Operations Management 18ME56

Module 1 : Production and operation Management

Introduction:
Operation is that part of as organization, which is concerned with the transformation of a range of
inputs into the required output (services) having the requisite quality level. Management is the
process, which combines and transforms various resources used in the operations subsystem of the
organization into value added services in a controlled manner as per the policies of the organization.
The set of interrelated management activities, which are involved in manufacturing certain
products, is called as production management. If the same concept is extended to services
management, then the corresponding set of management activities is called as operations
management.

Historical Development

The traditional view of manufacturing management began in eighteenth century when Adam
Smith recognised the economic benefits of specialization of labour. He recommended breaking of
jobs down into subtasks and recognises workers to specialized tasks in which they would become
highly skilled and efficient. In the early twentieth century, F.W. Taylor implemented Smith’s
theories and developed scientific management. From then till 1930, many techniques were
developed prevailing the traditional view. Brief information about the contributions to
manufacturing management is shown in the Table 1.1.
Production Management becomes the acceptable term from 1930s to 1950s. As F.W. Taylor’s
works become more widely known, managers developed techniques that focused on economic
efficiency in manufacturing. Workers were studied in great detail to eliminate wasteful efforts and
achieve greater efficiency. At the same time, psychologists, socialists and other social scientists
began to study people and human behaviour in the working environment. In addition, economists,
mathematicians, and computer socialists contributed newer, more sophisticated analytical
approaches.
With the 1970s emerge two distinct changes in our views. The most obvious of these, reflected
in the new name Operations Management was a shift in the service and manufacturing sectors of
the economy. As service sector became more prominent, the change from ‘production’ to
‘operations’ emphasized the broadening of our field to service organizations. The second, more
suitable change was the beginning of an emphasis on synthesis, rather than just analysis, in
management practices.

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Table 1.1 Historical summary of operations management

Date Contribution Contributor

1776 Specialization of labour in manufacturing Adam Smith
1799 Interchangeable parts, cost accounting Eli Whitney & others
1832 Division of labour by skill; assignment of jobs by Charles Babbage
Skill; basics of time study
1900 Scientific management time study and work study Frederick W.Taylor
Developed; dividing planning and doing of work
1900 Motion of study of jobs Frank B. Gilbreth
1901 Scheduling techniques for employees, machines Jobs Henry L. Gantt
in manufacturing
1915 Economic lot sizes for inventory control F.W. Harris
1927 Human relations; the Hawthorne studies Elton Mayo
1931 Statistical inference applied to product quality: quality W.A. Shewart
control charts
1935 Statistical Sampling applied to quality control: H.F.Dodge &
inspection sampling plans H.G.Roming
1940 Operations research applications in world war II P.M.Blacker & others
1946 Digital Computer John Mauchlly and
J.P.Eckert
1947 Linear Programming G.B.Dantzig, Williams &
others
1950 Mathematical programming, on-linear and stochastic A.Charnes, W.W.Cooper
processes & others
1951 Commercial digital computer: large-scale Sperry Univac
computations available
1960 Organizational behaviour: continued study of people L.Cummings, L.Porter
at work
1970 Integrating operations into overall strategy and policy
Computer
applications to manufacturing, scheduling, and W.Skinner J.Orlicky & G.
control, Material Requirement Planning (MRP) Wright

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1980 Quality and productivity applications from Japan: W.E. Deming & J.Juran
robotics,
CAD-CAM

Production and Production System

Production function is ‘the part of an organization, which is concerned with the transformation of
a range of inputs into the required outputs (products) having the requisite quality level’.
Production is defined as ‘the step-by-step conversion of one form of material into another form
through chemical or mechanical process to create or enhance the utility of the product to the user’.
Thus production is a value addition process. At each stage of processing, there will be value
addition.
The production system is ‘that part of an organization, which produces products of an
organization. It is that activity whereby resources, flowing within a defined system, are combined
and transformed in a controlled manner to add value in accordance with the policies communicated
by management’.
A simplified production system is shown below:

Fig Schematic production system

The production system has the following characteristics:

1. Production is an organized activity, so every production system has an objective.
2. The system transforms the various inputs to useful outputs.
3. It does not operate in isolation from the other organization system.

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4. There exists a feedback about the activities, which is essential to control and improve system
performance.

Classification of Production System

Production systems can be classified as Job-shop, Batch, Mass and Continuous production systems.

Fig. 1.2 Classifications of production systems

1.5.1 Job-Shop Production

Job-shop production are characterized by manufacturing one or few quantity of products designed
and produced as per the specification of customers within prefixed time and cost. The
distinguishing feature of this is low volume and high variety of products.
A job-shop comprises of general-purpose machines arranged into different departments. Each
job demands unique technological requirements, demands processing on machines in a certain
sequence.
Job-shop Production is characterized by
1. High variety of products and low volume.
2. Use of general purpose machines and facilities.
3. Highly skilled operators who can take up each job as a challenge because of uniqueness.
4. Large inventory of materials, tools, parts.
5. Detailed planning is essential for sequencing the requirements of each product, capacities for
each work centre and order priorities.

Advantages

Following are the advantages of Job-shop Production:

1. Because of general purpose machines and facilities variety of products can be produced.

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2. Operators will become more skilled and competent, as each job gives them learning
opportunities.
3. Full potential of operators can be utilized.
4. Opportunity exists for Creative methods and innovative ideas.
Limitations

Following are the limitations of Job-shop Production:

1. Higher cost due to frequent set up changes.
2. Higher level of inventory at all levels and hence higher inventory cost.
3. Production planning is complicated.
4. Larger space requirements.

1.5.2 Batch Production

American Production and Inventory Control Society (APICS) defines Batch Production as a form
of manufacturing in which the job pass through the functional departments in lots or batches and
each lot may have a different routing. It is characterized by the manufacture of limited number of
products produced at regular intervals and stocked awaiting sales. Batch Production is characterized
by 1. Shorter production runs.
2. Plant and machinery are flexible.
3. Plant and machinery set up is used for the production of item in a batch and change of set up
is required for processing the next batch.
4. Manufacturing lead-time and cost are lower as compared to job order production.
Advantages

Following are the advantages of Batch Production:

1. Better utilization of plant and machinery.
2. Promotes functional specialization.
3. Cost per unit is lower as compared to job order production.
4. Lower investment in plant and machinery.
5. Flexibility to accommodate and process number of products.
6. Job satisfaction exists for operators.

