OPERATIONS

MANAGEMENT
Goods, Services and Value Chains

CHAPTER 3
Measuring Performance
in Operations

DAVID A. COLLIER
AND
JAMES R. EVANS

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2 Measuring Performance in Operations
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 Chapter 3 Learning Objectives

1. To understand the principal types of

performance measures used in organizations
and by operations managers and to be able to
identify important measures and indicators to
manage and improve business performance.

2. To understand the importance of evaluating

relationships and cause-and-effect linkages
among performance measures and
approaches that companies use to understand
such relationships.

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 Chapter 3 Learning Objectives

3. To understand the characteristics of a good

measurement system and how to select
appropriate measures to support operations.

4. To understand how measurement systems

are integrated into comprehensive models of
business performance as a basis for better
design and improvement of operations.

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 Chapter 3 Measuring Performance in Operations

Introduction

Managers make many important decisions that

affect how an organization provides value to its
customers.

To know if decisions are effective and to guide the

organization on a daily basis, they need a means
of understanding performance at all levels of the
organization as well as in operations.

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 Chapter 3 Measuring Performance in Operations

Introduction
Good decisions are facilitated
through measurement, the act of
quantifying the performance criteria
of organizational units, goods and
services, processes, people, and
other business activities.

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 Chapter 3 Measuring Performance in Operations

Introduction

Key questions related to measurement in

operations include:
 How should we measure the performance of
goods and services?

 How should we measure the performance of

processes throughout the value chain?

 How should we measure overall organizational

performance and how does it relate to internal
operations?
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 Chapter 3 Measuring Performance in Operations

The Scope of Performance Measurement

Good performance measures enable

managers to control processes and make
decisions on the basis of facts, not opinions.

Selecting the right measures—not too many

and not too few is a very important decision
that all managers must make.

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 Chapter 3 Measuring Performance in Operations

The Scope of Performance Measurement

The list below details various categories of

Performance measurements.
• Financial • Time
• Customer and market • Flexibility
• Safety • Innovation and learning
• Quality • Productivity

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Exhibit 3.1 The Scope of Business and Operations
Performance Measurement

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 Chapter 3 Measuring Performance in Operations

Financial Measures

• Often take top priority in for-profit organizations.

• Traditional financial measures include revenue,

return on investment, operating profit, pretax
profit margin, asset utilization, growth, earnings
per share, and other liquidity measures.

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 Chapter 3 Measuring Performance in Operations

Financial Measures

• Cost of quality is not used in most organizations; it

measures what poor quality is costing an
organization.

• Nonprofit organizations focus more on minimizing

costs and maximizing value to their target markets,
customers, and society.

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 Chapter 3 Measuring Performance in Operations

Customer and Market Measures

• An effective customer-satisfaction measurement

system provides a company with customer ratings of
specific goods and service features and indicates the
relationship between those rating and the customer’s likely
future buying behavior.

• Measured in three areas: 1) goods quality, 2) service

quality, and 3) response time.

• Other customer focused measures include: customer

complaints, loyalty, customer retention, warranty claims,
service guarantee claims, service upsets/failures.

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 Chapter 3 Measuring Performance in Operations

Safety
• Measuring safety is vital to all organizations, as the
well- being of its employees and customers should
be an organization's principal concern.

• Performance measures include accident rates, parts

per million of arsenic in public water supply, or
security in a hotel room.

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Safety

• OM Spotlight: Dana Corporation

Safety integrated with continuous quality

improvement
If an accident happens the entire facility is shut
down.
Factory lost time accident rates were 39 times
lower than comparable factories.

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Quality
• Quality measures the degree to which the
output of a process meets customer
requirements.
• Goods quality relates to the physical
performance and characteristics of a good.

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Quality
• A common measure of goods quality is the
number of defects per unit, which is
computed by dividing the total number of
defects found by the number of items
examined.

• Nonconformities per unit are often reported

as rates per thousand or million, and the
measure dpmo—defects per million
opportunities—is often used.

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 Chapter 3 Measuring Performance in Operations

There are many dimensions of quality

including:
Performance: a good’s primary
operating characteristics. Example--
automobile brakes stop the vehicle.
Features: bells and whistles. Example-
- reclining seats.

