COURSE BOOK

Operations and Information

Management
DLMBAEOIM01
Course Book
Operations and Information
Management
DLMBAEOIM01
2 Masthead

Masthead

Publisher:
IU Internationale Hochschule GmbH
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DLMBAEOIM01
Version No.: 001-2022-0614

© 2022 IU Internationale Hochschule GmbH

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 Module Director 3

Module Director
Prof. Dr. Philippe Tufinkgi

Mr. Tufinkgi is a lecturer at the IU International University of Applied

Sciences for General Business Administration with a focus on logis-
tics.

In the course of his work as a research assistant to the Chair of Logis-

tics at the Technischen Universität Berlin, he received his doctorate in
the field of humanitarian logistics.

Mr. Tufinkgi is co-founder of the planning and consulting company

International Transfercenter for Logistics (ITCL) GmbH and as manag-
ing director of ITCL, he managed logistics projects in the main areas
of logistics strategy development, plant logistics planning, sustaina-
bility, logistics and inventory optimization for companies in the auto-
motive industry, mechanical engineering, and logistics services. In
addition, he was responsible for the conception and implementation
of numerous further education programs for logistics service provid-
ers and industrial companies and worked as a freelance lecturer at
the International School of Management (ISM).
4 Contents

Table of Contents
Operations and Information Management

Module Director . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Introduction
Operations and Information Management 7
Signposts Throughout the Course Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Unit 1
Introduction to Operations Management 12
1.1 What Is Operations Management? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1.2 Challenges of Operations Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Unit 2
Preparation of Reliable Demand Forecasts 22
2.1 What Is Forecasting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

2.2 Qualitative Forecasting Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

2.3 Quantitative Forecasting Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.4 Measuring Forecast Error . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Unit 3
Site Selection 36
3.1 Importance of Site Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

3.2 Problems Associated with Site Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

3.3 Optimization with Predetermined Locations . . . . . . . . . . . . . . . . . . . . . . . . 39

3.4 Factors Affecting Site Selection Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . 40

3.5 Site Selection Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

 Contents 5

Unit 4
Process Design and Process Planning 50
4.1 Process Types and Factors Affecting the Process Design . . . . . . . . . . . . . 50

4.2 Types of Manufacturing Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

4.3 Process Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

4.4 Process Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

4.5 Priority Rules for Planning and Controlling Processes . . . . . . . . . . . . . . . 65

Unit 5
Inventory Management and Production Control 70
5.1 Models for Optimizing Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

5.2 Continuous Inventory Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

5.3 Function and Application of MRP and Just-in-Time Systems . . . . . . . . . . 78

5.4 Methods for Optimal Planning of Capacities and Production Plans . . . 83

Unit 6
Information Systems in the Supply Chain 90
6.1 Increased Performance through Product and Process Design . . . . . . . . 90

6.2 Order Policy, Demand Forecast, and Demand Planning . . . . . . . . . . . . . . 93

6.3 Conceptual Frameworks of Supply Chain Management (SCM) . . . . . . . . . 95

6.4 Complexities for Supply Chain Information Systems . . . . . . . . . . . . . . . . . 96

Unit 7
Behavioral Operations Management 100
7.1 Decision Heuristics for Solving Complex Problems . . . . . . . . . . . . . . . . . 100

7.2 Decision Behavior and Decision Prognosis . . . . . . . . . . . . . . . . . . . . . . . . 103

7.3 Decision-Making Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

6 Contents

Appendix 1
List of References 110

Appendix 2
List of Tables and Figures 116
Introduction
Operations and Information
Management
8 Introduction

Signposts Throughout the Course Book

Welcome

This course book contains the core content for this course. Additional learning materials can
be found on the learning platform, but this course book should form the basis for your
learning.

The content of this course book is divided into units, which are divided further into sections.
Each section contains only one new key concept to allow you to quickly and efficiently add
new learning material to your existing knowledge.

At the end of each section of the digital course book, you will find self-check questions.
These questions are designed to help you check whether you have understood the concepts
in each section.

For all modules with a final exam, you must complete the knowledge tests on the learning
platform. You will pass the knowledge test for each unit when you answer at least 80% of the
questions correctly.

When you have passed the knowledge tests for all the units, the course is considered fin-
ished and you will be able to register for the final assessment. Please ensure that you com-
plete the evaluation prior to registering for the assessment.

Good luck!
 Introduction 9

Learning Objectives

Operations management is critical for any organization regardless of its size, the nature of its
products and services, or its business sector. The course Operations and Information Man-
agement will illustrate the importance of operations management in delivering products and
services to meet customers’ demands.

You will discover how factors such as globalization, innovative technologies, and disruptive
events such as pandemics, political conflicts, and natural disasters have altered the opera-
tions function within organizations. The role of operations management has changed signifi-
cantly in recent decades and organizations now recognize it as a core function that is critical
to remaining competitive.

You will gain insights into the characteristics of production and service organizations and
become more familiar with key historical developments in the field of operations manage-
ment and the application of innovative approaches. You will also learn about contemporary
challenges faced by operations management such as mass customization, demand volatility,
and shorter product life cycles.

The recommended reading will add a further dimension to the concepts that constitute this
course by introducing you to the most important authors and articles in the field of opera-
tions management.
Unit 1
Introduction to Operations Management

STUDY GOALS

On completion of this unit, you will have learned …

… what the operations function is within an organization.

… the history of operations management and its role in an organization.

… the difference between the production of goods and the delivery of services in the
context of operations.

… how operations management is conducted in production and service organizations and

how it has been affected by challenges.

DL-E-DLMBAEOIM01-U01
12 Unit 1

1. Introduction to Operations Management

Introduction
You might think that operations management is a novel field of study. However, it is
likely that you have already encountered it during your studies or in your workplace. To
understand operations management, one needs to understand the purpose of organi-
zations and businesses, which is to deliver products and services in the most efficient
manner possible to meet customer demands. Consider the role that operations man-
agement plays in the delivery of products and services for the following organizations:

• BMW, a leading German multinational automotive company renowned for producing

branded vehicles (BMW AG, n.d.)
• Henkel, a family business that specializes in consumer and chemical goods (Henkel,
n.d.)
• KPMG, a multinational auditing and financial services provider that services a broad
range of industries, businesses, and governments in more than 140 countries (KPMG,
n.d.)

Operations management has always had a central and critical role in the production of
products and delivery of services, but that role has changed significantly in recent dec-
ades. Globalization, the growth of e-commerce, the unprecedented use of information
technology in all walks of life, growing customer influence on companies thanks to
their ability to purchase alternatives, the presence of social media, and expectations
regarding the swift delivery of products and services have all changed how businesses
operate. The current business landscape in particular is characterized by an unprece-
dented level of disruption due to global events such as pandemics, greater demand
volatility, and the increased speed of technological changes. In spite of these disrup-
tions, organizations must deliver high-quality products and services at an increasingly
faster speed to ensure the retention of their customers. Operations management has
become an integral part of any nature of organization whether small or large, profit-
seeking or non-profit seeking, private or government. The aforementioned companies
are market leaders in their individual business sectors because of their continued
focus on operations management, optimizing systems, and processes that ensure the
efficient delivery of products and services and satisfy their customers.

In this unit, we will explore the role of operations management, the relationship
between operations and supply chain management, and the differences between pro-
duction and service companies. We will also learn about various challenges affecting
operations management.

1.1 What Is Operations Management?

Operations management is a business function that involves converting inputs, or
resources, into outputs such as finished products and services through effective plan-
ning, scheduling, coordinating, and controlling processes. The main goal of operations
 Unit 1 13

Introduction to Operations Management

management is to deliver products and services in a way that most effectively meets Operations manage-
customer demands and maximizes company profits. Ultimately, operations manage- ment
ment is about supply and demand—matching the demand of products and services This ensures the
with their supply and ensuring the success of the organization by satisfying customers. most efficient and
An operations manager is a person responsible for overseeing the operations manage- effective delivery of
ment function within an organization. products and serv-
ices by an organiza-
The core activities of an organization are its main operations. For example, operations tion.
at Deutsche Bank deliver banking services (Deutsche Bank, n.d.), operations at IUBH
deliver quality online education, and operations at Volkswagen produce cars (Volkswa-
gen, n.d.). The following figure provides an overview of the operations function within
an organization. An organization has access to resources such as materials, people,
information, money, facilities, and machines. The operations function involves convert-
ing these resources into outputs that meet the demands of customers. An output
includes products or goods, services, satisfied customers, emissions, and useful infor-
mation. For example, automotive companies convert inputs such as raw materials, elec-
tricity, labor, and machine hours into cars and automotive spare parts by executing
operations functions such as cutting, welding, and assembling.

An important distinction needs to be made between the outputs of an organization, i.e.,

goods and services. The following is a list of definitions for terms used throughout this
unit:

• Goods and products are tangible items that we can touch, see, and feel.
• Services are intangible items that cannot be seen or touched and are consumed at
the point of delivery, e.g., auditing and consulting services.
• The operations or business function is a combination of people, technology, and
delivery systems that has the conversion of inputs into output in the most efficient
manner as its core task.
14 Unit 1

Brief History of Operations Management

Along with changing consumer demands and the state of technology, the role of opera-
tions management within an organization is highly dynamic and has evolved over
time . During the 1960s, the main goal of many businesses was the mass production of
products and goods in order to create economies of scale (Ivanov et al., 2019). However,
this led to issues regarding the quality of the goods and services produced, leadint to
Total quality man- the emergence of the total quality management (TQM) approach in the 1970s. TQM is
agement an approach where all employees are responsibile for maintaining high standards and
This is an approach engaging in continuous improvement practices to ensure that the goods and services
focused on improv- produced by the organization meet customer requirements. Over time, TQM became an
ing all functions of integral component of business operations, affecting every sphere of the organization.
an organization con- During the 1980s, the role of operations management shifted towards the delivery of
tinuously. customized products and services, and organizations increasingly sought to manage
their inventories more effectively.

During the 1990s, the operations function in many businesses became increasingly
overwhelmed with a wide variety of products and goods, and customers began
demanding faster delivery of products and services. To meet rapidly growing customer
demands, organizations sought to improve their internal and external business pro-
cesses. In the early twenty-first century, due to the increasing market deregulation by
various countries (most notably, China and India) and rapid advancements in informa-
tion technology and the internet, organizations started enhancing production compe-
tencies by utilizing low-cost labor and cheap raw materials which became available
through joint ventures and collaborations with companies and countries in which these
resources were plentiful. Since 2010, the business landscape has witnessed unprece-
dented changes in business operations as the result of technological trends such as
Industry 4.0 digitalization, smart factories, and Industry 4.0 (Ivanov et al., 2019).
Also known as the
fourth industrial rev-
olution, Industry 4.0 Scope of Operations Management for Production and Service Organizations
refers to environ-
ments in which Before we explore the scope of operations management in production and service
machines and busi- organizations, we need to understand the fundamental purpose of an organization. An
ness processes are organization is essentially a combination of people, resources, systems, and processes
connected 24/7 via organized into a structure and managed for performance of commercial, industrial, or
information technol- professional activities. An organization is typically managed via three fundamental and
ogy. significant functions: operations management, finance, and marketing (Reid & Sanders,
2007). The scope of the finance and marketing functions is often a lot clearer than the
operations management function. For example, it is the responsibility of the finance
function to provide the necessary financial resources in order to purchase raw materi-
als and meet the working capital needs of an organization, whereas activities such as
assessing customer demands and providing product and service information to poten-
tial customers fall under the marketing function. Operations management plays an
essential role in converting resources into outputs through planning, organizing, coor-
dinating, and controlling these resources in the most efficient way possible.
 Unit 1 15

Introduction to Operations Management

While the goal of operations management is the same for all organizations, the tasks
involved in managing operations differ depending on whether a business is providing
products or services. The main characteristics and features of these two types of organ-
izations are summarized below:

Production or manufacturing companies

• The outcomes of the production process are physical goods.

• There is a longer response time to fulfil customer orders.
• Companies have less customer contact.
• Goods and products can be stored for future use.
• Larger investments are required to build manufacturing infrastructure.

Service companies

• Service delivery typically involves a rapid response to customer demand and a high
level of customer engagement.
• The outcome of the production process is services that are consumed at the point
of delivery and cannot be stored for future use.
• Service companies employ a large percentage of the labor force.

Depending on the nature of the product or service produced and the business sector in
which the organization is positioned, the role of operations management may vary.
However, the fundamental task of operations management remains the same: deliver
products and services to customers most efficiently and effectively. The following table
illustrates examples of operations management in the manufacturing and services sec-
tors.
16 Unit 1
 Unit 1 17

Introduction to Operations Management

1.2 Challenges of Operations Management

Mass Customization

Mass customization is the large-scale production of goods and services that accommo- Mass customization
dates for individual customer needs while minimizing the costs of production. The mar- This is a customer-
ket demand for mass customization is a major challenge facing designers, marketing centric approach to
executives, and senior management in contemporary organizations. To respond to the producing products
challenge of mass customization, companies must identify which components and and services on a
aspects of products need to be customized. Modern consumers want outstanding prod- large scale at a low
ucts and services that are tailored to their specific needs and desires; at the same time, cost.
they are often price conscious and unwilling to pay more for their desired level of cus-
tomization. This is unsurprising given that consumers today have more options than
ever before when purchasing goods and services thanks to a growing number of
national and international companies, globalization, and the availability of online
products and services that can be consumed immediately or distributed directly to the
consumer.

While mass customization has huge benefits for consumers, it poses a significant chal-
lenge for established companies. Existing production processes and delivery systems in
these companies are simply not designed to produce a diverse range of unique prod-
ucts and services. Such companies have relied on developing mass production capaci-
ties in order to minimize costs, develop economies of scale, and maintain quality
through standardization. For these companies, production and business processes are
often interdependent and making any changes to their processes is incredibly complex.
As a result, changing production processes is often quite capital intensive, which limits
the ability of organizations to adapt quickly to changes in the market. Start-ups and
emerging companies are often in a better position to analyze and cater for the needs
of customers. Many of these companies have based their entire business around
designing and producing customer-centric products and services, a viable business
model thanks to the internet. This type of business model is the result of a major
change in managerial mindset to focus on unique customer requirements and design
production processes and delivery systems so that they can adapt quickly to changing
customer desires.

Demand Volatility

Saldanha et al. (2013) define demand volatility as the “inconsistent, unstable or highly
variable demand for company goods and services” (p. 314). Demand volatility occurs
when there are fluctuations in demand and uncertainty regarding consumer purchasing
patterns for products and services. Demand volatility exists due to factors at a macro-
level (i.e., global perspective, large scale, hyper-competitive markets, global events,
market types and size, regulatory changes, political unrest) and microlevel (i.e., com-
pany-specific, changing customer demands, seasonality of products, disruptions in
supply chain management) level. As discussed earlier in this unit, the goal of the oper-
18 Unit 1

Supply chain man- ations function is to deliver products and services that meet customer demands. How-
agement ever, in the case of demand volatility, if an organization is unable to forecast customer
A company coordi- demand, how can that organization reasonably determine the number of products to
nates the flow of manufacture and services to render? Demand volatility therefore presents numerous
materials, informa- challenges to operations managers and supply chain experts because they are unable
tion, and finance in to forecast their requirements accurately. Demand volatility is a serious challenge for
order to effectively organizations, who constantly seek ways to manage it. Successful companies are those
deliver products and that effectively manage demand volatility, reducing their supply chain costs while
services. meeting quality standards demanded by their customers (Gangadharan, 2007).