Limitations

Following are the limitations of Batch Production:

1. Material handling is complex because of irregular and longer flows.
2. Production planning and control is complex.

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3. Work in process inventory is higher compared to continuous production.

4. Higher set up costs due to frequent changes in set up.

1.5.3 Mass Production

Manufacture of discrete parts or assemblies using a continuous process are called Mass Production.
This production system is justified by very large volume of production. The machines are arranged
in a line or product layout. Product and process standardization exists and all outputs follow the
same path.
Mass Production is characterized by
1. Standardization of product and process sequence.
2. Dedicated special purpose machines having higher production capacities and output rates.
3. Large volume of products.
4. Shorter cycle time of production.
5. Lower in process inventory.
6. Perfectly balanced production lines.
7. Flow of materials, components and parts is continuous and without any back tracking.
8. Production planning and control is easy.
9. Material handling can be completely automatic.

Advantages

Following are the advantages of Mass Production:

1. Higher rate of production with reduced cycle time.
2. Higher capacity utilization due to line balancing.
3. Less skilled operators are required.
4. Low process inventory.
5. Manufacturing cost per unit is low.

Limitations

Following are the limitations of Mass Production:

1. Breakdown of one machine will stop an entire production line.
2. Line layout needs major change with the changes in the product design.
3. High investment in production facilities.
4. The cycle time is determined by the slowest operation.

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1.5.4 Continuous Production

Production facilities are arranged as per the sequence of production operations from the first
operations to the finished product. The items are made to flow through the sequence of operations
through material handling devices such as conveyors, transfer devices, etc.
Continuous Production is characterized by
1. Dedicated plant and equipment with zero flexibility.
2. Material handling is fully automated.
3. Process follows a predetermined sequence of operations.
4. Component materials cannot be readily identified with final product.
5. Planning and scheduling is a routine action.

Advantages

Following are the advantages of Continuous Production:

1. Standardization of product and process sequence.
2. Higher rate of production with reduced cycle time.
3. Higher capacity utilization due to line balancing.
4. Manpower is not required for material handling as it is completely automatic.
5. Person with limited skills can be used on the production line.
6. Unit cost is lower due to high volume of production.

Limitations

Following are the limitations of Continuous Production:

1. Flexibility to accommodate and process number of products does not exist.
2. Very high investment for setting flow lines.
3. Product differentiation is limited.

Production Management
Production management is ‘a process of planning, organizing, directing and controlling the
activities of the production function. It combines and transforms various resources used in the
production subsystem of the organization into value added product in a controlled manner as per the
policies of the organization’.
Objectives of Production Management
The objective of the production management is ‘to produce goods and services of Right Quality and
Quantity at the Right time and Right manufacturing cost’.

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1. Right Quality: The quality of product is established based upon the customers need. The
right quality is not necessarily being the best quality. It is determined by the cost of the product and
the technical characteristics as suited to the specific requirements.
2. Right Quantity: The manufacturing organization should produce the products in right
number. If they are produced in excess of demand the capital will block up in the form of inventory
and if the quantity is produced in short of demand, leads to shortage of products.
3. Right Time: Timeliness of delivery is one of the important parameters to judge the
effectiveness of production department. So, the production department has to make the optimal
utilization of input resources to achieve its objective.
4. Right Manufacturing Cost: Manufacturing costs are established before the product is
actually manufactured. Hence, all attempts should be made to produce the products at pre-
established cost, so as to reduce the variation between actual and the standard (pre-established) cost.

Operations System:
An operation was defined in terms of the mission it serves for the organization, technology it
employs and the human and managerial processes it involves. Operations in an organization can be
categorized into Manufacturing Operations and Service Operations. Manufacturing Operations is a
conversion process that includes manufacturing yields a tangible output: a product, whereas, a
conversion process that includes service yields an intangible output: a deed, a performance, an
effort.
In some of the organization the product is a physical good (breakfast in hotels) while in others it
is a service (treatment in hospitals). Bus and taxi services, tailors, hospital and builders are the
examples of an operations system. The basic elements of an operation system show in Figure 1.3
with reference to departmental stores.
A departmental store's has an input like land upon which the building is located, labour as a
stock clerk, capital in the form of building, equipment and merchandise, management skills in the
form of the store’s manager. Output will be serviced customer with desired merchandise. Random
fluctuations will be from external or internal sources, monitored through a feedback system.

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Fig.1.3 Operations system for department stores

Framework of Managing Operations:

Managing Operations can be enclosed in a frame of general management function as shown in
above figure. Operation managers are concerned with planning, organizing, and controlling the
activities, which affect human behaviour through models.
Planning is the activity that establishes a course of action and guide future decision-making.
The operations manager defines the objectives for the operations subsystem of the organization, and
the policies, and procedures for achieving the objectives. This stage includes clarifying the role and
focus of operations in the organization’s overall strategy. It also involves product planning, facility
designing and using the conversion process.
Organizing is the activities that establish a structure of tasks and authority. Operation managers
establish a structure of roles and the flow of information within the operations subsystem. They
determine the activities required to achieve the goals and assign authority and responsibility for
carrying them out.
Controlling is the activities that assure the actual performance in accordance with planned
performance. To ensure that the plans for the operations subsystems are accomplished, the
operations manager must exercise control by measuring actual outputs and comparing them to
planned operations management. Controlling costs, quality, and schedules are the important
functions here.
1. Behaviour: Operations managers are concerned with the activities, which affect human
behaviour through models. They want to know the behaviour of subordinates, which affects
managerial activities. Their main interest lies in the decision-making behaviour.
2. Models: Models represents schematic representation of the situation, which will be used as
a tool for decision-making. Following are some of the models used.
Aggregate planning models for examining how best to use existing capacity in short term,

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break-even analysis to identify break-even volumes, Linear programming and computer simulation
for capacity utilization, Decision tree analysis for long-term capacity problem of facility expansion,

Operation Management
Joseph G .Monks defines Operations Management as the process whereby resources, flowing
within a defined system, are combined and transformed by a controlled manner to add value in
accordance with policies communicated by management.
The operations managers have the prime responsibility for processing inputs into outputs. They
must bring together under production plan that effectively uses the materials, capacity and
knowledge available in the production facility. Given a demand on the system work must be
scheduled and controlled to produce goods and/or services required. Control must be exercised over
such parameters such as costs, quality and inventory levels.

