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Production Operations Management

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Production and Operations Management ­MGT613
VU
Lesson 17
In our earlier lectures we talked about importance of capacity planning along with the idea that capacity
planning decisions are carried out with certain objectivity in mind both at the individual level as well as
at the organizational level. We also learnt the various measures of capacity. We now focus our attention
on various alternatives available to us along with cost volume relationship.
Evaluating Alternatives
Minimum Average Cost per Unit
Average cost
per unit
Minimum Cost
0
Rate of output
Explanation of the Cost Curve
The explanation for the shape of the cost curve is that low levels of output (Production), the costs of
facilities and equipment must be absorbed (paid for) by few units. Hence the cost per unit is very high.
As the output is increased, there are more units to absorb the fixed cost of utilities, facilities and
equipment, so unit cost is decreased.
Minimum Cost would be recorded at the optimal rate, beyond that the unit cost will
start to increase. Other factors now become more important which include worker fatigue, equipment
breakdown, the loss of flexibility, which leaves less margin for error and increases difficulty in
coordinating activities.
Evaluating Alternatives
Minimum cost & optimal operating rate are functions of size of
production unit.
Average cost per unit
Small
Medium
plant
plant
Large
plant
0
Output rate
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Production and Operations Management ­MGT613
VU
Evaluating Alternatives
As the general capacity of the plant increases, the optimal output rate increases and the
minimum cost for the optimal rate decreases. This is the prime reason why larger plants tend to
have higher optimal output rates and lower minimum costs than smaller plants. The senior
management normally takes in to account the same considerations in addition to availability of
financial, capital resources and forecasted demand.
The important step is to determine enough points for each size facility to be able to make a
comparison among different sizes. In some industries or types of services, facility sizes are
given, where as in other facility size are continuous variable. Occasionally the management
decides for a size which does not have the desired rate of output. E.g. Pharmaceutical Company,
oil field, gas fields.
An organization needs to examine the alternatives for future capacity from a number of different
perspectives. Economic Conditions set the external conditions which influence the following
5. Will Alternative be feasible.
6. How much will it cost?
7. How soon can we have it?
8. What will be the operating and maintenance costs?
Possible Negative Opinion due to the following decisions.
4. Decision to build a new power plant, nuclear, coal, geothermal
5. Displacement of people if a new hydro plant is to be built.
6. Environmental issues related to company's new project.
Planning Service Capacity
Services are different that manufacturing cant be inventoried while services cannot be inventoried, this
reason alone makes it necessary and pertinent to plan for service capacity.
Need to be near customers as Capacity and location are closely tied.
Inability to store services as Capacity must be matched with timing of demand
Degree of volatility of demand it can vary between peak and low periods.
Cost-Volume Relationships
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Production and Operations Management ­MGT613
VU
Assumptions of Cost-Volume Analysis
1.
One product is involved
2.
Everything produced can be sold
3.
Variable cost per unit is the same regardless of volume
4.
Fixed costs do not change with volume
5.
Revenue per unit constant with volume
6.
Revenue per unit exceeds variable cost per unit
Cost Volume Relationship focuses on relationships between costs, revenue and volume of output. The
primary purpose of cost volume analysis is to estimate the income of an organization under different
operating conditions. It is particularly useful as a tool for comparing capacity alternatives.
The application of Cost Volume Relationships requires identification of all costs related to the
production of a given product. These costs are assigned to fixed costs or variable costs.
Fixed costs tend to remain constant regardless of volume of output. Examples include Rental costs,
property taxes, equipment costs, heating and cooling expenses, and certain administration costs.
Variable costs vary directly with volume of output. The major portions of variable cost are materials
and labor cost. For our analysis part we can assume that the variable cost per unit remains the same
regardless of volume of output.
Let us construct the model for Cost Volume Relationship. If we select FC , VC, TC, TR R , Q, QBEP , P
and R to represent Fixed Cost, Variable Cost, Total Cost, Total Revenue, Revenue per unit, Quantity or
Volume of Output, Quantity or Volume of Output at BREAK EVEN and Profit respectively then
Step I
The total cost TC associated with a given volume of output is equal to the sum of the fixed cost FC and
the Variable Cost per Unit
TC= FC+ VC X Q
Step II
Revenue per unit, like variable cost per unit, is assumed to be the same regardless of the quantity of
output. Total Revenue will have a linear relationship with the output.