Shorter Product Life Cycles

A product life cycle (PLC) refers to the lifespan of a product or service in the market,
from when it is first introduced to consumers to when it is eventually withdrawn from
the market. It is comprised of four stages: introduction or launch, growth, maturity, and
decline, as shown in the following figure.

The first stage of PLC is the introduction or launch of a product and service wherein
organizations create customer awareness through marketing channels. The second
stage is the growth of a product or service in the market due to its perceived value and
increasing customer demand. During this stage, companies can increase their market
share by minimizing price competition through product differentiation and product
innovation. In the maturity stage, companies sell large quantities of their products and
services as consumer demand reaches its peak. However, at this point in the product
 Unit 1 19

Introduction to Operations Management

life cycle, the level of competition is greatest due to new market entrants and market Product differentia-
saturation. The final stage of PLC is decline wherein a company starts witnessing a tion
rapid decline in sales and market share due to the increasing availability of cheap sub- This refers to the
stitute products, changing demand patterns, and the availability of more innovative unique features of a
products. product or service
that distinguish it
Intense market competition and a large variety of available products and services force from those offered
companies to shorten their PLC to remain profitable. A shorter product life cycle poses by competitors.
several challenges to organizations. Firstly, it squeezes profit margins due to fewer
sales. Secondly, it amplifies the pressure placed on research and development (R&D)
departments to develop new designs and work simultaneously on multiple projects
and concepts. A prominent example of a company embracing the shorter product life
cycle is Apple. Apple capitalizes on the shorter PLC of the smartphone to increase their
revenue by continually developing innovative products and releasing updated models
of their popular iPhone. However, Apple is the exception; many companies are simply
unable to obtain the financial resources required to meet increasing development
costs and capital expenditures associated with continually releasing new products and
investing in that level of innovation. At the same time, as markets become more
dynamic and volatile, organizations find it harder to accurately forecast customer
demand and make informed decisions about when to introduce new products and
services.

Summary

A critical functionin organizations, operations management is responsible for effec-

tively and efficiently converting inputs into outputs in order to deliver products and
services to customers. Inputs consist of materials, people, information, capital,
machines, energy, and delivery systems, whereas outputs are the products and
services that are the result of the organization’s operations.

There are two basic types of organizations: production or manufacturing and serv-
ice. Products or goods are tangible items that can be stored, whereas services are
intangible items that cannot be stored and are consumed at the point of delivery.

Operations management within organizations today faces several critical chal-

lenges: mass customization, demand volatility, and a shorter product life cycle.
Mass customization is the large-scale production of goods and services that accom-
modates for individual customer needs while minimizing the costs of production.
Demand volatility occurs as a result of fluctuations in customer demands, disrup-
tions in supply chains, and other factors occurring on a macro- and microlevel. The
product life cycle is the overall life of a product or service in the market that con-
sists of four stages: introduction or launch, growth, maturity, and decline. Compa-
nies are experiencing shorter product life cycles due to intense market competition,
the growing availability of substitute products, increased market entry of new com-
panies, and changing customer demand patterns.
20 Unit 1

Knowledge Check

Did you understand this unit?

You can check your understanding by completing the questions for this unit on the
learning platform.

Good luck!
Unit 2
Preparation of Reliable Demand
Forecasts

STUDY GOALS

On completion of this unit, you will be able to …

… explain the purpose of demand forecasting.

… differentiate between the various types of forecasting used by businesses.

… apply various forecasting techniques.

… conduct regression and correlation analyses.

DL-E-DLMBAEOIM01-U02
22 Unit 2

2. Preparation of Reliable Demand Forecasts

Introduction
Forecasting plays a significant role in the field of operations management for three
major reasons. Firstly, businesses rely on forecasting for effective planning. Secondly,
accurate forecasting improves the effectiveness of production, capacity, and scheduling
systems. Finally, forecasting errors affect all significant business functions including
finance, marketing, and personnel planning. In this unit, we will explore forecasting as a
general concept before examining specific qualitative and quantitative methods and
forecasting errors.

2.1 What Is Forecasting?

Forecasting Forecasting is the art and science of predicting future events. It involves the collection
This is the process of and application of historical data to predict future outcomes using various prediction
determining the out- strategies. There are three main prediction methods used in forecasting: subjective,
come of a future objective, and intuitive prediction.
event.
• Subjective prediction is a qualitative approach to forecasting that relies heavily on
judgements and educated guesses. This technique is more suitable for long-range
forecasting.
• Intuitive prediction is a non-regressive approach to forecasting that often results in
extreme predictions due to the use of unreliable information.
• Objective prediction is a quantitative approach to forecasting that uses econometric
models to analyze publicly available and reliable information.

Good forecasting often requires a combination of these methods to derive the most
desirable outcome. For example, objective predictions derived from the use of a math-
ematical model can be adjusted using subjective predictions made by a manager who
draws on their vast experience to make informed judgements. In the majority of cases,
there is seldom one superior method of making predictions. It is important to note that
businesses can choose not to make any predictions at all, avoiding forecasting alto-
gether and basing decisions on actual events and data available in real time. However,
the decision to avoid forecasting can prove to be costly as effective planning in both
the long-term and short-term relies on accurate forecasting.

Forecasting Based on Time Horizon

Time horizon Forecasts can be classified according to their time horizon as follows:
This is a way of clas-
sifying forecasts • Short-range forecasts have a time span of up to one year but generally cover less
based on time peri- than three months.
ods. • Medium-range forecasts typically span from three months to three years.
• Long-range forecasts cover three years or more.
 Unit 2 23

Preparation of Reliable Demand Forecasts

Types of Forecasting

Organizations use three major types of forecasts in planning future operations:

1. Economic forecasts predict inflation rates, money supply, housing starts, and other
economic indicators relevant for business.
2. Technological forecasts predict technological innovations and the rate of technolog-
ical progress.
3. Demand forecasts provide projections of a company’s products or services.

Generating forecasts can be quite a daunting task for businesses. There are many chal-
lenges to creating accurate forecasts including a limited degree of control over some
performance measures and concerns with its goal congruence. Even global giants such
as Walmart often have inventory problems and run out of stock (Rosenblum, 2014).

Goals of Forecasting

The goals of forecasting include the following:

• managing demand
• optimizing supply chain management
• improving organizational performance
• increasing turnover
• meeting profitability targets
• improving managerial decision-making capabilities
• improving the efficiency of human resources
• reducing shortages

Seven Steps in the Forecasting System

The process of forecasting can be divided into the seven steps shown in the following
figure.
24 Unit 2

The relevant activities for each step in the forecasting process are as follows:

1. Purpose. This step requires a business to determine why a forecast is necessary and
what information about the future activities of the company is important to deter-
mine. A simple purpose of forecasting might be using customer information to pre-
dict future sales. For example, a TV streaming service can use the number of users
streaming specific content to determine the genre-specific demand for a particular
period. Capturing customer information in this way allows the streaming service to
develop content that appeals to its audience, advertise to its target customers, and
improve its market share.
2. Selection. This step involves selecting appropriate information to conduct the fore-
cast. For example, a supermarket can monitor sales in a different location to main-
tain effective scheduling.
3. Time and size. This step involves identifying the time horizon and sample size for
the forecast. For example, an automotive company would need to identify the most
effective time period, i.e., short, medium, or long, for a forecast related to the pro-
duction of a specific model of car in a specific region.
4. Models. This step involves selecting models for forecasting. The selection of the
model often depends on the company and its specific needs. In many cases, the
model chosen will be a statistical model but managers may opt to utilize non-statis-
tical models or judgement sampling in certain circumstances.
5. Data collection. This step involves collecting data for forecasting. Different compa-
nies use different approaches to collect the necessary data to conduct forecasts. For
example, a large organization might use external firms to collect primary data on
the travel industry, economic indicators, and financial trends to conduct necessary
forecasts. Conversely, smaller enterprises may rely solely on internal company data
that is easily accessed for the purpose of generating forecasts.
 Unit 2 25

Preparation of Reliable Demand Forecasts

6. Forecast. In this step, the company uses the data collected to conduct a forecast
based on the model selected. In the case of methods based on judgement, a com-
pany does not rely heavily on data. Instead, it makes a forecast based on managerial
experience regarding customer expectations, supply chain vulnerability, and eco-
nomic uncertainty.
7. Validate and implement. In this final step, companies review the results of the fore-
casting process, eliminate errors, and develop strategies for continuous improve-
ment. Some of the critical activities in this step include data validation and error
measurement.

2.2 Qualitative Forecasting Methods

There are many qualitative forecasting methods available to those working in opera-
tions management including sales estimates, expert estimates, customer surveys, and
the Delphi technique. Each of these methods have associated strengths and weak-
nesses, but all of them can be utilized to generate a qualitative forecast of demand.

Sales Estimates

A sales estimate is where information is collected from sales representatives, sales

teams, and company management in order to project the number of sales that will be
made weekly, monthly, quarterly, or annually. This approach often requires sales repre-
sentatives to predict the sales they are likely to make in their territory. The marketing
division then typically collects all projections and reviews them to ensure they are real-
istic. These reviewed projections are then used to reach an overall forecast for the
company. The sales estimate approach often requires input from district-level market-
ing managers who are asked to provide expertise regarding current market trends in
order to develop a sales forecast.

Expert Estimate

In this method, a group of high-level experts is assigned the task of estimating

demand. Experts contributing to this process have the option of using qualitative,
quantitative, or blended approaches when contributing to the estimate. The advan-
tages of this forecasting approach are that it can be easily implemented and that the
company benefits from experts with knowledge of the product and business functions
who also have insights into the likely impact of a new product on the bottom-line of
the company.
26 Unit 2

Customer Survey

The customer survey method is one of the most commonly used methods of qualitative
forecasting. In this method, the company relies on customer responses regarding their
current and future purchasing plans. Companies often engage external firms to conduct
such surveys. In the age of digital technology, companies frequently use online ques-
tionnaires to elicit customer feedback on new and existing products and services
offered by the firm. The customer survey approach can have additional benefits such
as helping a firm to improve its product design and generating ideas for new products
based on customer feedback. However, the customer survey method can also result in
the generation of unrealistic sales forecasts and the development of product designs
with limited market potential if the customers surveyed are not representative of the
customer base, the questionnaire is poorly constructed, or the sample size is insuffi-
cient.

The Delphi Technique

Delphi method The Delphi method is a sophisticated approach to generating forecasting data com-
The Delphi method pared to the other qualitative forecasting approaches. In this method, at least three dif-
is a structured ferent levels of participants are used, including experts, company staff, and respond-
approach that com- ents. Company staff play a vital role in assisting experts by preparing, distributing,
bines sales esti- collecting, and summarizing responses received using quantitative methods.
mates and expert
estimates. The Delphi method has broader applications in project management where it is used to
estimate the likelihood and outcome of future events. This technique requires careful
evaluation of the opinion of various stakeholders and requires application in stages.
The first stage involves a manager finding a facilitator to serve as a neutral person. The
second stage involves identifying experts who are knowledgeable about the product
and the industry. In the third stage, managers are in a position to define the problem
and develop questions that facilitate the extraction of experts’ views on the defined
problem. Based on the input from the experts, managers can then update the research
problem and revise the research questions. In the fourth stage, other stakeholders are
included in the discussion. All of the information gathered in stages three and four is
analyzed in the final stage to assess the risks and opportunities associated with a
project.

2.3 Quantitative Forecasting Methods

Two key quantitative forecasting methods are time series forecasting and associative
forecasting. There are different methods for each of these types of forecasting. Here, we
explore three different methods of time series forecasting: naive approach, moving
average, and exponential smoothing. We will also explore two methods of associative
forecasting: linear regression analysis and multiple regression analysis.
 Unit 2 27

Preparation of Reliable Demand Forecasts

Time Series Forecasting

Time series forecasting methods rely on the assumption that the future is a function of
the past, meaning that they can use historical information to generate forecasts. For
example, to create a time series forecast, an IT company could use the data on the sale
of a previous operating system to predict the sales of a new operating system. A time
series forecast has the following four components:

1. Trends. This component shows whether there is a gradual increase or decrease in

the unit of analysis over time. Examples of a unit of analysis include income, popu-
lation, exchange rate, and sales.
2. Seasonality. This component refers to a pattern of repetition that occurs over a
specified interval. The interval can be days, weeks, months, quarters, or years. Exam-
ples of seasonality include an increase in ice cream sales during summer or an
increase in the demand for umbrellas during the rainy season.
3. Cycles. This component represents a pattern in the data that is repeated after a
specified interval. Cycles are short-term in nature and have the potential to signifi-
cantly affect business operations if the business does not adequately prepare for
them. While it is important to determine cycles, it can be challenging to predict
them as they can be caused by unforeseeable external events such as political
events or global crises.
4. Random variations. This component represents unusual variations in the data
caused by chance or unusual circumstances. Random variations cannot be predic-
ted in advance.

There are three different methods of time series forecasting available to businesses:
the naïve approach, moving average, and exponential smoothing.

Naïve approach
The naïve approach represents the simplest method of time series forecasting. It relies Naïve approach
on the most recent information for the prediction of future events. For example, using The naïve approach
the naïve approach, a music streaming service could assume that the number of new is a cost-effective
subscribers will be 800 in March if the number of new subscribers was 800 in February. way to predict future
This type of forecasting may not provide the most accurate results but it is cost-effec- events.
tive and provides a starting point for businesses that can be used as a benchmark or
later refined.

Moving average
The moving average method relies on actual historical data to conduct a forecast. This
method is suitable for a business if demand remains relatively consistent over time.
The main benefit of using the moving average method is that it is simple to calculate. A
quarterly average can be derived by dividing total demand for the last three months by
three. It becomes a moving quarterly average by adding the latest month and excluding
the earliest month from the denominator. The formula for the moving average is as fol-
lows:
28 Unit 2

∑ Demand in the previous n periods

Moving Average =
n

Here, n is the number of periods in the moving average.

Example

Note: The forecasting demand for March 2019 is derived by adding the demand for
December, January, and February and then dividing the total by three. All forecasting
figures are rounded to the next whole number.
 Unit 2 29

Preparation of Reliable Demand Forecasts

Exponential smoothing
Exponential smoothing is a form of moving average forecasting that includes weighting.
One of the advantages of exponential smoothing is that it requires a limited amount of
record keeping and can be easily calculated. The formula for exponential smoothing is
provided below.

Forecast for the current period = Forecast for the previous period + α
Previous period’s demand – Previous period’s forecast

Here, α is the smoothing constant (it can take any value between 0 and 1).

Example
In March, a smartphone dealer predicted April demand for a new phone to be 15,000
units in Florida, US. Actual April demand was 20,000 units. Top management at the
company has decided on a smoothing constant of α = 0.45 and requires a forecast for
May. The equation needed is

Forecast for May = 15,000 + 0.45 20,000 − 15,000 = 17,250

Therefore, the total demand for the new phone in May is expected to be 17,250 units.

There are three exponential smoothing techniques available in time series forecasting.
These are defined as follows:

• Single exponential smoothing is the purest form of exponential smoothing that can
be applied to univariate data sets that lack trend or seasonality characteristics.
• Double exponential smoothing is an extension of the single exponential smoothing
method with an added feature of trend analysis in multivariate datasets.
• Triple exponential smoothing, often referred to as Holt-Winters exponential smooth-
ing, allows both trend and seasonality analysis in univariate time series data sets.
This is the most advanced exponential smoothing technique and incorporates level,
trend, and seasonality analysis, which is not possible in the single or double expo-
nential smoothing.