Scope of Operation Management

Operations Management concern with the conversion of inputs into outputs, using physical
resources, so as to provide the desired utilities to the customer while meeting the other
organizational objectives of effectiveness, efficiency and adoptability. It distinguishes itself from

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other functions such as personnel, marketing, finance, etc. by its primary concern for ‘conversion
by using physical resources’. Following are the activities, which are listed under Production and
Operations Management functions:
1. Location of facilities.
2. Plant layouts and Material Handling.
3. Product Design.
4. Process Design.
5. Production and Planning Control.
6. Quality Control.
7. Materials Management.
8. Maintenance Management.

Fig. 1.9 Environment of operations

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Productivity
Productivity is defined in terms of utilization of resources, like material and labour. In simple terms,
productivity is the ratio of output to input. For example, productivity of labour can be measured as
units produced per labour hour worked. Productivity is closely linked with quality, technology and
profitability. Hence, there is a strong stress on productivity improvement in competitive business
environment.
Productivity can be improved by (a) controlling inputs, (b) improving process so that the same
input yields higher output, and (c) by improvement of technology. These aspects are discussed in
more detail in the lesson on Productivity Management.
Productivity can be measured at firm level, at industry level, at national level and at international
level.

Factors Affecting Productivity

Economists site a variety of reasons for changes in productivity. However some of the principle
factors influencing productivity rate are:
1. Capital/labour ratio: It is a measure of whether enough investment is being made in plant,
machinery, and tools to make effective use of labour hours.

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2. Scarcity of some resources: Resources such as energy, water and number of metals will create
productivity problems.
3. Work-force changes: Change in work-force effect productivity to a larger extent, because of
the labour turnover.
4. Innovations and technology: This is the major cause of increasing productivity.
5. Regulatory effects: These impose substantial constraints on some firms, which lead to change
in productivity.
6. Bargaining power: Bargaining power of organized labour to command wage increases excess
of output increases has had a detrimental effect on productivity.
7. Managerial factors: Managerial factors are the ways an organization benefits from the unique
planning and managerial skills of its manager.
8. Quality of work life: It is a term that describes the organizational culture, and the extent to
which it motivates and satisfies employees.

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OPEARATIONS DECISION MAKING

Business firms make hundreds of decisions relating to operations every day, some having a
significant impact on the firm’s future business and some others with very less impact, some routine
and some others non-routine, some having immediate repercussions and some long-term
implications, some based on full information, and some on partial or no information, some simple
and some others very complex, some based on judgement and some others based on complex
analysis of data, some at the top level of the firm and others at the lower levels, and so on.

For example, where to locate a new plant? How much material to order? Should the labour
demands for new standard time be entertained? Who should take a particular decision? How many
maintenance personnel to be employed? Where to train personnel? How long to train? How much to
spend on R&D? Which technology to buy? Whom to collaborate with? How to motivate personnel?
Which capacity machine to install? Whom to promote? What should be the strategy to attract
customers? When to maintain a machine? Whether to buy or make a component? Which market to
enter and with which products? Etc.
Can all these decisions be made by our natural ability or simple judgement? Often, the
decision situations are so complex that one cannot effectively handle them in the absence of
mathematical, statistical and other tools. Hence, it is necessary to understand decision making (a
component of management) as a scientific process, the characteristics of decisions, framework for
decision making and decision methodologies and techniques.
MANAGEMENT AS A SCIENCE

As Management science knowledge has the following characteristics similar to other

sciences, it is also treated as science.
(i) Organized principles of knowledge: span of control, decision theories, queuing models,
etc.

(ii) Use of empirical data: knowledge-base developed based on experimental data

(iii) Systematic analysis of data: Use of mathematical and statistical tools, use of computers

(iv) Repeatable results: Consistent results under similar experimental conditions

While there are a large number of decisions void of personal-value to be made, there are
occasions where personal values influence decisions too.

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CHARECTARISTICS OF DECISIONS
Decisions can be broadly grouped into three categories namely, (i) Strategic decisions, (ii)
Tactical decisions and (iii) Operational decisions. Hence, with respect to operations activity too, we
can identify strategic, tactical and operational decisions.
Regardless of the level of decision making, the use of quantitative and qualitative techniques
is wide spread among business community. This is because, the use of such tools provide a
systematic approach to solving the problem and making a decision. Several techniques have been
developed to aid decision making. However, not all tools can be used in all decision making
situations. The appropriateness of the technique for a decision-making situation depends on several
factors such as: (a) the significance of the decision, (b) time and cost limitations and (c) the degree
of complexity of the decision. The decisions with far reaching consequences need to be based on
adequate amount of data, thorough analysis and careful interpretations and sound judgement.
Several causal models are available for analysis of such decision situations. Often, the decisions are
to be made quickly. In such situations techniques that require large amount of time may not be
appropriate. Further, the decision maker should be able to provide cost justification for the
technique used. Finally, increased complexity of decisions calls for the use of sophisticated
techniques as a normal human being cannot comprehend the problem situation in its entirety. The
complexity increases with increasing number of variables, decision criterions, constraints, and
paucity of relevant and timely data.

FRAMEWORK FOR DECISION MAKING

The following steps constitute a framework for decision making and provide a systematic
approach.
(i) Defining the problem: This step involves identification of relevant variables, scope of the
problem, realistic assumptions to work with, etc. Identifying the stake holders, the direct and
indirect impact of the decisions, immediate and delayed impact of the decisions are also a part of
this stage.

(ii) Establishing the decision criteria (objectives): Establishing the objectives/goals/purpose of

decision is crucial. Quite often, maximizing the profit is used as a criterion. However, these days,
firms use multiple criteria such as employee welfare, cost, impact on environment, market share,
productivity, stability, growth, technological leadership, reputation and good will, etc.