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 Chapter 3 Measuring Performance in Operations

There are many dimensions of quality

including:

Reliability: probability of the

manufactured good working over a
certain time. Example—vehicle engine
always starts on cold days.
 Conformance: the degree to which
characteristics match preestablished
standards. Example—vehicle door does
not leak water.
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Quality
There are many dimensions of quality including
(continued):
 Durability: use before it physically
deteriorates. Example—auto corrosion.
 Serviceability: speed, courtesy and
competence of repair work. Example—
vehicle oil change.
 Aesthetics: how good a manufactured good
looks, feels, sounds, tastes, or smells.
Example—vehicle’s style and color.
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 Chapter 3 Measuring Performance in Operations
Another Way to Think About Quality

 Critical defect -- one that judgment and

experience indicate will surely result in
hazardous or unsafe conditions for individuals
using or experiencing the good or service.
 Major defect -- one that is not critical but is
likely to materially reduce the usability of the
good or service for its intended purpose.
 Minor defect -- one that is not likely to
materially reduce the usability of the good or
service for its intended purpose.
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 Chapter 3 Measuring Performance in Operations
Quality

• Service quality is consistently meeting or exceeding

customer expectations and service delivery system
performance for all service encounters.

– Tangibles -- physical facilities, uniforms, equipment,

vehicles, and appearance of employees (i.e., the
physical evidence).
– Reliability -- ability to perform the promised service
dependably and accurately.
– Responsiveness -- willingness to help customers
and provide prompt recovery to service upsets.
– Assurance -- knowledge and courtesy of the service-
providers, and their ability to inspire trust and
confidence in customers.
– Empathy – caring attitude and individualized
attention provided to its customers.
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Service Quality

 Every service encounter provides an

opportunity for error. Errors in service
creation and delivery are sometimes called
service upsets or service failures.

 In services, a measure of quality analogous to

defects per unit is errors per million
opportunities (epmo).

 Environmental quality focuses on

designing and controlling work processes to
improve the environment.
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Service Quality
 Example epmo: A hotel might determine
that there are 100 opportunities for error
during the hotel check-in process and
yesterday the hotel had 200 check-ins so the
total opportunities for error is 20,000.
 A total of 40 service upsets were recorded by
well-trained hotel check-in staff for an error
rate of 40/20,000 or 2 per thousand, which is
equivalent to 2,000 epmo.

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Time

• Time relates to two types of performance measures:

the speed of doing something (average) and

the reliability of doing something (variance).

• Processing time is the time it takes to perform some task.

• Queue time is a fancy word for wait time—the time spent

waiting.

• Cycle time refers to the time it takes to accomplish one

cycle of a process that performs work.

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 Chapter 3 Measuring Performance in Operations
Time

• Manufacturing lead time represents the time between

the release of an order to production and shipment to the
customer.

• Purchasing lead time is the time required to obtain the

purchased item, including order preparation, supplier lead
time, transportation, and receiving and storage.

• Sometimes processing, cycle, and lead time are used

interchangeably making things confusing in the real world.
Always ask for a definition of these terms to see how the
organization is using it.

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Flexibility

• Flexibility is the ability to adapt quickly and effectively to

changing requirements.

• Goods and service design flexibility is the ability to

develop a wide range of customized goods and services to
meet different or changing customer needs.

• Volume flexibility is the ability to respond quickly to

changes in the volume and type of demand.

• OM Spotlight: Nissan Flexibility

Builds five models in one assembly factory.
They use modular assemblies.
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Innovation and Learning

• Innovation refers to the ability to create new and unique

goods and services that delight customers and create
competitive advantage.

• Learning refers to creating, acquiring, and transferring

knowledge and modifying the behavior of employees in
response to internal and external change.

• “Microsoft is always two years away from failure.”

Bill Gates.

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 Chapter 3 Measuring Performance in Operations
Productivity
• Productivity = Quantity of Output/Quantity of Input
• Productivity is often confused with efficiency or effectiveness.

• Efficiency is the degree to which a process generates

outputs with the minimal consumption of inputs or generates
a maximum amount of outputs for a given amount of inputs.

• Effectiveness is achieving the organization's objective,

mission, or goal through the eyes of the customer; that is,
doing the right things efficiently.

• Productivity is more closely associate with value as defined in

Chapter 1.
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 Chapter 3 Measuring Performance in Operations

Productivity

• Productivity = Quantity of Output/Quantity of Input

• Productivity is expressed in one of three forms:

1. Total Productivity
= Total Output/Total Input

2. Multifactor Productivity
= Total Output/Subset of Inputs

3. Partial Factor Productivity

= Total Output/Single Input
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Exhibit 3.2 Examples of Partial Productivity Measures

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Exhibit 3.3 Productivity Calculations for Miller Chemicals

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Exhibit 3.4 Computing Productivity Indexes
for Miller Chemicals

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 Chapter 3 Measuring Performance in Operations

Linking Internal and External Performance

Measures

• Managers must understand the cause-and-effect

linkages between key measures of performance.
These relationships often explain the impact of
operational performance on external results.

• The quantitative modeling of cause-and-effect

relationships between external and internal
performance criteria is called interlinking.
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 Chapter 3 Measuring Performance in Operations

Linking Internal and External Performance

Measures

• Another example of an interlinking model is the

financial value of a loyal customer (VLC), which
quantifies the total revenue or profit each target
market customer generates over some time frame.