Associative Forecasting Methods

While time series forecasting methods rely on historical information to generate fore-
cast data, associative methods are based on the assumption that other variables in the
environment need to be analyzed in order to create a forecast. Two associative fore-
casting methods that are explored here are linear regression analysis and multiple
regression analysis.
30 Unit 2

Linear regression analysis

Linear regression analysis is one of the most common quantitative forecasting techni-
ques used by businesses and analysts. This method requires the manager to develop a
dependent and independent variable before conducting the linear regression analysis.
An example of a dependent variable is the profit of the business while an independent
variable could be operating expenses. The linear regression equation is provided below

Y = a + bx

Here, y is the dependent variable (net profit), a is the intercept, b is the slope of the
regression line, and x is the independent variable (operating expense):

Σxy − n y x
b= 2
Σx2 − n x

Example
Given the data below, what is the simple linear regression model that could predict
sales for the KaPow Corporation?

Actual Data for KaPow Corporation

Month Advertising costs (in mil- Sales (in million euro) (y)
lion euro) (x)

January 15 200

February 16 210

March 16.5 220

April 17 225

May 17 230

June 18 230

July 20 240
 Unit 2 31

Preparation of Reliable Demand Forecasts

Forecast Calculations for KaPow Corporation

Advertising costs x2 Sales (y) x·y

in Euro (x)

15 225 200 3,000

16 256 210 3,360

16.5 272 220 3,630

17 289 225 3,825

17 289 230 3,910

18 324 230 4,140

20 400 240 4,800

Average = 17 Total = 2055 Average = 222 Total = 26,665

26,665−7 · 222 · 17
b= 2
= 7.719
2,055−7 · 17
a = 222 − 7.719 · 17 = 90.781

So, the regression equation is y = 90.781 + 7.719x.

Two important additions to calculating the linear regression are determining the stand-
ard error and correlation coefficient. The standard error of an estimate is important Standard error of an
when establishing the accuracy of the regression estimates. It is also known as the estimate
standard deviation of the regression. The standard error of an estimate measures the The standard error
error from the dependent variable to the regression line. The formula for the standard of estimate uses the
deviation of the regression is presented below standard deviation
to measure the
2 extent of variation in
Σ y − yc
Sy, x = the regression line.
n−2

Here, y is the value of the dependent variable of each data point, yc is the value of the
dependent variable derived from the regression equation, and n is the number of data
points.
32 Unit 2

Correlation coeffi- The correlation coefficient provides an additional method of analyzing the relationship
cient between two variables. While the linear regression line represents the relationship
The correlation coef- between variables, the correlation coefficient indicates the strength of such a linear
ficient indicates the relationship. The value of the correlation coefficient can range between —1 and +1, indi-
strength of the rela- cating a negative or positive relationship respectively.
tionship between
two variables. Multiple regression analysis
Multiple regression is an extension of the linear regression model discussed earlier. A
Multiple regression multiple regression, as the name implies, allows the introduction of more than one
This is an extension independent variable when developing the regression model. This is not permitted in a
of the linear regres- linear regression model. However, the number of dependent variables remains the
sion forecasting same as we cannot study more than one dependent variable with a single regression
method that allows equation. The multiple regression equation is
for more than one
independent varia- y = a + b1x1 + b2x2
ble.
The equation above includes two independent variables, x1 and x2, and y as the single
dependent variable. a and b are intercepted; the slope of the regression line, which was
present in the linear regression equation, is also intercepted. The Statistical Packages
for Social Sciences (SPSS) is a common tool used to perform such analysis, although in
most situations, multiple regression equations are calculated using a computer. The
following example provides a demonstration of the use of this formula.

Example
The multiple linear regression equation for a software corporation, calculated for the
production of their computer chips, is

y = 2, 500 + 0.5x1 + 0.8x2

Now, if we substitute x1 and x2 with 150,000 labor hours and 200,000 kilogram of mate-
rials, then the total production of computer chips will be

y = 2, 500 + 0.5 · 150, 000 + 0.8 · 200,000 = 237,500

By using both variables, the software corporation now has a production forecast of
237,500 computer chips.

2.4 Measuring Forecast Error

The forecasting techniques we have discussed so far may not provide results that
match an actual event. The gap between the forecast and the actual event is known as
the forecasting error. There are several methods that can determine the degree of the
forecasting error. In this section, we discuss some of the popular methods of determin-
ing forecasting errors including mean absolute deviation, mean squared error, and
mean absolute percent error.
 Unit 2 33

Preparation of Reliable Demand Forecasts

Mean Absolute Deviation (MAD)

The first method of determining forecasting error is known as the mean absolute devi-
ation (MAD). In this method, the forecasting error is determined by taking the absolute
value of each forecasting error, which is then divided by the total number of periods of
information covered to generate the forecast. The equation for the MAD is

ΣActual − Forecast
MAD =
n

Here, n is the number of periods.

Mean Squared Error (MSE)

Another way to determine forecasting error is by using the mean squared error (MSE)
method. The difference between the MAD and the MSE is that the MSE uses the mean
squared differences instead of absolute values to derive forecasting errors. The equa-
tion for the MSE is

2
Σ Forecasting errors
MSE =
n

Here, n is the number of periods.

Mean Absolute Percent Error (MAPE)

There are problems with both the MAD and the MSE, as the magnitude of the forecast
plays a vital role in the forecasting error. In the case of a large forecast, both the MAD
and the MSE return a large forecasting error. Mean absolute percentage error (MAPE) is
introduced to overcome such a problem. The equation for the MAPE is

n Actuali − Forecasti
∑i = 1 100
Actuali
MAPE =
n

Summary

Simply understanding the current demand for a product or service does not ensure
the long-term sustainability of a business; business managers need to make deci-
sions about future demand in order to achieve business goals. Forecasting the
demand for products or services is crucial for effective planning. Utilizing the most
34 Unit 2

appropriate forecasting technique to predict future demand can help a business to

develop a competitive advantage via cost minimization and efficient production
planning.

There are two methods of forecasting: qualitative and quantitative. Qualitative

methods require the judgement of the decision-maker, e.g., a manager makes a
forecast based on their experience in the field. Quantitative forecasting methods
rely on historical data to predict a future outcome.

While forecasting can improve planning capabilities for a business, forecasts can
differ from actual results. This is known as a forecasting error, which can be predic-
ted using various statistical methods. Despite the error associated with all available
forecasting methods, forecasting is nevertheless a critical process in operations
management. Three reasons for this are that successful companies develop reliable
demand forecasts to gain a competitive advantage over competitors, forecasting
economic conditions can influence merger and acquisition decisions, and the capi-
tal structure of a firm is often based on predictions related to interest rates and
stock market trends.

Knowledge Check

Did you understand this unit?

You can check your understanding by completing the questions for this unit on the
learning platform.

Good luck!
Unit 3
Site Selection

STUDY GOALS

On completion of this unit, you will be able to …

… explain the importance of site selection.

… identify the central problems affecting site selection.

… optimize site selection decision-making for pre-determined locations and identify

relevant factors affecting the decision.

… utilize various quantitative techniques for suitable site selection.

DL-E-DLMBAEOIM01-U03
36 Unit 3

3. Site Selection

Introduction
Site selection is a critical managerial decision that can have enormous implications for
the growth and viability of a business. Whether retail, service, manufacturing, or whole-
sale, the sites at which businesses are located can have a significant bearing upon all
operations. Thus, decisions related to sites and facilities require careful decision-mak-
ing whether starting, relocating, or expanding operations. Site selection determines
access to facilities, which are a non-current asset (i.e., long-term investment). When
selecting a site, a manager has to ensure that the necessary people, materials, and
machines required to produce goods or deliver services using available facilities are
sufficiently available; access to such resources will inevitably vary between potential
sites. Once site selection has occurred, site management plays a vital role in the effi-
cient operation of a production facility; Improved management of sites can lead to cost
reductions, improved quality, and minimum wastage of available resources.

There are several factors that need to be explored before managers can select a site
from existing alternatives. Criteria for site selection often vary depending on the indus-
try. For example, a bank would consider the physical location of a new branch and its
proximity to new customers to be of strategic importance whereas a manufacturer of
food products might consider access to distribution networks and manufacturing facili-
ties to be of greater strategic importance. Either way, careful analysis should be done
before a firm decides to expand its existing systems and add a new location.

This unit begins with a detailed discussion of the importance of site selection deci-
sions. We will then explore various issues affecting site selection decisions and discuss
the general procedure for making such decisions. This will be accompanied by discus-
sion of costs and location-related issues that affect site selection. The final section
focuses on the quantitative and qualitative techniques used in site selection decisions.

3.1 Importance of Site Selection

Site selection Site selection is an important strategic decision for top management. Site selection is
This refers to the often related to a company’s need to expand operations in order to meet growing cus-
process of analyzing tomer demand for its products or services or increase its market share. However, these
qualitative and are not the only reasons for site selection. In some cases, firms are forced to relocate
quantitative factors to a new facility due to the depletion of resources that were previously readily available
in order to identify or because of a shift in the market. Cost is also an important consideration as site
the most suitable selection plays an important role in the financial stability of a firm. In this modern era
location for a new of globalization, firms are often faced with the decision to expand operations to an
facility. overseas location to reduce costs or leverage available resources. In addition to costs
and the availability of resources, the political situation is also critical to consider when
contemplating overseas sites.
 Unit 3 37

Site Selection

The following three factors contribute to the importance of the site selection decision
(Stevenson, 2014):

1. Strategic importance. Site selection decisions require long-term commitments from

firms. Any new site will require significant initial investment, and making a poor
decision here has the potential to affect the entire financial viability of the firm.
Both manufacturing and service firms need to carefully consider all aspects of their
operations before selecting a new site—selecting the wrong site could significantly
increase operating costs. In addition to initial investments and operating costs,
manufacturing firms also need to evaluate the impact of any new site on the exist-
ing supply chain.
2. Objectives of site selection. Cost-benefit analysis is an important element in the site
selection decision. The primary objective of businesses is to maximize the wealth of
shareholders. Therefore, projected increases in revenue and operational costs
should be carefully analyzed before undertaking any expansion as they could have
long-term implications for the overall profitability of the business.
3. Available alternatives. There are three options that managers need to consider when
evaluating location alternatives:
• What is the purpose of expanding?
• How will the new location impact the overall supply chain?
• How important is it to maintain any existing location(s)?

Each factor adds further complexity to the site selection decision. After careful analysis,
the manager has to proceed with the expansion decision or do nothing and continue
with the current location.

3.2 Problems Associated with Site Selection

There are two primary problems associated with site selection: the location of sites,
and the allocation of demand to these sites. These problems are often intertwined and
are collectively referred to as the location-allocation problem.

The location problem refers to the dilemma of where to locate new facilities given mul-
tiple available sites. The complexity of the location problem increases when the num-
ber of sites sought is equal to the number of new facilities under consideration. The
location problem is a difficult one to resolve for managers as the costs associated with
each potential site may not be necessarily evident prior to selecting the site (or sites).
The costs associated with selecting a site can be divided into fixed and variable costs:
fixed costs include the cost of locating a facility while variable costs include ongoing
operating and transportation costs.

The exact nature of the location problem faced by a company will vary according to its
specific circumstances. The following examples are four different versions of the loca-
tion problem:
38 Unit 3

• Single location problems occur when a company is trying to determine the optimal
location for a single facility.
• Multi-facility location problems occur when managers have to choose from several
alternative locations for more than one site.
• Continuous space location problems relate to selecting a location for a site from
any part of a given geographic area. Such a situation creates an infinite number of
choices for a manager regarding the site and creates more difficulties in the location
selection process.
• Discrete space location problems are the opposite of the continuous space location
problem. They occur when the number of possible locations for a site in a given
geographic location is fixed.

The allocation problem is encountered when the number of sites to be selected and
their locations are fixed. The allocation problem relates to the stakeholders affected by
the site selection and refers to the dilemma of how to allocate customer demand to
each site. This problem requires managers to focus on the efficiency of the site to pro-
vide the best possible service or produce the most cost-efficient product that serves
customer needs.

When the simultaneous allocation of resources is required, this often exacerbates loca-
tion problems. In the case of a single allocation hub location problem, managers have
the following objectives: minimize cost and minimize process time.

One of the most effective methods for solving the location-allocation problem involves
Data envelopment the use of data envelopment analysis (DEA). In practice, this method has been success-
analysis fully used by businesses to identify the most suitable sites. DEA allows a manager to
This is a technique determine the relative efficiency of a location using a ratio of the sum of weighted out-
that helps managers puts to the sum of weighted inputs. The simplified DEA formula is
to measure produc-
tion efficiency. Σ Weighted Outputs
DEA Efficiency =
Σ Weighted Inputs

The DEA method allows a manager considering a number of projects (in this case, sites)
to identify the project that produces the greatest output for a given level of input. Uti-
lizing the DEA technique provides managers with the ability to choose the optimum
location for a site based on a set of pre-determined criteria classified as inputs and
outputs. A set of pre-determined factors is also known as a decision-making unit
(DMU). In the screening stage, comparing DMUs can facilitate the identification of the
most appropriate site for a project, which fulfills the objectives of cost minimization
and efficient operations.

In addition to DEA analysis, the equity-efficiency trade-off model can also be used to
address the location-allocation problem. In this model, equity refers to the even distri-
bution of outcomes (e.g., services delivered) while efficiency refers to the effective
transformation of inputs into outputs (e.g., human resources into services delivered).
However, the equity-efficiency trade-off model is more applicable to the selection of
medical facilities. This method focuses more on the socio-economic implications of the
location-allocation problem.
 Unit 3 39

Site Selection

3.3 Optimization with Predetermined Locations

As discussed, site selection is one of the most critical decisions made by companies,
with the implications of such decisions having widespread implications for the future
success of the company. Given the complexity of site selection and the associated
problems, different techniques have been developed to inform and optimize the deci-
sion-making process. Multi-attribute or multi-criteria techniques can be used for site
selection when seeking to select the most suitable sites from several predetermined
locations. Some of the most commonly used multi-attribute techniques are described
below:

• Analytic network process (ANP) is a multi-criteria decision-making method that

simultaneously considers qualitative and quantitative factors in order to evaluate
the suitability of site locations. It is essentially based on considering pre-deter-
mined criteria and conducting pair-wise comparisons of these criteria, assuming
that the criteria under consideration are interdependent. For example, when consid-
ering several potential sites, the first two criteria to be compared could be the cost
and benefit of the selected locations, with these two criteria weighed against one
another. The next two criteria compared could require managers to evaluate oppor-
tunities and risks associated with each of the locations. The data created using
these comparisons are weighted in order to select the most suitable site location.
• Analytic hierarchy process (AHP) is a unique variation of the analytic network proc- Analytic hierarchy
ess. AHP expands the criteria used in ANP so that the attributes under analysis are process (AHP)
not limited and the decision, possible solutions, and attributes or criteria are struc- The analytic hier-
tured into a hierarchy rather than a network (as in ANP). The number of factors used archical process pro-
in AHP is not fixed and managers have the flexibility to include criteria relevant to vides managers with
the core objectives of the project. Importantly, the criteria are considered to be the flexibility to use
independent of one another, rather than interlinked as in ANP. relevant criteria in
• The fuzzy multi-attribute decision-making (FMADM) model is becoming more popu- site selection deci-
lar in international site selection due to the use of imprecise qualitative criteria in sions.
previous models. The fuzzy multi-attribute decision model uses fuzzy set theory, lin-
guistic value, hierarchical structure analysis, and fuzzy analytic hierarchy process to
assign proper weights to relevant criteria used for site selection.
• Heuristic algorithms use the rule of thumb decision criteria to identify a potential Heuristic algorithm
location. By rule of thumb, we mean that the decision criteria used will result in a The term heuristic is
good enough or near optimal solution rather than the most optimized solution pos- used for algorithms
sible (which, in real life situations, can sometimes be near-impossible to deter- that find solutions
mine). One of the drawbacks of using heuristic algorithms is, of course, their lack of among all possibili-
ability to determine an optimum location. However, this technique can result in the ties, but they do not
identification of good-enough locations by utilizing various enumerative guarantee that the
approaches. Using various algorithms is recommended in order to to solve the same best will be found.
problem, helping managers to identify the most optimal solution. Some of the dif-
ferent heuristic algorithms available for use in site selection are as follows:
a. The add algorithm was first introduced by Kuehn and Hamburger (1963) to opti-
mize location planning decisions. The add algorithm follows a simple procedure,
beginning with a configuration of zero facilities, adding a new facility at the loca-
tion one at a time to identify the best combination that offers the lowest cost,
40 Unit 3

and ending when the desired number of facilities are reached. The add algorithm
requires the number of facilities needed by the firm to be predetermined before
beginning the process. Once the number of required facilities is determined, it
cannot be changed. The simplicity of the add algorithm has made it a popular
heuristic algorithm option for location selection.
b. The drop algorithm was first introduced by Chardaire and Lutton (1993) and uses
an opposite strategy to the add algorithm to identify the most cost-effective
location. In the drop algorithm, all possible locations are included in the pool,
and each location is removed from the pool after each iteration based on its
impact on the overall cost. This strategy also provides quick results and is an
effective alternative for firms trying to minimize the number of sites.
c. The bump and shift algorithm was first introduced by Teitz and Bart (1968). This
algorithm starts with an arbitrary number of possible locations and each loca-
tion is exchanged with other locations to identify the most cost-effective alterna-
tives for the firm. The algorithm continues until no additional improvements can
be found with further iterations.
d. The global-regional interchange algorithm developed by Densham and Rushton
(1992) provides faster and better results than the bump and shift algorithm. In
addition to the global exchange function of the bump and shift algorithm, the
global or regional interchange algorithm provides the option for a regional
exchange on each iteration.