(iii) Formulation of model: The relevant variables are abstracted from the real-life problem and
used to formulate a model to represent the problem in a simpler manner. Formulation implies
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expressing the underlying relationships among the variables in a testable form. There are several
types of models: (1) Verbal; (2) Physical or iconic; (3) Schematic or diagrammatic; and (4)
Mathematical models.

(iv) Generation of alternatives: Alternative solutions to the model can be generated by varying
the values of the variables and experimented. Mathematical and statistical models are more
amenable for modifications and hence to generate alternative solutions quickly.

(v) Evaluation of alternatives and selecting the best one: Alternative solutions are evaluated
against the already established criteria. Best alternative or decision is one which most closely
satisfies the criteria. Some procedures such as LPP inherently seek an optimum solution (either
maximizing or minimizing the criterion). Whenever optimum solution cannot be guaranteed at a
reasonable cost and time, heuristics can be tried out to arrive at solutions that are close to optimum.

(vi) Implementation and monitoring: Although these are not strictly a part of decision making,
the managerial action would be complete only when the decision is implemented and monitored.
Fellow managers have to be convinced of the merit of the decision made and its implementation has
to be followed through. Implementation of the decision is also an art.

DECISION METHODOLOGY

Techniques/methodologies that are useful for decision making can be categorized based on
the degree of certainty that exists with respect to the decision variables and possible outcomes. The
degree of certainty is classified as: (i) Complete certainty; (ii) somewhat uncertain and risky; and
(iii) complete uncertainty. When we know for sure what would be the outcome of our decision then
we are dealing with a problem under conditions of uncertainty. When a decision has more than one
possible outcome and we know the likelihood of each outcome we are dealing with a problem under
conditions of risk. Finally, when a decision has more than one possible outcome and we do not
know the likelihood of each outcome, we are dealing with a problem under conditions of
uncertainty. Examples of decision making under the three situations are given below.
EXAMPLE – Decision under conditions of Certainty
Problem 1. A chain of supermarkets is going to open a new store at one of four possible locations.
Management wishes to select the location that will maximize profitability over the next ten years.
An extensive analysis was performed to determine the costs, revenues, and profits for each
alternative. The results are shown below.

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Location Ten-year Annual Profit (in million R)

1 0.70

2 0.95

3 0.60

4 0.84

Management has a high degree of confidence in these figures. The decision criterion (profit) has
been explicitly identified and accurately calculated for each alternative. Management's strategy is to
select the alternative with the highest criterion value, in this case, location 2.

EXAMPLE - Decision under conditions of Risk

Further analysis of the supermarket chain's problem reveals that the profit associated with
each location is not known for sure. Management is convinced that the ten-year profitability of each
location will depend upon regional population growth. Therefore management cannot predict the
outcome with certainty. Three possible rates of population growth were identified: low, medium,
and high. The profitability (in million R) associated with each location and each rate of population
growth was calculated, as shown below.

Rate of Population Growth

Medium
Low High
(above 5%
Location (5% or (10% or
but below
less) more)
10%)

1 0.3 0.8 0.9

2 0.2 0.6 1.1

3 0.4 0.5 0.6

4 0.6 0.7 0.8

Probability (P) 0.2 0.3 0.5

The figures at the bottom of the table give the probability (likelihood) of each rate of population
growth. Decision strategy in this situation is more difficult than it is under conditions of certainty.

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In analyzing this situation, we have to arrange the data differently than we did under conditions of
certainty. The profit for low, medium, and high population growth is listed separately for each
location. Which alternative is best? If population growth turns out to be low, location 4 is best (R
0.6 million). If growth is medium, location 1 is best (R 0.8 million), and if it is high, location 2 is
best (R 1.1 million). But there is uncertainty with respect to the rate of population growth.
In the analyst's language, the three rates of population growth are called states of nature. As
the three states of nature have different probabilities of occurrences, we apply a procedure called
calculating the expected value in this case. For each alternative location, we calculate the product
of each outcome and its probability. The sum of these products is the expected value of the
alternative location. The expected value is highest for alternative 2: R 0.77 million. If management
faced this situation many times and always chose alternative 2, its average profit would be higher
than for any other alternative.
Calculation of expected value (R million):

Alternative Expected value

Outcome x Probabilities Summation
(profit)

1 0.3 x 0.2 = 0.06 0.8 x 0.3 = 0.24 0.9 x 0.06 + 0.24 + = 0.75
0.5 = 0.45 0.45

2 0.2 x 0.2 = 0.04 0.6 x 0.3 = 0.18 1.1 x 0.04 + 0.18 + = 0.77
0.5 = 0.55 0.55
3 0.4 x 0.2 = 0.08 0.5 x 0.3 = 0.15 0 .6 x 0.08 + 0.15 + = 0.53
0.5 = 0.30 0.30

4 0.6 x 0.2 = 0.12 0.7 x 0.3 = 0.21 0.8 x 0.12 + 0.21 + = 0.73
0.5 = 0.40 0.40

EXAMPLE - Decision under conditions of Uncertainty

Even further analysis has cast doubt on the probability of the rates of population growth.
New management doesn't know the probabilities of low, medium, or high growth, and is faced with
a problem under conditions of uncertainty. Obviously, strategy is much harder to come by in this
case.
Problems under conditions of uncertainty can also be structured in matrix form. Since the
probabilities are not known, however, rational strategies for decision-making are not well defined
or straightforward. We discuss three approaches from among several that analysts use. The first,
maximax, is an optimistic approach; the analyst considers only the best outcome for each

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alternative regardless of probability. Looking at the table for the risk example and ignoring the
probability row, the outcomes that would be considered are R 0.9 million for alternative 1, R 1.1
million for alternative 2, R 0.6 million for alternative 3, and R 0.8 million for alternative 4. Among
these, alternative 2 yields the maximum profit, and that is the one that would be chosen.
The second approach is maximin, a pessimistic approach; the analyst considers only the
worst outcome for each alternative and chooses the "best of the worst." In the table in the risk
example, in the outcomes that would be considered are R 0.3 million for alternative 1, R 0.2 million
for alternative 2, R 0.4 million for alternative 3, and R 0.6 million for alternative 4. The best of
these is alternative 4.
The third approach, the principle of insufficient reason, assumes that since we know
absolutely nothing about the probabilities of any state of nature, we should treat each with equal
probability, calculate the expected values accordingly, and choose the alternative whose expected
value is highest. Using this approach, we would choose alternative 4.
CLASSIFICATION OF DECISION METHODOLOGIES

Below given is a classification of decision making techniques available to operations managers.