• By multiplying the VLC times the absolute number

of customers gained or lost, the total market value
can be found.
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Exhibit 3.5 Interlinking Internal and External
Performance Measures

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 Chapter 3 Measuring Performance in Operations

Designing Performance Measurement

Systems for Operations

What makes a good performance measurement

system for operations?

Good performance measures are actionable,

providing the basis for decisions at the level at
which they are applied.

To generate useful operational performance

measures a systematic process is required.
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 Chapter 3 Measuring Performance in Operations

Designing Performance Measurement Systems

for Operations

1. Identify all customers of the value chain and

determine their requirements and expectations.
2. Define the work process that provides the good
or service.
3. Define the value-adding activities and outputs
that compose the process.
4. Develop specific performance measures.
5. Evaluate the performance measures to ensure
their usefulness.
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Exhibit 3.6 Example of a Pizza Ordering
and Delivery Process

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 Chapter 3 Measuring Performance in Operations

Models of Organizational Performance

1. Malcolm Baldrige National Quality Award

Framework

2. Balanced Scorecard

3. Value Chain Model

4. Service-Profit Model

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 Chapter 3 Measuring Performance in Operations

Models of Organizational Performance

• The first two models (Baldrige Award and
Balanced Scorecard) provide more of a ‘big
picture’ or organizational performance.

• The last two provide more detailed frameworks

for operations managers.

• It is important to understand these big picture

models because operations managers must
communicate with all functional areas.
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 Chapter 3 Measuring Performance in Operations

Malcolm Baldrige National Quality Award

Framework
• Organizations receive the awards in each of the
original categories of manufacturing, small
business, service, and nonprofit education and
health care.
• Primary purpose of the program is to provide a
framework for performance excellent through self-
assessment to understand the organization’s
strengths and weaknesses.
• www.baldrige.org
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Exhibit 3.7 Malcolm Baldrige National Quality Award Model
of Organizational Performance

Source: 2005 Malcolm Baldrige National Quality Award Criteria, U.S. Dept. of Commerce

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Exhibit 3.8 Example OM-Related Questions in
Baldrige Categories 4, 5, and 6, (slide 2)

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Exhibit 3.8 Example OM-Related Questions in
Baldrige Categories 4, 5, and 6, (slide 1)

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 Chapter 3 Measuring Performance in Operations

The Balanced Scorecard Model

• Consists of four performance perspectives:

1) Financial

2) Customer

3) Innovation and Learning

4) Internal

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Exhibit 3.9 The Balanced Scorecard Performance
Categories and Linkages

Source: Kaplan R. S., and Norton, D. P., “The Balanced Scorecard—Measures That Drive Performance,” Harvard Business Review, January–February 1992, p. 72.

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 Chapter 3 Measuring Performance in Operations

The Value Chain Model

• Evaluates performance throughout the value

chain: synchronized network of processes
including suppliers and inputs, processes and
associated resources, goods and service
outputs and outcomes, customers and their
market segments, synchronized information
and feedback loops, and management of
value chain.

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Exhibit 3.10 Examples of Value Chain
Performance Measurements

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 Chapter 3 Measuring Performance in Operations

Service-Profit Chain Model

• Most applicable to service environments.

• Model is based on a set of cause-and-

effect linkages between internal and
external performance and defines the
key performance measurements on
which service-based firms should focus.

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Exhibit 3.11 The Service-Profit Chain Model

Source: Adapted from J. L. Heskett, T. O. Jones, G. W. Loveman, W. E. Sasser, Jr., Jr., and L. A. Schlesinger,
“Putting the Service-Profit Chain to Work,” Harvard Business Review, March–April 1994, pp. 164-174.

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Exhibit 3.12 IBM AS/400 Division Performance Measure
Correlations (1984–1994 Data)

Source: Steven H. Hoisington and Tse-His Huang, “Customer Satisfaction and Market Share: An Empirical Case Study of IBM’s AS/400 Division,”
in Customer-Centered Six Sigma, Earl Naumann and Steven H. Hoisington (Milwaukee, WI: ASQ Quality Press, 2001.

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Exhibit 3.13 IBM AS/400 Division Interlinking Model

Source: Steven H. Hoisington and Tse-His Huang, “Customer Satisfaction and Market Share: An Empirical Case Study of IBM’s AS/400 Division,”
in Customer-Centered Six Sigma, Earl Naumann and Steven H. Hoisington (Milwaukee, WI: ASQ Quality Press, 2001.

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 Chapter 3 Solved Problem #1

Solved Problem # 1 Question:

Costs, revenue, and other relevant information for two nursing

units that admit and treat similar patients during a 6-month
period are shown in Exhibit 3.14.