3.4 Factors Affecting Site Selection Decisions

Several factors affect site selection decisions. Both manufacturing and service firms
need to identify such site selection factors for efficient site selection decisions. We dis-
cuss several factors affecting site selection below (Stevenson, 2014):

• Location of raw materials. There are a number of reasons why the location of raw
materials would be important for a manufacturing firm. Firstly, for manufacturing
firms in industries such as farming, fishing, and mining they simply cannot operate
without being located where raw materials are found. Secondly, the perishable
nature of raw materials might require a manufacturing firm to locate a site closer to
raw materials. Finally, firms can reduce transportation costs by establishing a site
near the source of raw materials.
• Location of markets. Firms can generate a competitive advantage by locating their
operations close to their target market. However, any decision to locate a site near a
specific market must be justified by the market size.
• Labor. This factor focuses on the cost and availability of the labor force as well as
psychological factors such as the attitude of the labor force. The presence of labor
unions and their relative influence on the wage and benefits of a workforce is
important to consider.
• Climate and taxes. These factors are particularly important when selecting sites in
foreign locations. For example, climate can affect delivery schedules and the effi-
ciency of workers while favorable corporate tax laws in specific countries can per-
suade top management to invest in a specific geographic location.
 Unit 3 41

Site Selection

• Natural resources. Often, firms will expand into a specific foreign location in order to
utilize available natural resources in their production processes.
• Community. This factor plays an important role in the site selection decision. Com-
munities can attract businesses by displaying a favorable attitude towards foreign
investments through both formal (e.g., regulations) and informal mechanisms (e.g.,
community sentiment).

3.5 Site Selection Techniques

There are three techniques used for site selection that we will now explore: the factor
rating method, the break-even analysis method, and the center of gravity method.

Factor Rating Method

The factor rating method uses selective factor weighting to determine the most suita-
ble site. This approach analyzes both qualitative and quantitative data to determine
the best alternative. The following procedure is used in the factor rating method (Ste-
venson, 2014):

1. Relevant factors for the site such as location, revenue potential, and market share
are determined.
2. A weight is assigned for each factor based on its relative importance when com-
pared to other factors.
3. A standard scale is determined, which allows a minimum acceptable score to be
generated if required.
4. Each location is given a score.
5. Each location score is multiplied by its associated weight.
6. The alternative that has the highest composite score is selected.

Example
A meat processing firm is planning to establish a new store. The following table con-
tains information regarding two potential locations.

Meat Processing Firm: Location Example

Score (out of 100)

Factor Weight Location 1 Location 2

Proximity to existing source 0.15 80 80

Traffic volume 0.10 100 100

42 Unit 3

Score (out of 100)

Factor Weight Location 1 Location 2

Rental costs 0.20 90 90

Size 0.20 75 85

Layout 0.15 60 90

Operating cost 0.20 100 100

1.00

Note: The weights and scores for each factor and locations are arbitrary and deter-
mining them relies on managerial expertise. A score of 0 indicates the least favora-
ble location while a score of 100 indicates the most favorable location. The total
weight for the factors should not be more than 1.

Meat Processing Firm: Location Solution

Factor Weight Location Location W · L1 W · L2

(W) 1 (L1) 2 (L2)

Proximity to existing 0.15 80 80 12 12

source

Traffic volume 0.10 100 100 10 10

Rental costs 0.20 90 90 18 18

Size 0.2 75 85 15 17

Layout 0.15 60 90 9 13.5

Operating cost 0.20 100 100 20 20

1.00 84 90.50
 Unit 3 43

Site Selection

Based on the above results, Location 2 will be most suitable for the new branch loca-
tion as it has a composite score of 90.50 compared to 84 for Location 1.

Break-Even Analysis

The primary objective of conducting a break-even analysis is to establish which site Break-even
will maximize profit. When using this method, we only consider the revenue generated This refers to the sit-
from a site and its associated costs. There are several requirements that must be met uation where the
before applying the break-even analysis for site selection. They are as follows: company does not
earn profit but also
• The relevant cost for each location should be identified in advance. does not suffer a
• Each relevant cost should be further classified into fixed and variable costs. loss.
• A graphic analysis should be conducted using revenue and cost information.

Using this information, managers can select the most suitable location for the site.

Example
The XYZ Corporation is located in Germany and produces the sports drink, Active X.
Active X has gained popularity and the demand for the product has increased signifi-
cantly in recent years. Considering the growth in demand, the company is planning to
build a new production site. Potential locations and their associated costs are provided
in the table below. The XYZ Corporation sells Active X for €10 per unit. The company
expects to sell 50,000 units of Active X in 2020 with the addition of the new production
facility.

XYZ Corporation: Location Example

Site location Fixed cost per year Variable cost per unit

Hamburg 150,000 20

Cologne 200,000 40

Munich 300,000 15

We need to calculate the total cost using the formula

Total cost = Total fixed cost + Total variable cost

44 Unit 3

XYZ Corporation: Location Solution

Site location Fixed cost Variable cost Units Total cost

per year per unit

Hamburg 150,000 20 50,000 1,150,000

Cologne 200,000 40 50,000 2,200,000

Munich 300,000 15 50,000 1,050,000

Based on the above results, Munich is the most suitable site location for the new pro-
duction plant as it has the lowest cost. In the next step, we will draw a graph using the
projected production volume to see the changes in total cost for the three locations.

Based on this graph, we can identify a different location for different ranges of activi-
ties. For example, if the XYZ Corporation expects production to fall below 5,000 units,
then Hamburg is the most appropriate location. For activities between 5,000 to 30,000
units, Hamburg is still the most appropriate location. However, Munich is the most suit-
able location for any production level above 30,000.
 Unit 3 45

Site Selection

Center of Gravity Method

When determining the location of a new site, it can be the case that distance as a func-
tion has a non-linear relationship with the total cost of operating the site. If the rela-
tionship between distance and total cost is quadratic (i.e., linear), the decision-making
process is much simpler. The center of gravity method is a popular technique for deter-
mining the optimal location of a new site when there is a non linear relationship
between distance and cost. This method uses inputs such as markets, volumes of
goods, and transport costs to determine the geographic coordinates of an optimal site.
In this method, the optimal locations A and B are the weighted average of the A and B
coordinates of the existing facilities.

Example
Consider the following information for the XYZ Corporation.
46 Unit 3

ΣX · W 1,369,033.347
X= = = 50.705
ΣW 27,000
ΣY · W 233,482.325
Y= = = 8.647
ΣW 27,000

After receiving the longitude and latitude, we can use Google Maps to find the optimum
location using the center of gravity method. The result from Google Maps (n.d.-a) is pro-
vided in the following figure.

The center of gravity method indicates that, based on the current weekly demand, the
most suitable location for a new site will be Marburg-Biedenkopf, Germany.

However, there can be another situation where the demand is constant. In such a case,
the formula for x and y is as follows:

Σx
X=
n

and

Σy
y=
n

Here, n is the number of locations under considerations.

If we assume that, in the previous example, the XYZ Corporation has a constant
456.754 81.914
demand of 1000 units, then X = 9 = 50.750 and Y = 9 = 9.102. In this case,
the location changes to D-35329 Gemünden, Germany, as shown in the following figure.
 Unit 3 47

Site Selection

Summary

Site selection plays a vital role in optimizing the products and services offered by
the business. The site selection decision requires careful evaluation of the asset
utilization of a selected site. Tangible assets related to a site location include
plants, machinery, warehouses, and materials. Intangible assets, mostly intellectual
capital in the form of human resources, should also be included in site selection
decision. There are several objectives that a new site must meet including cost
minimization, quality enhancement, and optimal utilization of available resources.
A poorly selected site can affect the quality of products manufactured by firms,
employee morale, and customer satisfaction. There are several techniques for site
selection as discussed in this unit including the factor rating method, break-even
analysis, and the center of gravity method.

Knowledge Check

Did you understand this unit?

You can check your understanding by completing the questions for this unit on the
learning platform.

Good luck!
Unit 4
Process Design and Process Planning

STUDY GOALS

On completion of this unit, you will be able to …

… understand process types and factors affecting process design.

… identify different types of manufacturing processes.

… describe key features of process structure.

… utilize process performance and priority rules for planning and controlling processes.

DL-E-DLMBAEOIM01-U04
50 Unit 4

4. Process Design and Process Planning

Introduction
Process Process design and process planning are critical decisions that organizations have to
A process is the make carefully given their long-term implications. As it is not possible to change pro-
means by which cesses quickly, they have to be carefully designed and implemented. The exact nature
resources are con- of process design and planning depends on the types of products and services that an
verted into finished organization offers. Overseen by the function of operations management, inputs are
goods or services. converted into outputs (whether goods or services) via the manufacturing process.

4.1 Process Types and Factors Affecting the Process

Design

Process Types

A business entity is a collection of interrelated tasks and processes that are necessary
to perform certain functions, i.e., the delivery of products and services. There are three
major types of processes: core processes, supporting processes, and controlling or
management processes.

Core processes
Core processes, also known as primary or essential processes, play a vital role in the
operations and growth of an organization. For instance, for a manufacturing company,
core processes include procurement, production, marketing, and sales. In an academic
institution, core processes include enrollment, provision of lectures and tutorials, train-
ing, and examinations. Successful companies add value to their products via core pro-
cesses to gain a competitive advantage over rival companies. Core processes are part of
the value chain of a company.

Support processes
Support processes are those that ensure core business processes can occur such as
recruitment of employees, IT services, accounting, finance, and maintenance. Support
processes are not an integral part of core processes but are still very important for the
Outsourcing overall success of the company. Sometimes companies outsource support processes to
This is a process by reduce costs and source the best available products, services, and technology, while
which a third party maintaining their focus on the core activities of the company.
produces products
and goods and pro- Controlling and management processes
vides services on the Processes that help to govern overall business functions effectively and efficiently are
behalf of a company. known as controlling or management processes. Controlling processes help an organi-
zation to formulate plans, measure performance, monitor ongoing operations, and con-
trol any deviations in business. Corporate governance (rules and regulations about the
functioning of an organization) is an example of a controlling process.
 Unit 4 51

Process Design and Process Planning

There is a close relationship between core, supporting, and controlling processes. Sup-
porting processes ensure that necessary resources are available to a company. Core
processes then use these resources to create value for external customers. Controlling
processes then provide guidance, rules, procedures, and practices to ensure the effec-
tive execution of all other processes within the company.

Factors Affecting Process Design

The main task of manufacturing or industrial companies is converting raw materials

into finished goods and products. The operations function is responsible for identifying
and selecting an appropriate process design so that this can occur. Process design
should be able to meet the technical and business requirements of the products (Hill
& Hill, 2018). Technical and business requirements are interconnected and play an
essential role in how companies satisfy their customers’ needs by maintaining high-
quality standards, offering products at an optimal price, ensuring that the design of
products appeal to consumers, and making sure that products are delivered in the
most efficient manner. They are defined as follows:

• Technical requirements (also known as functional requirements) refer to the differ-

ent steps that a company undertakes to convert resources into outputs. For exam-
ple, pharmaceutical companies require printing, slitting, and injection molding
machines to package their pharmaceutical products. Technical requirements can be
thought of as “how” an organization undertakes processes.
• Business requirements refer to the nature of operations which a company under-
takes to meet the market demand for their products. For example, when designing
their operations, pharmaceutical companies make decisions about their printing,
slitting, and injection molding machines based on their production volume and the
variety of products demanded by customers. Business requirements can be thought
of as “what” processes an organization undertakes.

According to Stevenson (2002), the process strategy of a company shapes the process
design. The essential elements of a process strategy are whether a company makes or
buys products, the level of capital intensity, and process flexibility. To make or buy
product decisions (outsourcing) is a strategic choice made by an organization after
considering factors such as internal expertise, product complexity, access to raw mate-
rials, the nature of demand for their products and services, quality considerations, level
of investment, and delivery systems. Capital intensity is a combination of labor and
equipment used to make products. In the current volatile business environment, proc-
ess flexibility can be a competitive advantage. Companies that can adjust their product
design, production volume, lead time, and quickly implement technological changes to Lead time
meet growing customer demands have a greater chance of success. This is the total
length of time from
As seen in the following figure, process design selection is impacted by several factors receiving an order to
including capacity planning, facilities and equipment, product and service design, and the delivery of goods
work design. or services to the
customer.
52 Unit 4

There are three important considerations in process design: the variety of products and
services to be managed by the system, process flexibility, and the desired level of out-
put.

Process Reference Model: SCOR Model

The supply chain operations reference (SCOR) model was developed by the Supply
Chain Council in 1996 with the support of 69 practitioner companies. The purpose of
this model is to ensure reliability, consistency, and efficiency of supply chains by care-
fully evaluating the business processes of an organization (White, 2018). It is worth
mentioning that the SCOR model does not dictate how organizations should run their
business, organize their supply chain, or streamline the flow of information, products,
and services. Rather, this model helps companies to identify significant issues and
challenges in supply chains and provides guidance on how an organization can
develop a better supply chain roadmap to align business processes and take advantage
of capital investments.

As seen in the following figure, the SCOR model consists of six core management pro-
cesses: planning, sourcing, making, delivering, returning, and enabling.