TR= R X Q
Cost-Volume Relationships
Step III
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Production and Operations Management ­MGT613
VU
Profit is P difference between Revenue TR and Costs TC. Construct the model for Cost Volume
Relationship
P= TR-TC
P= R X Q ­(FC + VC X Q)
Rearranging and factorizing
P=Q ( R-VC) ­FC
Or P + FC= Q ( R-VC)
Also Q = ( P +FC)/ (R-VC)
Q= Quantity or Volume of Output
QBEP= Quantity or Volume of Output at BREAK EVEN, would be where
P=Profit is 0
So QBEP = FC/ R-VC
Cost-Volume Relationships
Capacity alternatives involve step costs.
These step costs increase in stepwise as potential volume increases.
For example an organization may have the option of purchasing one, two or three machines, with
each additional machine increasing fixed cost in a non linear way.
In such a scenario, the fixed costs and potential volume would depend on number of machines
purchased or installed.
Break-Even Problem with Step Fixed Costs
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Production and Operations Management ­MGT613
VU
The implication is that multiple break even quantities may occur, possibly one for each range.
Note the total revenue line might not intersect the fixed cost line in a particular range, meaning that
would be no break even point in the first range.
In order to decide how many machines to purchase a manager must consider projected annual
demand (volume) relative to Multiple Break Even Points and the most appropriate number of
machines.
Example
The Business Owner of a sports good factory in Sialkot is contemplating adding a new line of cricket
bats, which will require leasing new equipment for a monthly payment of Rs. 60,000. Variable Costs
would be Rs. 200 per bat and Bats would be sold for Rs. 2000 only.
1. How many bats would be sold in order to break even?
2. What would be the profit or loss if the 100 bats are made and sold in 1 month?
3. How many bats must be sold to realize a profit of Rs. 40,000?
Solution
1. QBEP= FC/ ( R-VC)
=Rs. 60,000/ 2000-200= 60,000/1800
= 33.33 bats = 33 Bats
2. For Q =100 bats, the Profit or Loss would be
P= Q(R-VC)-FC=100(2000-200)-60,000=100X 1800-60,000=180,000-60,000=120,000
3. For P =40,000
Q = (FC+P)/ ( R-VC)=(60,000+40,000)/(2000-200)
=100,000/1800=55.56 = 56 Bats
Financial Analysis
Mathematical Techniques that can be used to evaluate alternatives are
Cost Volume Relationships
Financial Analysis
Decision Theory
Waiting Line Analysis
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Production and Operations Management ­MGT613
VU
Capacity alternatives are often evaluated with the aid of certain financial analyses. Operations manager
along with managerial accountant often work to calculate what cash flow or present value in terms of
rupees is available for the organization to proceed with a capacity alternative decision. It is important to
understand what cash flow and present values are
1. Cash Flow - the difference between cash received from sales and other sources, and cash
outflow for labor, material, overhead, and taxes.
2. Present Value - the sum, in current value, of all future cash flows of an investment proposal.
Waiting Line Analysis and decision theory are also two important ways in which capacity alternatives
are evaluated.
Conclusion
Capacity planning is important that it helps an organization to formulate its long term (organizational)
strategy and short term (operational) strategy. Long term capacity decisions relate to overall level of
capacity while short term capacity decisions refer to seasonal, random or irregular variations in demand.
Ideally capacity should match demand but it rarely happens. Capacity alternative decisions should be
taken in view of what we have already covered the concept of systems approach or the over all big
picture approach as quite often removing a bottle neck at the department level may not improve the
organizations effectiveness. An effective operations manager would make use of qualitative as well as
quantitative analysis to evaluate capacity alternatives.
Capacity decisions are often based on facilities layout and together they define the very existence of an
organizational unit.