Some techniques may be suitable for use under more than one condition.
Complete certainty Partially certain and risky Extreme uncertainty
(all information is assumed to (Some information is available) (No information)
be available)
Algebra: Statistical analysis: Game theory
Break even analysis Estimation & test of hypotheses Flipping coin
Benefit/cost analysis Regression and correlation
Multivariate analysis
Calculus Queuing theory
Mathematical programming: Simulation
Linear Heuristic models
Nonlinear Network analysis
Integer Decision trees
Dynamic PERT/CPM
Goal Utility theory

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In the recent days there has been a great inclination among business firms to use quantitative
methods to arrive at good decisions, especially, mathematical and statistical techniques. Some
examples of Economic models, Statistical models and Decision support systems are discussed
below.
Decision Support System (DSS): This is an information system to aid decision making. Although
it has been in existence for a long time in the form of manual recording, storage, analysis and
retrieval of data and information, these days it is supported by computers, peripherals and
communication networks in order to enable effective decision making at all levels. Computers are
of a big help especially in generating and evaluating alternatives. However, it is the manager who
has to take decisions and not computers. It is strongly suggested that the manager shall condition
the outcome of analysis with his judgment, experience, and skills before arriving at a decision and
committing resources. Occasionally, the DSS may also involve expert systems.

Economic Models:

(i) Break-Even Analysis (BEA) :

This technique helps us to determine the volume of business operation at which the total costs
become equal to the total revenue. i.e. no profit or no loss situation. For any investment, it is
important to know the BEP vis-à-vis level of market demand and thus the safety margin of
operation.
At BEP, total revenue = total cost
Total revenue = total fixed cost + total variable cost
(Price/unit) * volume at BEP = total fixed cost + (variable cost/unit) * volume at BEP
P * VBEP = FC + VC* VBEP
Hence, VBEP =FC/(P-VC)
As (P-VC) is known as contribution margin from the unit sold, we have,
VBEP =FC/Contribution margin
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Quantity of output

Break-Even Chart

The advantages of BEA are that (i) it is very simple to understand, (ii) it addresses
profitability of an investment which is very important, (iii) it allows quicker manipulation of the
model and easier sensitivity analysis.
Its limitations include it assumes that all data (costs, price and volume) are known and certain. It
further assumes linear relationships between variables (e.g. volume sold and total revenue) and that
all output can be sold. It is useful for only one product business. It assumes that variable and fixed
cost elements can be separated.
Problem. 2. For an existing product that sells at P = Rs. 650/- per unit, FC = Rs. 82,000/- and
VC = Rs. 240/- per unit. Determine (i) the BEP and (ii) volume needed to earn a profit of Rs.
10,250/-.

Solution. (i) VBEP =

FC /(P-VC)
=
82,000/(650-
240)
= 200 units
(ii) Vfor profit of 10,250 = (FC+ 82,500) /(P-VC)
= (82,000+10,250) / (650-240) = 225 units
Problem 3. A producer of digital watches sells his product at Rs. 30 each. The
production costs at volumes of 10,000 and 25,000 units are as follows. Using the data
prepare a break-even chart and determine the BEP.

Item 10,000 units 25,000 units

Labour Rs. 60,000 Rs. 1,00,000
Materials 1,20,000 2,00,000
Overheads 90,000 1,10,000
(FC+VC)
Selling and 50,000 60,000
administration
Depreciation 80,000 80,000

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and other FC
Total 4,00,000 5,50,000
Solution. In the following figure, we know that the slope (change in Y/Change in X) of the
total cost line represents the variable cost/unit.

5,50,000
Co ∆Y
4,st
00,000
an
d
∆X
Re
ve
nu
e

10,000 25,000

Quantity of output

VC = (Change in Y/Change in X) = ∆Y/∆X

= (5,50,000 - 4,00,000) / (25,000 - 10,000)
= Rs.10 per unit
At volume of 10,000 units, total variable cost = 10 * 10000 = Rs.1,00,000
Hence, at that volume, total fixed costs = total costs - total variable costs
Rs. 4,00,000 – 1,00,000 = 3,00,000
We know that BEP = FC/(P-VC)
3,00,000 / (30-10) = 15,000 units

Problem 4. A company has 30 employees and handles 1500 loads per year of grain from a
warehouse. The firm has fixed costs of Rs.70,000 per year and variable costs of Rs. 170 per
load. The firm is considering installing an Rs.80,000 automated material handling system that
will increase fixed cost by Rs.20,000 per year but will increase the per unit contribution of
each load by Rs.20. The firm operates 250 days per year and receives an average of Rs.300
revenue for each load passed through the warehouse. Determine the current annual profit or
loss. What is the new BEP volume if the investment is made?

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Solution:

(i) Current annual profit = total revenue – total cost

= (1500 loads * Rs.300 per load) – [70,000 + (1500 loads * Rs.170 per
load)]
= 4,50,000 – 3,25,000 = Rs.1,25,000

(ii) New BEP if the investment is made

VNew BEP = New FC /( New contribution margin)

= (70,000 + 20,000) / (130+20) = 600 loads

Statistical Models:

In the above problems the decision making was under the conditions of certainty. However,
there are several situations where the information available for making decisions is incomplete or
uncertain. Sometimes even if the entire data can be collected, it may not be justified cost and
timewise. For eg. in quality control we do sample inspection instead of 100% inspection. Inventory,
maintenance, work-sampling and queuing theories also pose similar situations. Hence, an
understanding of probability and sampling distributions is necessary to make good decisions.
Two events are independent events if the occurrence of one in no way affects the other. Two events
are said to be mutually exclusive events when the occurrence of one precludes the occurrence of the
other, i.e. either this or that. Basic probability rules:
Complement: P(A) = 1-P(Ā)
Multiplication: P(A and B) = P(A) P(B│A), if A and B are dependent events
= P(A) P(B), if A and B are independent events

Addition: P(A or B) = P(A) + P(B) – P(A and B), if A and B are not mutually
exclusive events = P(A) + P(B), if A and B are mutually exclusive events

