n = D/Q
Number of days between orders t = 360/n
Daily demand (units per day) d = D/360
 Re-order Point ROP = dL
(L is the lead time in days)
ECONOMIC ORDER QUANTITY – EOQ – EXAMPLE
You´re a buyer for Express, a company that produced coffee.
Express needs 1.000 coffee makers per year. The cost of each coffee maker is
$80. Administrative and shipping costs amount to $100 per order. Lead time in
5 days. Express is open 365 days per year.
Assuming a cost of capital of 5% answer the following questions
 What is the optimal order quantity (EOQ)?

 Re-order point
EOQ=
√ 2 SD
(H +iP)
=
√ 2 ∙100 ∙ 1000
¿¿
¿

D 1000
ROP=dL= ∙ L= ∙ 5=13 , 70 ≃ 14 units
365 365
 Number of orders
D 1000
n= = =10 orders
Q 100