1. Plan: Planning processes ensure that the business objectives of a company are met
by carefully managing resources, identifying business needs, and maintaining effec-
tive communication with stakeholders.
2. Source: Sourcing processes include the management of inventory, procuring raw
materials, managing supplier relationships, and ensuring compliance with agree-
ments.
3. Make: Making processes are concerned with the production of goods and products
that meet customer demands.
 Unit 4 53

Process Design and Process Planning

4. Delivery: Any activity related to the delivery of finished products and services to cus-
tomers fall under delivery processes. This includes order receipts, processing, ware-
housing, and inventory management.
5. Return: Returning processes refer to business processes that deal with returned
products from customers.
6. Enable: All other business processes that enable the smooth functioning of supply
chains are considered enabling processes.

The SCOR model is a reference model that helps companies to evaluate the effective-
ness of their supply chains at multiple levels. As shown in the following figure, the
SCOR hierarchical process model consists of four levels. Level 1 describes the scope of
the supply chain and the types of processes. Level 2 outlines the strategy and process
capabilities of the supply chain, such as make-to-stock or make-to-order. Level 3
describes process elements and execution steps such as scheduling deliveries, ship-
ments, and payment authorizations. Finally, Level 4 outlines various activities to be per-
formed within the supply chain.
54 Unit 4

4.2 Types of Manufacturing Processes

There are five main types of manufacturing processes: project processes, jobbing pro-
cesses, batch processes, line processes, and continuous processes.
 Unit 4 55

Process Design and Process Planning

Project Process

A project process is characterized by one-of-a-kind production, where the manufactur-

ing process results in a unique product for a single customer. Project processing is also
known as job-based production. It is used by companies that are engaged in highly
complex and large-scale products. For some of these projects, it is not possible to
physically transport the product or easily move it from one place to another (Hill & Hill,
2018). In this case, resources have to be moved to the project site. Examples of products
created using project processes include software design, movie production, housing,
and large infrastructure projects such as dams, roads, tunnels, and bridges. Generally,
project processes are characterized by large variety and low volume.

Jobbing Process

A jobbing process is characterized by wide variety, low volume, highly skilled workers,
and a high level of equipment flexibility. The purpose of a jobbing process is to meet
the one-off needs of customers, and it is likely that jobs will not be repeated (Slack et
al., 2016). For a jobbing process, a small group of workers are usually responsible and
the product is generally only required in small volumes due to low demand. Examples
include customized furniture, customized equipment, and hand-crafted shoes and
clothes.

Batch Process

A batch process is characterized by standardized, high volume products. A batch proc-

ess requires considerable investment as the products may be demanded by customers
in the future. With this in mind, a company establishing batch processes seeks to opti-
mize the process design so that it doesn’t have to be redesigned when another batch
of products is required. Batch processes are designed in such a manner that they can
be used to create different products. However, each different batch requires a change-
over and resetting of operations. Changeovers and resets are costly as they result in
delays in production and lost production. Depending on the complexity of the product,
a batch process is divided into different steps (Hill & Hill, 2018). In the case of a basic
product, the process may be completed in a single step, whereas a more complex prod-
uct may take multiple steps. Examples of products created using batch processes
include bakeries making cakes and bread in batches, a printing company making differ-
ent batches of visiting cards, and a theatre offering plays to different batches of peo-
ple.

Line Process

Companies use line processes if production volumes are high and products are stand-
ardized. Line processes are not flexible and the skill level of workers is reduced com-
pared to more specialized processes (Stevenson, 2002). Examples of line processes
56 Unit 4

include the manufacture of home appliances, vehicles, laptops, computers, and televi-
sion sets. Generally, companies use production and assembly lines where workers keep
adding different components to the products. As products are standardized, line pro-
cesses do not require changeover and reset as in the case of batch processes.

Continuous Process

A continuous process is characterized by the creation of standardized, high volume

products. Due to the homogenous nature of these products, continuous processes do
not require flexibility. Any interruption of a continuous process results in high costs.
Therefore, continuous processes are designed in such a manner that “one or several
basic materials are processed in successive stages and refined into one or more prod-
ucts” (Hill & Hill, 2018, p. 123). Examples of products manufactured using continuous
processes include sugar, flour, and steel products.

The following table summarizes the various types of manufacturing processes with rel-
evant examples (Hill & Hill, 2018, p. 124). It also shows the relationship between process
types moving from individualized to mass-produced products.

Manufacturing Processes and Their Relationship to Product Categories

Process Product Process description

type
Category Examples

Project Special • Sydney Opera Products that cannot be

House physically moved once com-
• Øresund Bridge pleted use a project process.
connecting Here, resources (materials,
Denmark and equipment, and people) are
Sweden brought to the site where the
• Gotthard Base product is to be built. These
Tunnel in the resources are allocated for
Alps the duration of the job and
will be reallocated once their
part of the task is completed
Standard • Estate housing or at the end of the job.
• Prefabricated
industrial and
warehouse
units
 Unit 4 57

Process Design and Process Planning

Process Product Process description

type
Category Examples

Batch Special • Ocean racing Once a product can be

yacht moved, companies will
• Injection mold- choose to make it in-house
ing tools and then dispatch it to the
• Racing cars customer. Jobbing is the
• The design and name of the process used for
installation of a special (that is, unique) prod-
process control ucts that will typically not be
system repeated. Here, one person or
a small group of skilled peo-
ple will complete all of the
product. Often the provider is
required to install and com-
mission the product as part
of the order.

Standard • Business cards The repeat and high volume

↓ • Golf tees nature of standard and mass
Mass • Wheel rims products requires a process
• Packaging designed to take advantage
• Plastic bottles of these characteristics.
Batch, line, and continuous
processing are the alterna-
tives, but which one to use
depends on the volumes
involved. The batch can be
appropriately used for low
through to high (mass) vol-
umes.
58 Unit 4

Process Product Process description

type
Category Examples

Line Mass • Domestic appli- Higher volumes mean that

ances processes can be dedicated
• Cans of soda to the needs of a given range
• Automobiles of products. Whereas in batch
• Pet food processing, a process has to
• Mobile phones be reset each time a new
product is to be made, in line
processing, the process does
not have to stop as it has
been designed to make the
range of products required
without being reset. The
steps to make them are
sequentially laid out in a line
and a product goes from step
to step until completed.

Continu- Mass • Petrochemicals For some products, the high

ous pro- • Oil refineries volumes involved are best
cessing • Some chemical handled by continuous pro-
plants cessing. In addition to high
volumes, the nature of these
products will need to be of a
type that is transferable
through piping or in liquid
form. Continuous processing
is similar to line processing
in that it handles mass prod-
ucts without being stopped
and reset. This distinguishing
feature means that stopping
and restarting the process is
lengthy and expensive, and
consequently, it is designed
to be run continuously.
 Unit 4 59

Process Design and Process Planning

Process Product Process description

type
Category Examples

Jobbing Special • Ocean-going Once a product can be

racing yacht moved, companies will
• Injection choose to make it in-house
moulding tools and then dispatch it to the
• Formula One customer. Jobbing is the
and Indy racing name of the process that is
cars used for special (that is,
• The design and unique) products that will
installation of a typically not be repeated.
process control Here, one person or a small
system group of skilled people will
complete all of the product.
Often the provider is required
to install and commission the
product as part of the order.

The following table provides an overview of the activities and functions affected by
process design. In the case of project processes, we can see that cost estimation is
complicated, the cost per unit is very high, the equipment used is varied, and the labor
skills required in these processes range from low to high. In jobbing, cost estimation is
difficult, the cost per unit is high, general-purpose equipment is used, and a high level
of labor skills are required. Unlike those associated with project and jobbing processes,
cost estimates for batch processes are routine while fixed and variable costs are mod-
erate. Line and continuous processes have low per-unit costs and require only a low
level of labor skills but generally require special-purpose equipment.

Activities and Functions Affected by Process Design

Activity/ Project Jobbing Batch Line Continu-

function ous

Cost esti- Complex Difficult Somewhat Routine Routine

mation routine

Cost per Very high High Moderate Low Low

unit
60 Unit 4

Activity/ Project Jobbing Batch Line Continu-

function ous

Equip- Varied General- General- Special Special

ment used purpose purpose purpose purpose

Fixed Varied Low Moderate High Very high

costs

Variable High High Moderate Low Very low

costs

Labor Low to High Moderate Low Low

skills high

Marketing Promote Promote Promote Promote Promote

capabili- capabili- capabili- standar- standar-
ties ties ties; semi- dized dized
standard goods/ goods/
goods and services services
services

Schedul- Complex, Complex Moder- Routine Routine

ing subject to ately com-
change plex

Work-in- Varied High High Low Low

process
inventory

4.3 Process Structure

All activities completed in an organization use a combination of processes. Under-
standing processes and their relationship with one another requires careful analysis of
process structure and designing new processes requires careful attention to the organi-
zation of each process step. Two methods of documenting process structures are spa-
ghetti diagrams and event-drive process chains.
 Unit 4 61

Process Design and Process Planning

Spaghetti Diagram

A spaghetti diagram, also known as a spaghetti chart, map, plot, or model, is a visual
depiction of the physical space within an organization and the passage of objects,
information, or activities within it as a process occurs. The purpose of a spaghetti dia-
gram is to identify the movement of goods, people, and other resources using a contin-
uous line through a physical space and then find the optimal movement patterns that
maximize speed, efficiency, and effectiveness. Using a spaghetti diagram allows manag-
ers to identify redundancies, bottlenecks, and needless transportation in processes
and streamline the flow of resources. Balaji and Kumar (2014) state that a spaghetti
diagram identifies

• inefficiencies in the area or plant layout,

• opportunities for less handling,
• opportunities for better workforce communication,
• resource allocation opportunities, and
• opportunities for safety improvement.

As an example of a spaghetti diagram, Uddin et al. (2013) proposed the use of smart
devices to solve healthcare problems. As seen in the following figure, flow paths can be
determined by tracking the smartphones of health care officials. Using this data, the
optimal path for patients to receive necessary treatments is determined.
62 Unit 4

Event-Driven Process Chain (EPC)

An event-driven process chain (EPC) is a type of flow chart used for business process
modeling. A company is a combination of different activities, processes, and events.
According to Davis (2001), an EPC is the core element of Architecture of Integrated Infor-
mation Systems (ARIS). EPC is generally used to depict a specific process of a business
function and its relevant workflows. EPC divides all the activities of a company into
functions which are interconnected via various events. In addition to modeling specific
events, EPC allows careful analysis of workflows and resources allocated to complete
such events. By conducting an EPC, operational managers are able to continuously
improve their functions by identifying areas for improvement in operational processes.
Examples of events include, but are not limited to, ordering, production, customer rela-
tionships, and supplier relationships.

The following figure provides an illustration of car configuration at a production facility.

Two events trigger the overall process: receipt of a customer inquiry and creation of the
customer inquiry in the system. The event is faced with a rule operator where decisions
regarding the process of customer inquiry evaluation need to be made. Based on the
evaluation process, the core function is developed. In this case, it is the opening of a
customer inquiry with the assistance of the organizational unit.
 Unit 4 63

Process Design and Process Planning

The arrows in the EPC diagram indicate the flow of information from one event to the
next. We can see that the opening of the customer inquiry by the organizational unit
leads to the function of product configuration and finally results in the car configura-
tion based on the customer inquiry. The process of car configuration based on cus-
tomer inquiry leads to outputs in the form of documents that maintain the decision
trail and all functions leading towards the outcome.
64 Unit 4

4.4 Process Performance

Process Performance Metrics

Process performance metrics are used to measure the performance of a process. This is
an essential function in operations management as performance metrics allow for the
careful identification of efficient processes. There are various types of performance
metrics available to measure the functionality of a process. Several of the most com-
monly-used performance metrics are discussed here:

• Throughput time refers to the time required to complete the production process.
The total production time consists of the time required to convert raw materials into
finished products (Reid & Sanders, 2007). Operational managers monitor throughput
time to ensure the production process runs efficiently. The entire throughput time
can be further divided into four stages:
1. Processing time is the time required for the production of finished products.
2. Inspection time is the time required to identify defective products.
3. Move time is the time required to move the raw materials and work in process
across various functional areas. It also includes the delivery time to move fin-
ished products from the production facilities.
4. Queue time is the time required to start the next batch of production.
• Process velocity refers to the flexibility of the production process with regards to
customer demand. Process velocity is calculated by dividing the total number of
value-added steps by the lead time. A long lead time obviously adversely affects
process velocity. For example, in a process that includes ten value-added steps, a
lead time of ten hours allows 1.0 value-added steps per hour. The value-added steps
per hour can be increased by reducing the lead time.
• Productivity is a measure of the proper utilization of resources in operations. It is
measured as a ratio of the total output and total input. The formula for productivity
is

Output
Productivity =
Input

Examples of outputs include finished products; inputs include raw materials and
direct labor used in the production process.
• Utilization is a commonly used as a key performance indicator (KPI) that indicates
the capacity being utilized to meet the current level of production demand. The for-
mula to derive utilization is

Capacity utilized
Utilization =
Optimum capacity
 Unit 4 65

Process Design and Process Planning

For example, the optimum capacity of the new automated cutting machine of the
XYZ Corporation is 150,000 units per hour. However, the machine is currently pro-
cessing 100,000 units in one hour. Therefore, the cutting machine is 66.67 percent
utilized (100,000/150,000).
• Efficiency refers to the degree to which a process is completed in the right manner.
In other words, efficiency is “doing things right.” It requires careful analysis of the
proper utilization of a firm’s resources in the production process. Efficiency analysis
is a holistic process and requires careful attention to the scale of operations,
demand fluctuations, and competitor analysis, and requires continuous improve-
ment in the supply chain. There are two types of efficiency: absolute operational
efficiency and relative operational efficiency. Absolute operational efficiency refers
to the ideal benchmark for a process in perfect market conditions. It is derived by
dividing actual throughput by ideal throughout. Relative operational efficiency is the
level of efficiency that can be achieved in practical conditions. It is derived from a
ratio of actual throughput over best-observed throughput.

Process Flow Analysis

The primary purpose of process flow analysis is to identify areas for improvement,
which could improve capacity utilization, reduce lead time, improve product quality at
reduced cost, and increase the flexibility of the production process. A company can
take several steps to ensure such an outcome by carefully adopting some of the follow-
ing strategies:

• Minimize work-in-process. Work-in-process is current inventory in the production

process. It refers to a stage between raw materials and finished products. A firm can
decide to carry a lower level of work-in-process inventory which could result in
lower lead time.
• Increase capacity. This strategy allows firms to expand bottlenecks in the production
process, which often reduce the optimum use of all available resources. For exam-
ple, a firm can bring in an additional machine to increase production during a
period of increased customer demand.
• Improve process. This strategy allows firms to redesign the current process to
ensure more flexibility of the various units involved in the production process.
• Outsource. This strategy refers to subcontracting functions to an external provider to
create flexibility in the production process.
• Reduce non-value added activities. This strategy requires careful analysis by opera-
tional managers and can result in cost reductions through reduced lead time during
the production process.

4.5 Priority Rules for Planning and Controlling Processes

Performance indicators are used by businesses to evaluate the efficiency of individual
employees or operational units. They allow firms to compare their performance with
industry benchmarks and pave the way for strategic decision-making to improve overall
66 Unit 4

operations, product quality, or service delivery. However, performance indicators need

to be carefully controlled so that they do not deviate from company standards. The
controlling process is complex and requires participation from managers at all levels of
the firm. However, the controlling function in operations management is different from
the controlling mechanisms applied to behavioral decision-making. The controlling
process is dependent on careful planning and needs specific standards to compare
performance measures with predetermined benchmarks. Any deviation from a bench-
mark would require careful investigation to identify its cause. Once the reason for a
deviation is determined, managers must take corrective actions to ensure this devia-
tion does not occur in the future. Controlling allows for the continuous improvement of
various units of the businesses which are performing at a sub-optimum level.