Compare the total dollar value of inputs for each unit, total
productivity, and the partial-productivity measure of direct
nursing labor productivity.

How do the units compare?

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Exhibit 3.14 Nursing Unit Productivity Analysis

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 Chapter 3 Solved Problem #1

Answer:
Total Productivity:
• Unit A: 1.12
• Unit B: 0.95
Unit A is more productive than Unit B by 17.9%.
Partial-productivity:
• Unit A: 6.47
• Unit B: 5.75
Unit A is also more productive based on labor
(partial) productivity.
These productivity ratios assume that
quality is the same in both nursing units.

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 Chapter 3 Solved Problem #2

A factory department consists of three types of employees:

laborers earning $10 per hour, machine operators earning $15
per hour, and machinists earning $30 per hour. For a certain
job, over two periods, the performance shown below was
collected:

Type of Labor Hours per Period

Employee Period 1 Period 2
Laborer 20 16
Machine operator 12 16
Machinist 6 11

Output increased by 20 percent in period 2. How has

productivity changed?
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 Chapter 3 Solved Problem #2
Solution:
Because labor costs are given, we will use a total labor-cost productivity
measure. With no knowledge of actual output figures, we index output for
period 1 as 100 and for period 2 as 120 (or 1.0 and 1.2, for example). Then
we divide the output index for each period by the sum of the input costs to
obtain the productivity measure. The total labor costs for each period are
shown below.
Period 1Period 2
Laborer $200 $160
Machine operator $180 $240
Machinist $180 $330
Total $560 $730

The productivity index for period 1 is 100/560 = 0.1786; for period 2 it is

120/730 = 0.1644. The relative change in productivity in period 2 is (0.1644
- 0.1786)/0.1786 = -0.0795, or a decline of -7.95 percent. Management
should identify possible reasons factory productivity decreased in period 2
and work to fix or improve the problem or situation.
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 Chapter 3 Solved Problem #3

A steel company produces long, thin sheets of steel called coils

that each weigh 10 to 15 tons. The slitting operation involves
cutting the coils into smaller widths. An average of 5,000 tons
per month is sold. The scrap rate from this operation is 3
percent. Material costs are $600 per ton. It takes .75 hours of
labor at a rate of $20 per hour to produce one ton sold.

a.How many tons per month must be produced to meet the

sales demand?

b. What annual savings would result from decreasing the scrap

rate from 3 percent to 2 percent?

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 Chapter 3 Solved Problem #3
Solution:
a. The required production to make 5,000 tons of good steel
with a 3 percent scrap rate is 5,000/(1 - 0.03) = 5,155 tons
(not 5,000 times 1.03!).
b. The required production to make 5,000 tons of good steel
with a 2 percent scrap rate is 5,000/.98 = 5,102 tons. If the
scrap rate is 3 percent, the additional 155 tons per month
requires $93,000 ($600/ton*155 tons) in material and
(.75)(20)(155) = $2,325 in labor, for a total of $95,325.
If the scrap rate is 2 percent, the additional 102 tons costs
$61,200 in material and $1,530 in labor, for a total of
$62,730. The difference incurred by reducing the scrap rate
from 3 to 2 percent is $32,595 per month, or $391,140
annually. Even a small improvement in internal failure costs
can result in big savings!
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 Chapter 3 Solved Problem #4

What is the value of a loyal customer (VLC) in the small

contractor target market segment who buys an electric drill
on average for $100 every 4 years, when the gross margin
on the drill averages 50 percent, and the customer
retention rate is 60 percent? What if the customer
retention rate increases to 80 percent?

What is a 1 percent change in market share worth to the

manufacturer if it represents 100,000 customers? What do
you conclude?

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 Chapter 3 Solved Problem #4
Solution:
• If customer retention rate is 60 percent, the average customer
defection rate = (1- customer retention rate). Thus, the customer
defection rate is 40 percent, or 0.4. The average buyers life cycle is
1/0.4 = 2.5 years. The repurchase frequency is every four years or
0.25 (1/4). Therefore,

• VLC = P*RF*CM*BLC = $100*0.25*0.50*(1/0.4) = $31.25 per year

• The value of a 1 percent change in market share = (100,000

customers)*($31.25/customer/year) = $ 3,125,000.
• If customer retention rate is 80 percent, the average customer
defection rate is 0.2, and the average buyers life cycle is 1/0.2 = 5
years. Then,

• VLC = P*RF*CM*BLC = $100*0.25*0.50*(1/.2) = $62.50 per year

• Thus, the value of a 1 percent change in market share = (100,000
customers)* ($62.50/customer/year) = $ 6,500,000.
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Exhibit 3.15 Greyhound Insurance Company Case: Sample of Check
Processing Performance Data

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Exhibit 3.16 BankUSA Case: Sample Internal and External
Credit Card Division Performance Data

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