Bayes’ rule: P(A│B) = P(A and B)/P(B)

= [P(A) P(B│A)] /{ [P(A) P(B│A)] [P(Ā) P(B│Ā)]}
Probability is a basic measure of uncertainty and it expresses the chance of occurrence of an
event in terms of a numerical value. Three approaches to study probabilities are:

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Classical approach: where probabilities can be computed prior to an event (a priori) – eg. rolling a
dice
Empirical approach: where probabilities are computed based on the observed frequency data – eg.
probability that the next item produced by a given machine will be a defective.
Subjective probability: where probabilities are computed based on personal experience and
judgment – eg. probability that the new product launch would be a success
Problem 5. Two assembly robots X and Y, each working at the same rate together
produce 400 dust filters per day. During a recent day’s production, 40 filters were
found to be defective. Given that a filter is defective, there is a 0.4 probability it was
produced by robot X (i.e. P(X│D) = 0.4). What is the probability that a filter selected
at random is:

(i) defective?

(ii) produced by robot Y?

(iii) defective and produced by robot X?

(iv) defective or produced by robot X?

Solution: Let P(X) be the probability that the item is produced by robot X
P(Y) be the probability that the item is produced by robot Y
P(D) probability that the item is defective

(i) P(D) = 40/400 = 0.10

(ii) P(Y) = (50% 0f 400)/400 = 0.50

(iii) P(D and X) = As the events are not mutually independent, P(D and X) = P(D)
P(X│D)

= (0.1) * (0.4) = 0.04

(iv) P(D or X) = As the events are not mutually exclusive, P(D or X) = P(D) + P(X) –
P(D and X) = (0.1) + (0.5) – (0.04) = 0.56

Problem 6. Great Automobiles limited has received from its supplier some
unmarked brackets for the left and right front doors of its passenger car and cannot
easily separate them. Neither the firm can distinguish the type of mounting i.e. A, B
or C. The shipment received has 500 brackets as below.

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Type A Type B Type C

Right front 264 0 36
door brackets
Left front door 152 45 3
brackets
The stores keeper receives an urgent call for a right front bracket, type A. He randomly
selects a bracket from the bin that contains all of them, and rushes it to the shop. (i) What is
the probability that he sends the correct bracket? (ii) Suppose the person could identify the
type of mounting but not whether it was for a right or left door. What would be the
probability of correct choice in that case.
Solution:

(i) The number of type A right front brackets/ total number of brackets = 264/500 = 0.528
(ii) As the events are not independent, P(R│A) = P(A and R) / P(A)
= 264/(264+152) = 0.635

Decision Trees:

These are schematic diagrams that show the alternative outcomes and
interdependence of choices in a multi-phase or sequential decision process. The tree like
diagram is constructed from left to right, using square boxes for representing controllable
points (decisions) and circles for uncontrollable (chance) events. Each branch leads to a
payoff that is stated in monetary or utility terms on the right end.
Decision trees are analyzed from right to left by multiplying the payoff s by their
respective probabilities (which are assigned to each chance event). The highest expected
value then identifies the best course of action and is entered at the preceding decision
point. It then becomes the payoff value for the next higher-order expectation, as the
analysis is continued back to the truck of the tree.

Problem. 7. A glass firm developing a substantial backlog of orders is considering

three courses of action (i) arrange for subcontracting (ii) begin overtime production
(iii) construct new facilities. The correct choice depends largely on future demand,
which may be low, medium or high. By consensus, management ranks the respective
probabilities as 0.10, 0.50 and 0.40. A cost analysis reveals the effect on profits as
shown below.

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Profit (in thousand R) if the demand is

Course of Low Medium(P= High(P=
action (P= 0.5) 0.4)
0.1)
A – Arrange 10 50 50
for
subcontracting
B – Begin -20 60 100
overtime
C – Construct -150 20 200
new facilities

Solution: Build a decision tree structure showing the decision (controllable) variables A, B and C at
the left hand side and followed by the chance alternatives of demand (uncontrollable variable) and
then the corresponding probabilities and payoff values at the end of respective branches. Then
compute expected value with respect to t each branch as follows.

Low (0.1) 10

Medium (0.5) 50

High (0.4) 50
A
Low (0.1)
-20
B
Medium (0.5) 60

High (0.4) 100

C Low (0.1)
-150

Medium (0.5) 20

High (0.4) 200

Expected payoff for decision A is E(A) = 10*0.1 + 50 * 0.5 + 50 * 0.4 = R 46,000

Expected payoff for decision B is E(B) = -20*0.1 + 60 * 0.5 + 100 * 0.4 = R 68,000

Expected payoff for decision C is E(C) = -150*0.1 + 20 * 0.5 + 200 * 0.4 = R 75,000
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These EVs are entered at circles of respective branches. Choice of alternative is made based
on the highest EV. Here, as EV corresponding to C (of R. 75,000) is highest, it is suggested to
construct new facilities.

The advantages of decision trees are that it is simple, decision situation is well structured,
explicitly identifies alternatives, distinguishes controllable from uncontrollable variables.
Limitations are that the monetary and probability values are still to be estimated by the user.

SYSTEM DESIGN AND CAPACITY PLANNING

Products / services before delivered to customers have to be designed and produced. Thus it
is necessary to design a system with appropriate capacity and plan for its financial requirements
(fixed capital & working capital). Further, the system need to be located (facility location) and laid
out (facility layout).
Design of operations system involves planning for inputs, transformation activities, and
output from the system. The design decisions are far-reaching and can leave lasting imprints on
firm’s business activities. This is because, such decisions may require the firm to commit
significant amount of resources (fixed costs) and may affect cost and productivity (variable costs)
over a long-run.
Assessment of the long term demand for the company’s output forms the basis for planning
its capacity. In this chapter we will learn about the capacity of the operations system, how to plan
it, strategies for meeting long-term and short-term capacity requirements, and the related topics.
The concepts of systems design and capacity planning discussed here are applicable to both
manufacturing and service systems.

Capacity means the ability to produce/deliver. Every individual, equipment, production

shop, or organization has its own capacity. It is expressed in terms of the quantity and quality of
output in a stipulated time from that entity. Three related terms are design capacity, systems
capacity and actual output of a facility.