Performance Indicators in Sequence Planning

Key performance indicators (KPIs) are used as a measure of performance to evaluate

the efficiency of a specific unit within an organization. KPIs need to fulfill several fun-
damental requirements: they must converge with organizational goals, be quantitative
in nature so as to be effectively measured, and be able to be controlled by manage-
ment to ensure the efficient performance of operations units. The following table pro-
vides examples of KPIs for sequence planning.

KPIs for Sequential Planning

No Performance Measure Description

indicators

1 First-time fix rate Percent- FTP deals with the ratio of activities that
(FTP) age require a single attempt for completion.

2 Operating time Hours Operating time considers the amount of

time required to complete a given task
in the planning process.

3 Costs Euro Costs of the overall process need to be

considered in the sequential planning
process.

4 Revenue Euro The amount of revenue generated

through the production process and
service delivery needs to be carefully
evaluated to see if it fits the overall rev-
enue model of the firm.
 Unit 4 67

Process Design and Process Planning

No Performance Measure Description

indicators

5 Resource utiliza- Percent- Resource utilization is an essential indi-

tion age cator for the successful implementation
of sequential planning.

Priority Rules

Scheduling refers to the assignment of jobs to individuals or production units for spe-
cific periods. Scheduling provides a wide range of benefits to the manufacturing proc-
ess such as enhancing production efficiency, reducing inventory, levelling labor load,
and being able to provide accurate delivery dates. Service firms may also benefit from
scheduling. There are several rules that can be applied when creating a production
schedule. Some of the rules are as follows:

• First-come-first-served (FCFS) is a rule that prioritizes the process that arrives first
during the scheduling process. It uses a queue system where the first element
leaves the queue before other elements. A real-life example of FCFS is the ticketing
system used in movie theatres where the first patron in line at a ticketing booth is
served before other patrons. There are several problems with the FCFS system,
which include not identifying high priority projects, sub-optimal average waiting
time, and poor resource allocation.
• Shortest processing time (SPT) follows the rule of prioritizing the job with shortest
completion time.
• Earliest due date (EDD) follows the due date to prioritize jobs during the scheduling
process.

Summary

Process design and process planning are critical decisions that organizations have
to make carefully given their long-term implications. Process design and planning
requires careful analysis of the overall business strategy, competitors, production
processes, customer demand, and supplier relationships. The first step in process
design is understanding the various types of processes and the factors that affect
those processes. Among other factors, product and service design play a vital role
in process design selection. Process design triggers the need for managerial deci-
sion-making in terms of capacity planning and the layout of the production facility
and often requires careful analysis of technological requirements in the production
facility. Such decisions are often affected by the cost-benefit analysis of the prod-
uct. The production process is affected by various types of costs, including variable
costs and fixed costs. Changing an existing process design is favorable when the
cost of making these changes outweighs the economic benefits of maintaining the
68 Unit 4

process design. Operations managers can utilize the performance indicators as a

controlling mechanism so that their process design does not deviate from the over-
all strategy of the firm.

Knowledge Check

Did you understand this unit?

You can check your understanding by completing the questions for this unit on the
learning platform.

Good luck!
Unit 5
Inventory Management and Production
Control

STUDY GOALS

On completion of this unit, you will be able to …

… calculate economic order quantity (EOQ).

… differentiate between a single and multi-period inventory system.

… explain what a continuous inventory management system is.

… perform capacity planning and scheduling.

DL-E-DLMBAEOIM01-U05
70 Unit 5

5. Inventory Management and Production

Control

Introduction
The business environment is evolving with the emergence of innovative technologies.
As we progress toward Industry 4.0, the business environment is characterized by
greater business competition. All organizations, whether public, private, or non-profit,
are focusing on resource optimization. While cost minimization was the primary focus
of managers prior to the Industry 4.0 era, we have since entered a business environ-
ment that aims to reduce inventory storage, improve capacity utilization, and create
sustainable business growth. A manager’s ability to make timely decisions that reduce
costs but maintain product quality can play a vital role in the survival and growth of an
industrial enterprise (Ashfaq, 2016).

One of the significant costs associated with production is inventory cost. As sufficient
inventory is essential for production, various mechanisms have been developed to
minimize any wastage of stock in the production line. There are three types of inventory
or stock: raw materials, work in progress, and finished products. Raw materials are core
components that are processed into finished products. For example, cocoa beans
imported from Indonesia are one of the primary raw materials for a Malaysian choco-
late producer. The next level of inventory is work in progress, which refers to stock
already in the production process and is neither raw material nor finished product. The
finished product is the outcome of the production line that can be sold to the cus-
tomer. The multiple layers of inventory often make the efficient management of inven-
tory difficult for production managers. In this unit, we will learn various techniques that
can be applied to improve inventory management practices for production companies.

5.1 Models for Optimizing Stocks

Economic Order Quantity (EOQ) Model

Economic order quantity (EOQ) is a widely used method that provides the ideal order
quantity that a company should purchase that results in the lowest inventory-related
costs (i.e., holding costs, shortage costs, and ordering costs). Application of the EOQ
model requires several assumptions:

• The lead time associated with each order is constant. Lead time is the time between
placing the order and receiving the request from suppliers.
• The demand for the product is constant during the lead time.
• The quantity ordered is received instantaneously.
• Companies can forecast annual demand accurately.
• Ordering costs are available in advance. Examples of ordering costs include, but are
not limited to, preparation of purchase orders and supplier invoice processing.
• Carrying costs are known in advance. Examples of carrying charges include the cost
of storage, opportunity costs, and insurance premiums.
 Unit 5 71

Inventory Management and Production Control

The most basic form of the EOQ model is known as the Wilson formulation. In this
basic EOQ model, the total cost of inventory is divided into ordering costs and carrying
costs. According to the EOQ model, when ordering and carrying costs are equal, total
inventory costs are lowest. The basic EOQ model is

2 · A · C0
EOQ =
CC

where EOQ is the economic order quantity, C0 is the ordering cost, CC is the carrying
cost per unit, and A is the annual inventory demand.

Example
Let’s take the example of the XYZ Corporation applying the EOQ model. The production
manager has provided the following information.

Annual demand 40,000 units

Carrying cost per unit $5

Ordering cost $10

Based on the above information,

2 · 40,000 · 10
EOQ = = 400 units
5

We can test whether the total ordering and carrying costs are equal at 400 units.

Annual demand 40,000 · 10

Ordering cost = = = $1,000 · Ordering cost
Quantity 400
Quantity 400 · 5
Carrying cost = = = $1,000 · Carrying cost
2 2
Ordering cost = = = $1,000

Carrying cost = = = $1,000

Total inventory cost = Total ordering cost + Total carrying cost = 1,000 + 1,000 = 2,000

Any deviation from the quantity derived using the EOQ model will increase the total
inventory cost for the company. The following figure summarizes the above discussion
on EOQ.
72 Unit 5

Single Period Inventory Management

A single period inventory model is used by businesses that make one-off or seasonal
orders to match the seasonality of customer demand. Effective individual period inven-
tory management is crucial for managers, as both an excess and a shortage of inven-
tory will have a negative impact on a company’s profitability. The order quantity has to
be accurate in a single period scenario, as the product has limited value for the com-
pany after the season has ended. The problem associated with single period inventory
is often referred to as the “newsboy problem.” A vendor selling a daily paper cannot
sell excess newspapers from the previous day to customers due to their limited value.
However, the vendor needs to order the publication one day in advance. If the vendor
requests a number of newspapers that exceeds demand, they face an opportunity cost
resulting from a lack of capital to invest in other products. If the vendor orders too lit-
tle inventory, they face the risk of losing potential revenue resulting from a stock-out.

Shortage cost and excess cost are two terms that are integral when determining the
adequate order quantity in a single period inventory model.

Shortage cost occurs when there is a loss of potential revenue due to a lack of inven-
tory. Any excess shipping costs incurred by the supplier during a stock-out are included
in shortage costs.

Cs is the Shortage cost when D > Q ($ / unit) (i.e., companies store less inventory than
the demand).
 Unit 5 73

Inventory Management and Production Control

Excess cost occurs when companies overestimate customer demand and are left with Excess cost
an inventory level that exceeds market demand. Excess inventory can lead to various This occurs as a
problems including a lack of storage space, increases in storage costs, and less availa- result of keeping
ble resources for investment in other profitable projects. In the case of perishable excess stock.
products, excess inventory can lead to waste if it cannot be used prior to its expiry
date.

Ce = Excess cost when D < Q ($ / unit) (i.e., companies store more inventory than the
demand).

Assuming a continuous distribution of demand, we can modify the above equations as

follows:

Ce p X ≤ Q = expected excess cost of the Qth unit ordered

Cs 1 − p X ≤ Q = expected shortage cost of the Qth unit ordered
p = expected excess cost of the Qth unit ordered

Multi-Period Inventory Management

A multi-period inventory model is not limited by the single order criteria of a single-
period inventory model. There are two main types of multi-period inventory model sys-
tems:

1. Fixed order quantity systems. In this type of multi-period inventory model, the
annual demand is specific and known in advance. Therefore, the order quantity is
adjusted for each order. The company has to follow a particular criterion when
ordering inventory in advance. The most common rule is to maintain a minimum
stock level so that the order can be placed in advance without increasing the short-
age cost. One of the most common fixed order quantity models is the economic
order quantity (EOQ) model.
2. Fixed period ordering systems. In this type of multi-period inventory model, time
plays a much more important role than quantity. A fixed period ordering system
requires companies to order inventory after a specific interval. The inventory order
depends primarily on the company requirements and typically follows a review of
stock levels by the procurement manager. The analysis of stock is done after regular
intervals. The order quantity for a fixed period ordering system can be derived using
the following formula:

Order quantity = Scheduled demand of Ordering cycle+Lead time + Safety stock

− Inventory quantity − Released order

There are several differences between a fixed order quantity and fixed period inventory
system, as summarized in the following table.
74 Unit 5

Differences between Fixed Order and Fixed Period Inventory Systems

Criteria Fixed order quantity Fixed period

Timing Before stock-out Based on company

assessment of stock

Order quantity Fixed in every order Different in every order

Seasonal variations in Cannot be adjusted Can be adjusted

demand

Lead time Shorter Longer

Time for paperwork Shorter Longer

Continuous monitoring Required Not required

of inventory level

5.2 Continuous Inventory Management

Continuous and Periodic Review

A continuous inventory review system requires continuous monitoring of inventory lev-

els. This method of inventory review requires a physical inspection of inventory. One of
the most common methods of implementing a continuous inventory review system
involves the use of barcodes, as seen in supermarkets. There are several advantages to
this type of inventory review system, including the ability to receive real-time updates
on stock levels, improving the ordering process and reducing shortage costs. However,
a continuous inventory review system can be expensive as it will require the applica-
tion of a computerized system to keep track of inventory in real-time, ongoing mainte-
nance of the system, and sufficient training for employees to utilize the system effi-
ciently.

Unlike a continuous monitoring system, a more conventional periodic inventory system

does not require companies to keep a real-time update of inventory. Instead, inventory
levels are periodically evaluated to determine the need to order new stock. A periodic
system allows companies to spend less time and resources monitoring inventory levels
and more time concentrating on other aspects of business. However, this type of inven-
tory review system can lead to increased shortage costs if the periodic inventory checks
are not conducted accurately.
 Unit 5 75

Inventory Management and Production Control

Reorder Level

The reorder level or reorder point is a preset level of inventory that triggers a company Reorder level
to place an order to replenish its inventory. The preset level is an estimate of the most This indicates the
optimal point at which to order inventory in order to minimize shortage cost. The reor- level of inventory at
der point is stated in terms of inventory units and can be determined using the follow- which companies
ing formula: should place an
order for new stock.
Reorder point = Average daily demand of inventory · Lead time

Lead time is the time between placing the order and receiving the request from suppli-
ers.

Example
Assume a company has an average daily demand of 100 units and a lead time of five
days. The reorder point is

Reorder point = 100 · 5 = 500 units

This calculation indicates that the company must order the next batch of inventory
when the current level of stock reaches 500 units. The following figure illustrates this
example. The company begins production on day one with a stock level of 500 units. By
the end of day five, the stock is replenished. We can see that the company needs to
place an order on day one to receive a new batch of inventory by day six and avoid a
potential shortage (Hill & Hill, 2018).
76 Unit 5

What would happen if the company placed an order at 400 units?

In this situation, the company may risk a day of production disruptions, as suppliers
would not be able to complete the order before the company runs out of stock. Given
this type of risk, it is common practice to maintain a safety-stock level to avoid produc-
tion disruptions. Safety stock is excess or additional stock that companies keep to
ensure production continues if the supply of inventory is not made on time. The reor-
der point formula is adjusted as follows to include a level of safety stock:

Reorder point = Average daily demand of inventory · Lead time + Safety stock

Using our previous example, if we assume that the company maintains a safety stock
level of 50 units, then the new reorder point is

Reorder point = 100 · 5 + 50 = 550 units

Optimization of Order Quantities

It is essential to optimize order quantities to reduce inventory costs and potential loss
of sales resulting from any shortage in stock. As such, a minimum and maximum level
of inventory should be determined by companies to optimize ordering decisions. There
are several factors which should be considered when determining the minimum and
maximum levels:

1. The company should have adequate storage space.

2. The company should have sufficient working capital to meet operational expendi-
tures.
3. Lead time and average annual demand should be known in advance.
4. The company should be able to accurately assess the risk of inventory obsoles-
cence.

The formulas for the minimum, maximum, and average inventory level are

Minimum level = Reorder level − Normal usage·Normal reorder period

Maximum level = Reorder level + Reorder quantity −

Minimum usage·Minimum reorder period

Maximum level+Minimum level
Average level =
2

Example
The operations manager provides the following information for the XYZ Corporation.
 Unit 5 77

Inventory Management and Production Control

XYZ Corporation Information

Normal usage 2,400 units per month

Maximum usage 3,600 units per month

Minimum usage 1,200 units per month

Reorder quantity 2,000 units

Reorder period 2–4 months

Using this information, the operations manager is able to determine the reorder level,
minimum and maximum levels, and the average level to optimize order quantities.

Reorder point = 3,600 · 4 = 14,400 units

Minimum level = 14,400 − 2,400 · 3 = 7,200 units

Maximum level = 14,400 + 2,000 − 1,200 · 2 = 14,000 units

14,000+7,200
Average level = = 10,600 units
2

Impact of Defined Service Levels

Service level refers to the likelihood that an item will be in stock when required, i.e., the
probability of not experiencing a stock-out or losing sales. The service level is obviously
affected by changes in demand. Therefore, a supplier needs to have a proper under-
standing of the relationship between service level and demand fluctuations to set
inventory service levels. This is an essential step in the inventory management process
as setting the service level provides companies with the data required to invest in tech-
nology to enhance operations and optimize the production process. An increase in the
inventory service level may result in the collection of sales previously lost due to insuf-
ficient inventory levels. A change in the inventory service level could also have an
impact on the orders received from retail buyers. Craig et al. (2016) report the following
findings after conducting a historical analysis of the relationship between inventory
service levels and retailer demand:

• In the short term, retailer demand has a positive association with supplier stock-
outs. Repeated stock-outs have the potential to damage the company’s reputation
and customer loyalty. When a stock-out occurs, customers have several choices
including decreasing their purchase orders, finding alternatives, or switching to
78 Unit 5

competitors. In the face of greater customer demand, retailers often make larger
orders, which can affect the service capacity of suppliers and result in a supplier
stock-out, limiting their ability to supply materials to other retailers on time.
• In the long term, retailer demand has a negative association with supplier stock-
outs. Using the EOQ and newsvendor (single period inventory) model, Silver (1976)
concludes that improving supplier capacity reduces retailers’ stock-out risk. In situa-
tions where a retailer has multiple suppliers supplying inventory, inventory orders
can be spread across various suppliers to eliminate stock-out costs.
• Finally, the relationship between the inventory service level and retailer demand is
affected by order frequency and information asymmetry. In an automated system,
the retailer can provide suppliers with access to information that can improve the
customer demand handling process and reduce the need to maintain safety-stock.