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Table of Contents:
  1. INTRODUCTION TO PRODUCTION AND OPERATIONS MANAGEMENT
  2. INTRODUCTION TO PRODUCTION AND OPERATIONS MANAGEMENT:Decision Making
  3. INTRODUCTION TO PRODUCTION AND OPERATIONS MANAGEMENT:Strategy
  4. INTRODUCTION TO PRODUCTION AND OPERATIONS MANAGEMENT:Service Delivery System
  5. INTRODUCTION TO PRODUCTION AND OPERATIONS MANAGEMENT:Productivity
  6. INTRODUCTION TO PRODUCTION AND OPERATIONS MANAGEMENT:The Decision Process
  7. INTRODUCTION TO PRODUCTION AND OPERATIONS MANAGEMENT:Demand Management
  8. Roadmap to the Lecture:Fundamental Types of Forecasts, Finer Classification of Forecasts
  9. Time Series Forecasts:Techniques for Averaging, Simple Moving Average Solution
  10. The formula for the moving average is:Exponential Smoothing Model, Common Nonlinear Trends
  11. The formula for the moving average is:Major factors in design strategy
  12. The formula for the moving average is:Standardization, Mass Customization
  13. The formula for the moving average is:DESIGN STRATEGIES
  14. The formula for the moving average is:Measuring Reliability, AVAILABILITY
  15. The formula for the moving average is:Learning Objectives, Capacity Planning
  16. The formula for the moving average is:Efficiency and Utilization, Evaluating Alternatives
  17. The formula for the moving average is:Evaluating Alternatives, Financial Analysis
  18. PROCESS SELECTION:Types of Operation, Intermittent Processing
  19. PROCESS SELECTION:Basic Layout Types, Advantages of Product Layout
  20. PROCESS SELECTION:Cellular Layouts, Facilities Layouts, Importance of Layout Decisions
  21. DESIGN OF WORK SYSTEMS:Job Design, Specialization, Methods Analysis
  22. LOCATION PLANNING AND ANALYSIS:MANAGING GLOBAL OPERATIONS, Regional Factors
  23. MANAGEMENT OF QUALITY:Dimensions of Quality, Examples of Service Quality
  24. SERVICE QUALITY:Moments of Truth, Perceived Service Quality, Service Gap Analysis
  25. TOTAL QUALITY MANAGEMENT:Determinants of Quality, Responsibility for Quality
  26. TQM QUALITY:Six Sigma Team, PROCESS IMPROVEMENT
  27. QUALITY CONTROL & QUALITY ASSURANCE:INSPECTION, Control Chart
  28. ACCEPTANCE SAMPLING:CHOOSING A PLAN, CONSUMERíS AND PRODUCERíS RISK
  29. AGGREGATE PLANNING:Demand and Capacity Options
  30. AGGREGATE PLANNING:Aggregate Planning Relationships, Master Scheduling
  31. INVENTORY MANAGEMENT:Objective of Inventory Control, Inventory Counting Systems
  32. INVENTORY MANAGEMENT:ABC Classification System, Cycle Counting
  33. INVENTORY MANAGEMENT:Economic Production Quantity Assumptions
  34. INVENTORY MANAGEMENT:Independent and Dependent Demand
  35. INVENTORY MANAGEMENT:Capacity Planning, Manufacturing Resource Planning
  36. JUST IN TIME PRODUCTION SYSTEMS:Organizational and Operational Strategies
  37. JUST IN TIME PRODUCTION SYSTEMS:Operational Benefits, Kanban Formula
  38. JUST IN TIME PRODUCTION SYSTEMS:Secondary Goals, Tiered Supplier Network
  39. SUPPLY CHAIN MANAGEMENT:Logistics, Distribution Requirements Planning
  40. SUPPLY CHAIN MANAGEMENT:Supply Chain Benefits and Drawbacks
  41. SCHEDULING:High-Volume Systems, Load Chart, Hungarian Method
  42. SEQUENCING:Assumptions to Priority Rules, Scheduling Service Operations
  43. PROJECT MANAGEMENT:Project Life Cycle, Work Breakdown Structure
  44. PROJECT MANAGEMENT:Computing Algorithm, Project Crashing, Risk Management
  45. Waiting Lines:Queuing Analysis, System Characteristics, Priority Model