Design Capacity:

This is the planned rate of output of goods and services under normal full scale operating
conditions. For eg. A paint company may have been designed to produce 10,000 liters of a
particular type of paint in a day. A sugar mill may be designed for crushing 2,00,000 tons of
sugarcane per annum. A hostel dining hall may be designed to cater to 400 students in one sitting.
The preliminary estimates of capacity (i.e. 10,000 liters, 2,00,000 TPA or 400 students) are based
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on long range forecasts i.e., a projection of demands into the future (say 5-10 years). This long-
range forecasts help in identifying whether the demand is likely to be temporary or a sustained one.
But preparing such forecasts is not a simple task due to the uncertainty in the future demand. While
some trend in the demand may be seen, the boom and recessions often cause swings about the trend.
Further, systematic fluctuations in demand due to seasonal factors and unexpected fluctuations due
to random events can also be seen.
The figure below shows a sample of demand variation for a company’s output over time.
The demand is fluctuating between high and low values. This variation can continue to exist in
future. Even the maximum and minimum demand shown might also get revised. An organization
cannot plan to satisfy all its demand because of fluctuations. If it plans to meet its maximum (peak)
demand its capacity will be underutilized for most of the time. On the other hand, if the designed
capacity of its facility is for minimum demand, the facility will be fully utilized, but often it may
face shortage of facility to provide satisfactory services to customers and may lose them. Hence, the
designed capacity should reflect the firm’s management’s strategy for meeting demand. Often, a
capacity in between minimum and maximum should be fine. But, where? Which probability
distribution can explain variation in demand more appropriately? What percentage of the times the
firm should be able to meet the demand completely? What alternatives it has for the rest of the
times? These are some questions to be answered while planning capacity.

Problem 9. Freddie’s fast foods has enjoyed considerable success in using multilane services
channels. Freddie’s can serve 32 cars/hour in one lane of its drive-throughs. Now they are planning
for new drive-through facility in a new location. Market research data suggests it may have the peak
hourly demands estimated below.
Number of cars per hour
0< 40< 80<1 120<1 160<2
40 80 20 60 00
Probabili .10 .35 .40 .13 .02
ty (%

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chance)
Cumulati .10 .45 .85 .98 1.00
ve
probabili
ty
The operations manager is considering two alternatives for deciding how much capacity to install.
What capacity is required to: (i) meet 85% of the estimated peak hourly demands and (ii)
accommodate 110% of the estimated average demand plus a 25% allowance for growth?

Solution :
(i) From the cumulative probability row, it is seen that 100% of the times the estimated
demand is less than 200 cars/hr, and 85% of the times it is less than 120 cars/hr.

With 32 cars/lane, the company needs: 120/32 ≈ 3.7

5, say a 4 lane facility.

(ii) The capacity required to accommodate 110% of the estimated average demand plus
25% allowance for growth.

Estimated (or expected) value of average demand = E (X) = ∑ (X . P(X)), where X is

the value at the midpoint of each class interval (i.e, 20 for 0-40 class)
E(X) = 20 (0.1) + 60 (0.35) +100(0.4) + 140 (0.13) + 180 (0.02) = 84.8 cars
110% of this E (X) = 84.8 X 1.1 = 93.28 cars /hr
Adding 25% allowance, we have, 93.28(1+0.25)=116.6 cars/hr or approximately 117
cars/hr
No. of lanes now required to be installed = (Total capacity/ Capacity per lane) = (
117/32)

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= 3.8 or 4 lanes
Four service lanes will satisfy both the criteria

System capacity:

This is the maximum output of a specific product or product mix that the system of workers
and machines is capable of producing as an integrated whole. System capacity is usually less than
or equal to the design capacity of the individual components because the systems may be limited by
the product mix, quality specifications, long run market conditions or the current imbalance
between equipment and labour. These factors are less controllable and long-term in nature. For eg.
A paint manufacturing plant, although its design capacity is 2.5 million liters of paints per day, can
produce a maximum of say 2 million liters of paints may be due to different mix of paints being
produced, OPEC adopts self-restraint in crude oil production, A company’s mining capacity limited
by environmentalists & political pressure, Computer capability underutilized due to limitations in
the capacity of peripherals, software and human beings.

Actual output:

The actual output of the system may be even less than its systems capacity because it is
affected by short-range factors such as actual demand, equipment breakdown, absenteeism and
worker and management inefficiencies. For eg. A paper mill may be constrained to produce a much
lesser output than its system capacity due to poor quality bamboos procured. A motor bike might
offer a mileage of 85kmpl under ideal conditions (designed performance), and under normal
conditions may give 68kmpl (systems capacity). But, depending up on the riding skill of the user its
performance could be only 55kmpl (actual output).

Design capacity (e.g. 125 tons)

Prod mix, log-term market conditions

Tight quality specifications
Inherent imbalance in eqpt and labour

System capacity (e.g. 100 tons)

Actual output Actual demand, Poor managerial

SE= --------------------- performance, Worker inefficiencies,
Systems capacity Machine inefficiencies, etc.

Actual output (e.g. 80 tons)

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Relationship between capacities and output

Problem 10. A chemical processor has been making a white plastic compound for dish-wear on a
continuous basis by processing it through a series of four tanks (for mixing, heating, molding &
cooling) at a rate of 50 liters of chemical per minute. The firm now plans to produce different
coloured plastic compound on the same equipment. However, the individual capacities of the tanks
will then be limited because of the time needed for cleanout, different temperature requirements and
other factors. If the individual capacities (in liter/ min) and actual output for new operations are as
shown below, what is (i) the system capacity & (ii) the system efficiency?

A B C D

48 50 43 48
Actual output 40 liter/min

Solution :

Design capacity = 50 gallons / min

System capacity (for new plastic compound) is determined by the capacity of
bottleneck equipment C = 43 gal / min

Hence, (i) System capacity = 43 gal /min

(ii) System efficiency = 40/43 = 93%

Problem 11. An automatic drive-in teller has the capacity of handling 2000 entries per day (as per
the claim of the manufacturer). However, because of limitations imposed by automobile access, the
teller is available for only 60% of the time. It is actually being used for about 800 entries per day.

What is the system efficiency?