5.3 Function and Application of MRP and Just-in-Time

Systems

Material Requirements Planning (MRP)

Material requirements planning (MRP) is an effective tool for inventory management

and can be used to create manufacturing forecasts, production plans, and schedules. In
most cases, implementing a MRP system involves the use of software but it can also be
done manually. MRP is essentially an inventory management system but it does not
just account for finished products, although top-level management often utilizes MRP
to forecast finished goods. It is more complex than standard inventory management
systems, recognizing the relevance of customer demand in production planning and
accounting for materials that are not part of the end products. In most cases, managers
are required to plan backwards from the scheduled completion of end products to the
point of inventory sourcing from suppliers. MRP requires the following information for
successful application:

Bill of materials • bill of materials (BOM) for finished goods. What components do we need?
This is a list of all • forecast of materials required based on customer demand. How many of each com-
raw materials and ponent do we need?
assembled compo- • the backlog of orders. When do we need the components?
nents that form an
end product. There are several benefits to implementing MRP, such as reducing inventory wastage
during production, increasing service coverage, improving information asymmetry and
decision-making, and optimizing operational efficiency. It is important to note that a
MRP system is different from the EOQ system previously discussed. While an EOQ sys-
tem is item-oriented, an MRP system is product or component-oriented. An MRP system
depends on demand, uses a time-phased ordering signal, and forecasting is limited to
only end items.

Assumptions required for a MRP system are as follows:

 Unit 5 79

Inventory Management and Production Control

• The demand forecast is available in advance.

• Each work center has unlimited work capacity.
• Sufficient data is available.
• There is an ability to process bulk data.
• There is a continuous inventory tracking system in place.

Manufacturing Resource Planning II (MRP II)

Manufacturing resource planning (MRP II) is a holistic process that links all activities of
the firm to the demand of end-users. The successful integration of MRP with informa-
tion management software allows firms to have greater control over all production
activities. The system as a whole is known as manufacturing resource planning II (MRP
II). Technological advancements have paved the way for the evolution of MRP II to
enterprise resource planning (ERP), which is essentially a more comprehensive busi- Enterprise resource
ness information integration system. MRP II serves the following objectives: planning (ERP)
This is a type of soft-
• improve production planning, ware that integrates
• ensure availability of raw materials, business processes
• reduce inventory storage to mitigate stock-outs, and such as production,
• integrate production and delivery processes to achieve material planning efficiency. customer services,
and procurement.
MRP II is not a perfect system and has the following shortcomings:

• The system assumes that capacity is infinite. This assumption can create difficulties
during production planning.
• The system works under the assumption of constant lead time. However, lead time
in practice does not remain constant and fluctuates for a variety of reasons.

MRP II is designed to ensure that customer demand is satisfied. There are two types of
demand that affects a firm’s production planning decisions. They are as follows:

1. Independent demand refers to the demand for an item that does not affect the
demand for another item in the production process. That is, the demand occurs
from outside the production process. Example of independent demand include
parts required for destructive testing or demand for finished products from con-
sumers.
2. Dependent demand refers to the demand for an item that is linked to another item
in the production process. For example, the demand for raw materials and compo-
nents used in the production process depends on the external demand for finished
goods and is therefore dependent demand. Dependent demand plays an essential
role in production planning and should be forecast in advance.

MPR II procedure
The MRP procedure includes the consolidation of two forecast items for the determina-
tion of finished product requirement as part of the production planning process. The
two forecast items are independent demand and customer orders. The MPR procedure
involves the following process:
80 Unit 5

1. The master production schedule provides the schedule of end items in terms of
quantity and timing of production.
2. Available-to-promise (ATP) is a business function that allows firms to respond to
customer orders based on the availability of resources. ATP can be calculated by
adding the inventory on hand and the amount of inventory expected to be supplied
and then deducting the customer demand for the inventory.
3. Planned order releases (POR) determine the gross requirement of a component in
the production line. Planned order releases depend on the net requirements and
the lot-sizing procedure.
4. Net requirements determination is calculated using the following formula:

Net requirements = Gross requirement − Available inventory

Here, the gross requirement can be extracted from the bill of materials (BOM) and takes
the value of independent demand. The available inventory formula is the same as ATP.
The formula for ATP can be extended further by incorporating backorders and safety
stocks as follows:

Available inventory =
= On hand inventory
+ Scheduled receipts
− Customer demand+Backorders + Safety stock Customer demand + Backorders
+ Safety stock

Just-in-Time (JIT) Production

Just-in-time produc- Just-in-time (JIT) production is based on the theoretical concept that the amount of
tion finished inventory can be minimized or eradicated if the production process is conduc-
This is a system that ted in such a manner that each stage of production occurs only at the point that it is
does not require required and raw materials from suppliers are ordered in the exact quantity needed to
storing inventory. complete the operation of each production unit (Reid & Sanders, 2007). Originating in
Japan where it was first introduced by Vice President of Toyota, Taiichi Ohno, for the
motor division, JIT production is also known as the Toyota production system (TPS). The
core principle for JIT is simple: each manufacturing unit produces the necessary prod-
ucts at the necessary time with the minimum amount of inventory. As production is
matched with demand and coordinated with the supply of materials, the JIT system
does not allow for waiting time or storing excess inventory.

Objectives of the JIT system are as follows:

• improved customer response time

• improved communication with stakeholders
• improved flexibility
• improved product quality
• reduced cost
 Unit 5 81

Inventory Management and Production Control

Advantages of the JIT system are as follows:

• minimized inventory storage cost

• improved resource utilization
• eliminated waste in the production process

Disadvantages of the JIT system are as follows:

• little margin for error in the production process

• greater dependence on supply chains
• potential for stock-outs if fluctuations in demand exceed supplier capacity

The implementation of JIT production allows firms to develop a production environ-

ment that facilitates repetitive manufacturing and total quality management (TQM).
These terms are defined as follows:

• Repetitive manufacturing refers to the production of items using the same sequence
of processes (i.e., manufacturing using a production line). Repetitive manufacturing
can be applied to both make-to-order (MOT) and assemble-to-order products.
Repetitive manufacturing requires the uninterrupted flow of materials from one pro-
duction unit to the next.
• Total quality management (TQM) requires all members of the organization to be
responsible for continually improving product quality in order to ensure customer
satisfaction and the sustainable growth/long-term success of the company. TQM
adopts a plan-do-check-action (PDCA) approach to quality management.
◦ The planning step involves identifying any problems that could hinder customer
satisfaction.
◦ The do step involves the firm developing strategies and taking actions to elimi-
nate the problem.
◦ The checking phase involves evaluating the effectiveness of strategies imple-
mented to eliminate the problem.
◦ The final step requires careful evaluation of the process implemented and deter-
mination of new strategies if the problem still exists.
The firm will continue the PDCA process until the problem is eliminated before
moving onto the next problem. TQM allows firms to improve the quality of their
products or services by continuously monitoring and addressing bottlenecks in
the production process or service delivery.

JIT follows a pull system where the materials from the previous production unit are
pulled to the next unit only when demand dictates it. As such, there is not an accumu-
lation of inventory between production units. The MRP, on the other hand, uses a push
system. Differences between JIT and MRP production are outlined in the following table.
82 Unit 5

Differences between MRP and JIT Production

Factors Material resource plan- Just-in-time (JIT)

ning (MRP)

Inventory storage Requires inventory stor- Does not require inven-

age to reduce stock-outs tory storage

Safety stock Maintained Not required

Forecasting technique Long-term Short-term

Production planning Forecast-based Demand-based

System Push system Pull system

Documents used for pro- Purchase orders Delivery schedule

duction planning

Compared to MRP production, a JIT system emphasizes the reduction of wastage from
the production process. This philosophy requires careful analysis of the 5S concepts
introduced under the lean thinking methodology for improving the production process
and reducing cost through efficient waste minimization (Hill & Hill, 2018). The 5Ss are
explained in the following list:

1. Sort refers to organizing the production process by identifying steps in the produc-
tion line which can be eliminated to improve operations. An effective way to sort
ineffective items is to use the “red tagging” method where a red tag is given to any
item in the production line which is not essential.
2. Set in order allows the firms to order items in the production process based on their
importance (as identified in the earlier step).
3. Shine refers to the continuous review of the new production process to sustain the
improvements envisioned by the management.
4. Standardize allows firms to identify best practices after completing the first three
steps. In doing so, firms can develop a consistent approach which can be imple-
mented in other production units.
5. Sustain ensures continuous improvement by maintaining the changes brought
about by implementing the previous steps.
 Unit 5 83

Inventory Management and Production Control

5.4 Methods for Optimal Planning of Capacities and

Production Plans

Capacity

In the context of production, capacity is the maximum load an operating unit can han-
dle. The operating unit can be a manufacturing machine, a production unit, a specific
department in the organization, or an individual employed in a specific division of the
organization. There are several ways that capacity can be assigned to a production unit.
Input refers to the amount a production unit can handle in a given time. For example, if
a newly installed automated bread-making machine can process 200 pounds of flour,
the production capacity of the machine is 200 pounds per hour. Output refers to the
number of finished products a production unit can make with a given amount of input.
If the automated machine described above can produce 20 loaves of bread using 200
pounds of flour in one hour, then the output in 20 units per hour.

Capacity can be further defined according to the following terms:

• Design capacity describes the highest output that can be generated by a production
unit.
• Sufficient capacity takes a more realistic approach and includes scheduling difficul-
ties and similar problems in the production process.
• Actual output is the output generated in practice. Actual capacity is lower than suffi-
cient capacity due to machine breakdowns, inventory shortage, and defective out-
puts.

Several techniques can be used to determine the effectiveness of the production unit
using these definitions of capacity. The first technique is efficiency, which is a ratio of
actual output over sufficient capacity. This technique is widely used by managers to
determine the optimum utilization of the available production facilities. Efficiency
scores also provide ways to compare the performance of different production units to
identify any constraints that reduce the production capacity.

Actual output
Efficiency =
Effective capacity

The second technique is utilization, which is the ratio of actual output over design
capacity.

Actual output
Efficiency = Utilization =
Design capacity

Example
Given the following information, what is the efficiency and utilization rate for the XYZ
Corporation?
84 Unit 5

XYZ Corporation Capacity Information

Design capacity 400 units per week

Effective capacity 300 units per week

Actual output 240 units per week

The solution is as follows:

Actual output 240

Efficiency = = = 80%
Effective capacity 300
Actual output 240
Utilization = = = 60%
Design capacity 400

The XYZ Corporation’s production unit is 80 percent efficient but only 60 percent uti-
lized. A manager could use either the efficiency or utilization scores for decision-mak-
ing purposes.

If an organization decides to increase the actual output of a new or existing product as

a measure to increase the efficiency or utilization of a production unit, it would need to
undertake sufficient capacity planning, which includes

• conducting an existing capacity assessment,

• forecasting capacity,
• identifying alternative methods to improve capacity,
• evaluating the financial and non-financial impact of capacity-enhancing decisions,
and
• selecting a capacity enhancement strategy that fits the company objectives.

Scheduling

Scheduling refers to the assignment of jobs to individuals or production units for spe-
cific periods. Scheduling provides a wide range of benefits to manufacturers, but serv-
ice firms may also benefit from scheduling. There are different rules that can be
applied when creating a schedule. Some of the most common rules used in scheduling
are first-come-first-served, shortest processing time, and earliest due date. They are
defined as follows:

• First-come-first-served (FCFS) prioritizes the process that arrives first. It uses a

queue system where the first element to arrive leaves the queue earliest.
• Shortest processing time (SPT) follows the rule of prioritizing the job with shortest
completion time.
• Earliest due date (EDD) uses the due date to prioritize jobs during the scheduling
process.
 Unit 5 85

Inventory Management and Production Control

Example
We will now use each of these scheduling rules to determine which is the optimal
scheduling rule for XYZ Corporation to process the following jobs.

XYZ Corporation Scheduling Date

Job Order received Operating time Due date (in

(in days) days)

Job 14583 June 11 15.1 22

Job 24823 June 21 13.2 30

Job 34723 March 2 14.5 20

Job 45523 April 20 16.0 26

Job 54723 January 8 12.9 28

XYZ Corporation Scheduling Date: First-Come-First-Served (FCFS)

Job Order Operating Due date (in Lateness (in

received time (in days) days)
days)

Job 54723 January 8 12.9 28 –15.1

Job 34723 March 2 14.5 20 7.4

Job 45523 April 20 16.0 26 17.4

Job 14583 June 11 15.1 22 36.5

Job 24823 June 21 13.2 30 41.7

Total 213.9 87.9

Average 42.78 17.58

86 Unit 5

Using the FCFS method, the orders are ranked based on the date they were received.
The earlier order is processed first. After sorting the orders based on their date, we
need to determine whether an order is late by subtracting the due date from the oper-
ating time. As indicated in the previous table, Job 54723 is the first order (received Janu-
ary 8) and is due in 28 days. The difference between operating time and the due date
for Job 54723 is –15.1. A negative lateness value indicates that the order is on-time; in
this case, the firm has another 15.1 days to process the order before the due date. How-
ever, the rest of the orders are late when scheduled using the FCFS method. On aver-
age, the firm is 17.58 days late when processing jobs.

XYZ Corporation Scheduling Date: Shortest Processing Time

Job Order Operating Due date (in Lateness (in

received time (in days) days)
days)

Job 54723 January 8 12.9 28 –15.1

Job 24823 June 21 13.2 30 –3.9

Job 34723 March 2 14.5 20 20.6

Job 14583 June 11 15.1 22 33.7

Job 45523 April 20 16.0 26 45.7

Total 207 81

Average 41.4 16.2

Using the shortest processing time (STP) method, orders are ranked based on their pro-
cessing time. The order with the shortest processing time is processed first. After sort-
ing the orders based on their processing time, we need to determine whether an order
is late by subtracting the due date from the operating time. As indicated in the previous
table, Job 54723 has the shortest order time. The difference between operating time and
the due date for Job 54723 is –15.1, which indicates that the firm has another 15.1 days to
process the order. Therefore, a negative lateness value indicates that the order is on
time. Job 24823 is also on time (–3.9). However, the rest of the orders are late based on
the STP method. On average, the firm is 16.2 days late to process its overall customer
orders.
 Unit 5 87

Inventory Management and Production Control

XYZ Corporation Scheduling Date: Earliest Due Date

Job Order Operating Due date (in Lateness (in

received time (in days) days)
days)

Job 34723 March 2 14.5 20 –5.5

Job 14583 June 11 15.1 22 7.6

Job 45523 April 20 16.0 26 19.6

Job 54723 January 8 12.9 28 30.5

Job 24823 June 21 13.2 30 41.7

Total 219.9 93.9

Average 43.98 18.78

Using the EDD method, orders are ranked based on their due date. The order with the
shortest due date is processed first. After sorting the orders based on their due date,
we need to determine whether an order is late by taking the difference between oper-
ating time and due date. As indicated in the previous table, Job 34723 has the shortest
due date. The difference between the operating time and the due date for Job 34723 is
–5.5, indicating that the firm has another 5.5 days to process the order. However, the
rest of the orders are late based on the STP method. On average, the firm is 18.78 days
late to process its overall customer orders.