Solution:
Design capacity: 2000 entries per day
System capacity: 2000 x 0.60 = 1200 entries per day
Actual operation = 800 entries per day

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Hence, system efficiency = (Actual output/system capacity) = 800 / 1200 = 66.7%

Problem 12. An aerospace manufacturer must acquire some molding machines capable of
producing 1,60,000 good parts per year. They will be installed in a production line that normally
produces 20% rejects because of tight aerospace specifications.
(i) What is the required systems capacity?

(ii) Assume that it takes 90 seconds to mold each part and the plant operated 2000 hours per year. If
the molding machines are used only 50% of the time and are 90% efficient, what actual (usable)
molding machine output per hour would be achieved?
(iii) How many molding machines would be required?

Solution:
(i) System efficiency = (Actual output / System capacity)
System capacity = (Actual output per year/system efficiency) = 1,60,000 / (1.0-0.2)
= 2,00,000 units per year

(ii) At 1.5 mins (i.e. 90 secs)/unit , a molding machine produces 40 units per hour.
But, with only 50% utilization, and 90% efficiency, the machine produces
40 x0.50 x 0.90 = 18
units per hour.
i.e., individual machine capacity per year = 18 x 2000 = 36,000 units

(iii) Number of machines required = (quantity of items to be produced per year/individual machine
capacity per year)
= 2,00,000/36,000 = 5.56 machines or 06 machines are required

Capacity planning:

Definition of capacity: Capacity is defined as a measure of the ability to produce, or serve,

i.e. having enough worker- or equipment-time to do the job. In other words, capacity is the rate of
output that can be produced with a given facility (eg. so many liters of chemical/day; no of

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customers/hr, etc). Sometimes, one would use monetary unit such as Rs/month. But this is more
appropriate as an aggregate measure of capacity when a variety of products are produced by the
facility. For eg. Suppose that a milk dairy’s output includes milk, cova, milk powder, curd, butter,
ghee, etc., then either total weight of the products processed or its sales turnover can be a better
measure to indicate its capacity. Capacity is the limit on one’s ability to produce. Both upper &
lower bounds of capacity are important because upper bound determines the firm’s ability to meet
the customer demands and lower bound should be well above the break-even point.
Capacity planning refers to deciding on short- or long-range capacity needs of an
organization and determining how these needs will be satisfied. The capacity decisions should link
customer demands with the resources (such as human, material, financial, machines, etc.) of the
organization.
Long-term capacity strategy: Long-term capacity is concerned with accommodating major
changes that affect the overall level of output in the longer-term (say more than 1-2 years)
Assessing market demands & implementing long term capacity plans are strategic responsibilities
of the top management. Decisions relating to start or closure of a production facility, expansion of
an existing facility, etc will significantly affect the capacity levels of a firm.

(i) Multiple products in the same plant: The strategy of firms to produce more than one type of
product or provide more than one type of service in the same facility increases the chances of
better profits and reduce the risk from the failure of one of the products. In view of the changing
demand over the life cycle of a product, this strategy helps better utilization of the capacity.
Introducing a new product when the other is in its mature or decline phase keeps the facilities
optimally loaded and utilized.

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(ii) Phasing-in capacity (Commissioning additional capacity): Some times, even before a firm has
the knowledge of which specific product it is going to produce, it may need to commit
resources/people to a facility. Many software companies hire engineers even before they know
the kind of projects they will get. A university may acquire large ground space even before it has
least idea of which departments it is going to launch over time. This would lessen the response
time of the firm to market demands, especially when project gestation period is longer than the
product life cycle and the firm wants to introduce the product to market before it becomes
obsolete). In such situations, the firm phases-in portions of capacity on a modular basis as new
products become available. Phasing in or commissioning additional capacity through new
technology can be sometimes risky unless a thorough preparation is done well before.

(iii) Phasing-out capacity (reducing capacity): Today, as firms are faced with intense competition
and need to respond to the same, often they come across the situation wherein they need to
decommission or phase-out their plants and facilities. Hence, operations managers should also
be familiar with phasing out operations in unviable plants. Closure of plant impacts not only the
fixed costs and commitment with suppliers, but also could have a serious adverse impact on
direct and indirect employment and may lead to social problems too. The society would suffer
this social and economic cost. The socially responsible firms may retrain workers for other jobs,
offer them employment in other locations, offer employees ownership of the firm, or
compensate in some other way such as offering VRS. Decommissioning nuclear power plants,
disposal of hazardous waste, phasing out satellite after useful life in space all need to be planned
before commissioning them to service.

Short- term capacity strategy: Short-term capacity planning is concerned with handling
fluctuations in demand caused due to seasonal, uncertain and economic factors. It involves
responding to immediate variations (in the immediate future) in demand. Manufacturing and
service firms will have their own strategies to deal with the situation.
Manufacturing plants can choose to vary to employment levels, work either over time or
operate 2nd/ 3rd shifts to meet the temporary strong demand. For eg. demand for crackers, fruit
juices, ice creams, woolen dress, etc. They may accumulate stock during slack demand season
and use it during peak demand season. Alternatively, they may also shift the excess work load
to subcontractors.
Service providing firms may choose to shift the demand to lean periods by appropriate
schemes. For eg. charging less for STD telephone calls made after working hours shifted part
of the demand from day hours to night. Reduction in room-rent during off-seasons in a tourist
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place shifts part of the demand. A trust may run both school and college in the same building,
but with different working hours. This amounts to rescheduling of work/demand. Service units
such as hotels, transport corporations work over-time to handle emergency rush demand or idle
time to cope with lean demand, where as police and hospitals depend on part-time employees
such as seeking homeguards or NGOs. Doctors, professors and lawyers use appointment
system to spread the demand uniformly over time, in which case the customers are forced to
adapt to the system’s capacity. Traffic police, to avoid congestion during peak hours (when the
traffic demand is greater than the capacity of roads), advises car pooling, one-way traffic,
flexible working hours, and so on. Alternatively, get customers in queue. For eg. appliance
repair shops, tailors stitching dresses who keep the same work force and delay the delivery of
service until they can produce it. Thus there are several strategies to deal with immediate
variation in the demand. We should also remember that an innumerable number of
combinations of the above strategies is possible in a given situation.

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