Based on these calculations, the shortest processing time (SPT) is the optimum sched-
uling method for the XYZ Corporation as the average operating time and lateness is
lower than when the FTFS and EDD method were used.

Summary

Recent financial crises and the rapid development of new technology are posing
challenges for businesses. Whether operating in a manufacturing or service based
industry, all companies are required to optimize the use of available resources. As a
result, inventory management has become an integral part of managerial decision-
making. Inventory management is a broad term and includes stock optimization,
continuous inventory management, capacity planning, and scheduling. Adopting
88 Unit 5

the most appropriate inventory management tool given a company’s specific busi-
ness needs can make a significant impact on profitability by reducing wastage. One
way to optimize the use of stock is through the implementation of the economic
order quantity (EOQ) model in production planning. The EOQ model is simple and
effective in determining the lowest inventory costs. Managers must understand how
to utilize single and multi-period inventory management systems in order to deter-
mine which system best suits their inventory planning needs. While EOQ allows
companies to determine the optimum order size, concepts such as materials
requirement planning (MRP) and just-in-time (JIT) production allow companies to
ensure a holistic change in the production process. Finally, capacity planning and
scheduling are critical to operations management as they can enhance the effi-
ciency of production facilities and facilitate better allocation of available resources.

Knowledge Check

Did you understand this unit?

You can check your understanding by completing the questions for this unit on the
learning platform.

Good luck!
Unit 6
Information Systems in the Supply Chain

STUDY GOALS

On completion of this unit, you will be able to …

… explain the importance of information technology (IT) in supply chain management.

… differentiate between product and process design.

… compare demand forecasting and demand planning.

… identify complexities in the supply chain management process.

… evaluate available IT solutions for efficient supply chain management.

DL-E-DLMBAEOIM01-U06
90 Unit 6

6. Information Systems in the Supply Chain

Introduction
It is common practice among organizations to integrate advances in information and
communication technology (ICT) with production functions in order to improve produc-
tion processes. The main objective of such integration is improving production design
so that businesses can offer better quality products at lower costs, creating competitive
advantages and increasing market share. Recent developments in information and
Supply chain man- communication technology have made supply chain management (SCM) heavily
agement (SCM) dependent on ICT for activities such as transaction processing, communicating with
This is an integral stakeholders, disseminating information, and even strategy development.
part of the business
value chain and Integrating ICT into SCM has occurred in various stages. With the introduction of elec-
refers to all aspects tronic data interchange (EDI) in the 1960s, supply chain management became more
of the supply chain streamlined and efficient, as it became easier to exchange information between trading
from raw materials partners. In the 1990s, enterprise resource planning (ERP) was introduced, which
to end customers. allowed businesses more control over their operations via a single software applica-
tion. Since then, we have witnessed numerous ICT innovations that have facilitated bet-
ter management of increasingly complex supply chains. The supply chain information
system (SCIS) has now become an integral part of supply chain management (SCM).

6.1 Increased Performance through Product and Process

Design

Product Design

Within the product life cycle, there are two points that are especially challenging: the
period of declining demand for existing products, and the complex stage of product
development, where companies are required to invest significant resources in the
development of new products in order to ensure the long term success of the organiza-
tion. The product development process can be divided into eight stages, which are
briefly discussed here (Bunse et al., 2011):

1. Idea generation is the first step in the product design process. It is essential to fol-
low a systematic process for product design as a haphazard process could result in
a new product that does not actually appeal to the designated market. Top manage-
ment has a vital role in this stage, providing clear direction on the nature of the
product and the market to target. Companies can use market research, internal
resources, and other information to inform product design.
2. Idea screening is essential to select a suitable product design from the designs
identified in the idea generation stage. Idea screening allows companies to reduce
the number of product designs to the most suitable designs that corresponds with
the strategic vision of the organization.
 Unit 6 91

Information Systems in the Supply Chain

3. Concept development and testing is necessary to find the practical uses of the new
product. Companies can use focus groups to understand customer reactions to the
new product.
4. Market strategy development allows companies to design a suitable market strategy
that allows them to introduce the new product to the target market.
5. Business analysis involves the analysis of revenue, production, and operational
costs to identify the profit potential of the new product.
6. Product development is initiated once the new product passes the business analysis
stage, ensuring the inherent profit potential of the physical product. A prototype (or
multiple prototypes) is made and tested via a process that includes functional test-
ing to ensure the safety of the new product for the target customers.
7. Test marketing is initiated once a newly developed product passes the functional
and consumer test and is ready to be offered to customers. In this stage, the prod-
uct is introduced to the market via an appropriate promotional campaign.
8. Commercialization is the final stage when the product is finally introduced to the
market.

Product Design Tools

Companies require information to develop new products. There are various tools avail-
able to companies to provide the necessary information such as the following:
92 Unit 6

1. Market research uses a target group to extract information from target demograph-
ics. Survey interview techniques are the most commonly used tools to extract infor-
mation from the target population.
2. Competitive analysis requires the company to analyze the products offered by com-
petitors. This process often requires analysis of competitors’ products to the individ-
ual component level in a process known as “reverse engineering” to identify gaps
that could be filled by a new product.
3. Value engineering is where the company seeks to add value to a product with mini-
mum cost. The value engineering process requires efficient utilization of all opera-
tional areas including procurement, personnel, suppliers, and production personnel.
Value engineering allows companies to identify flaws in the product design that can
be eliminated to improve product quality and reduce production costs.

Process Design

Process design is an integral part of new product development and often occurs con-
currently with product design stages. The process design phase plays a vital role in new
product development, determining operational costs, defining production processes,
and validating the required suppliers. The process design phase also involves simula-
tion analysis, which aims to identify the practical application of the new product. The
process design phase of new product development can be divided into two stages:

1. Process analysis. This includes preliminary analysis of the capital or labor intensity,
outsourcing requirements, and resource flexibility of the company required to con-
tinue production of the newly developed product. The process analysis stage allows
companies to identify the most appropriate equipment (primary and secondary) to
efficiently produce the new product.
2. Operational analysis. This follows the process analysis stage and focuses on the
operational aspects of new product development. In this stage of process design,
management makes decisions regarding the viability of each process required to
produce the new product efficiently. An operation sheet is typically generated in this
phase, which specifies the steps and elements required at each workstation.

In general, two types of processes are associated with new product development: mar-
ket orientation processes, and production system processes.

Postponement

In the modern competitive business environment, firms are focusing on reducing their
lead time. One of the advantages of reduced lead time is that it allows firms to reduce
the amount of inventory on hand, which increases free cash flow. The process of lead
time reduction is tedious and requires careful analysis of each step of the value chain.
Each component of the value chain plays its part in the production of the finished
product. However, firms can choose whether to complete a certain step in the value
 Unit 6 93

Information Systems in the Supply Chain

chain until a customer order is confirmed. This strategy is known as postponement. The
following are requirements for the effective utilization of a postponement strategy (Li
et al., 2007):

• visualization of the product value chain,

• identification of a step in the value chain that can be postponed, and
• review of the benefits achieved with postponement.

Interchangeable Manufacturing

Interchangeable manufacturing processes can reduce production costs for firms by

reducing the direct labor cost of operating different machines. In an interchangeable
manufacturing process, a machine component can be transferred to another depart-
ment for batch processing without sacrificing its function. Prior to implementing this
approach, it is important to evaluate the tolerance of the interchangeable manufactur-
ing unit, which is calculated as follows:

Tolerance = Maximum clearance − Minimum clearance

Here, maximum clearance is equal to the maximum possible capacity under optimum
conditions while minimum clearance is equal to the actual capacity under service con-
ditions.

6.2 Order Policy, Demand Forecast, and Demand

Planning

Demand Forecasting and Planning

Demand forecasting involves estimating future demand. It requires the application of Demand forecasting
mathematical models and often uses historical data to predict future demand for a This is the process of
new or existing product. Forecasting is required to plan for uncertainties regarding cus- applying mathemati-
tomer demand, allowing firms to make necessary changes in their production deci- cal models to predict
sions. Forecasting is also critical for facilitating communication across business seg- future demand for a
ments as it aids decision-making across teams. product.

Demand planning allows companies to manage supply and demand to match real-time Demand planning
changes in customer demand that result from various micro- or macroeconomic This differs from
changes. Demand planning serves to reduce the cost of production, which can, in turn, forecasting as it
attract customers and boost revenue. Effective utilization of the demand planning func- focuses more on
tion requires a reliable software application that can managing fluctua-
tions in demand.
• develop a demand planning process that is accurate and sustainable,
• develop models and perform simulation exercises required to study the impact of
demand fluctuations,
94 Unit 6

• provide a network to share information across supply chain partners, and

• accurately predict demand and market performance of a new product.

Sales and Operations Planning (S&OP)

While demand forecasting is used to estimate future demand, demand planning is

used to maintain timely and cost-effective operational processes. Cost-effective and
time-effective operations are critical as the main objective of the company—maximizing
revenue—cannot be achieved if products are not available for sale. Effective inventory
planning is also critical as inventory absorbs a large amount of capital and any inven-
tory wastage reduces the profit potential of new products.

Regardless of whether companies utilize demand forecasting or demand planning, the

ultimate objective of these activities is to adequately monitor customer demand fluctu-
ations in order to provide useful and timely information for the sales and operations
planning (S&OP) process. The S&OP process has a vital role in the overall supply chain
management process. It incorporates demand, supply, and financial planning to pro-
vide much needed strategic planning. As such, both demand forecasting and planning
activities need to be integrated with S&OP.

Software Solutions for Demand Forecasting

Advances in technology have made dedicated demand planning software solutions

available to most companies; in the past, only large companies were able to utilize
them given the significant initial investment required to purchase and implement them.
That said, Microsoft Excel remains one of the most popular software tools for demand
planning and continues to be widely used by small and medium-sized manufacturing
firms around the world. Demand planning software has become an essential part of
supply chain management due to its ability to optimize production and act as an effec-
tive communication-sharing platform with supply chain partners. The following is a
brief description of four popular demand planning software packages:

1. Oracle Demantra is developed by Oracle. It provides both demand and supply chain
management tools that can create automated forecasts of product demand as part
of the overall demand planning process. Oracle Demantra also provides companies
with the ability to plan sales and operational activities and develop promotional
solutions (HCL, n.d.).
2. Logility Solutions is developed by Logility. It includes a variety of demand planning
solutions such as demand sensing, demand planning, life cycle planning, and pro-
portional profile planning (Logility, n.d.).
3. SAP Integrated Business Planning is developed by SAP. It features cloud-computing
technology to provide real-time SCM. SAP-integrated business solutions provide
real-time scenario analysis for effective demand planning (SAP, n.d.).
4. JDA Demand Planning is developed by Blue Yonder Group. It has become a cost-
effective software solution for management that offers demand planning capabili-
ties (Capterra, n.d.).
 Unit 6 95

Information Systems in the Supply Chain

The following table provides a market analysis of selected IT systems that can be used
in small, medium, and large enterprises.

Summary of Supply Chain IT Solutions

Software solu- Description Advantages

tion

SAP supply Uses artificial intelligence and Inter- Provides end-to-end

chain manage- net of Things (IoT) to provide soft- supply chain visibility
ment ware solutions covering all aspects
of the supply chain process

Logility Allows companies to gain a compet- Provides functions to

itive advantage by offering advance monitor demand
analytics which makes a significant across global markets
improvement in the planning proc-
ess

Oracle supply Offers end-to-end visibility of the Provides inventory-

chain manage- supply chain software solutions via tracking mechanisms
ment cloud-based services which can and convenient infor-
generate revenue and growth fore- mation sharing plat-
casts form between manu-
facturer and suppliers

JDA supply Offers planning and forecasting Optimizes global

chain manage- tools to analyze complex customer resource allocation to
ment demand across the globe improve inventory
planning

Manhattan sup- Ensures top-line growth prospects Reduces operational

ply chain man- for the business without sacrificing and administrative
agement the bottom line cost and improves
service efficiency

6.3 Conceptual Frameworks of Supply Chain

Management (SCM)
Kuhn and Hellingrath (2002) divide supply chain management into three pillars: inte-
gration, process redesign, and application of IT systems. To achieve integration, the
authors emphasize the importance of trust to facilitate the close cooperation of all
96 Unit 6

partners in the supply chain network as well as developing a shared process-oriented

understanding between partners. Process redesign provides businesses with the
opportunity to ensure the efficient flow of information and eliminate non-value-adding
activities that exist across the company. Redesign of operational activities can reduce
operational and administrative expenses for the firm and improve the production proc-
ess. In this global era of Industry 4.0, the application of IT systems serves several vital
functions in the supply chain, specifically coordination and communication. However, a
lack of trust and reluctance among various supply chain partners to share information
has remained a challenge to transforming traditional SCM using effective IT systems.

Schönsleben (2011) also provides a conceptual framework of SCM transformation that

highlights three key elements. The first element is the SCM structure, which includes
supply chain networks, leadership capabilities, and trust among stakeholders. The sec-
ond element is the SCM organization. To maintain an effective supply chain, partners
need to recognize their responsibilities to the supply chain, engage in performance
evaluation, and develop information-sharing networks built on trust. The final element
is SCM information technology (IT). IT plays an essential role in the modern supply
chain framework and companies have to embrace IT-based solutions to improve their
traditional supply networks and compete in the global business environment.

6.4 Complexities for Supply Chain Information Systems

There are a number of complexities present in supply chain information systems. In
this era of globalization, even small and medium companies have a global presence
and utilize distribution centers operating in multiple locations, relying on information
systems to coordinate operations. There is heightened interest in minimizing the com-
plexity of these supply chain information systems, improving the cost-effectiveness of
software solutions, and enhancing their ability to improve operational efficiency.

In general, an effective supply chain information system is expected to:

• reduce operational and administrative costs,

• improve delivery schedules and reduce lead times,
• ensure the efficient use of inventory in all stages of the production process, and
• enhance the quality of the product being produced by the firm.

However, operational and information complexities can interfere with these objectives
and reduce the effectiveness of the supply chain information system. As such, these
complexities require careful consideration by management.

Operational complexity refers to difficulties in the procurement process resulting from

the overall shift towards more decentralized operations. The primary reason for the
move toward decentralization is the prospect of value addition. Decentralization is also
expected to increase transparency across the organization, reducing internal costs.
However, decentralization increases operational complexity, creating diverse logistical
problems, lead time uncertainties, and the need to respond rapidly to changes in for-
 Unit 6 97

Information Systems in the Supply Chain

eign regulations when they occur. For firms operating at a single manufacturing plant,
globalization has resulted in increasing pressure to relocate their production sites over-
seas.

Information complexity results from the large volume of data generated through the
supply chain process. Companies are now required to continually filter and process
data to extract meaningful information for planning purposes. In the process of filter-
ing and processing, the integrity and reliability of data can be compromised as the
result of manipulation or input errors from the providers of data. It is obviously chal-
lenging to ensure the accuracy of data derived from external sources, but firms are nev-
ertheless forced to use such information in their forecasting and planning procedures.

Supply Chain Design and Planning

Designing and planning the supply chain is one of the most significant tasks in supply
chain management. It requires taking a holistic look at the overall supply chain net-
work and formulating a strategy to enhance the value added by existing processes
without incurring additional expenses. There are several major challenges associated
with transforming traditional supply chain networks into more dynamic, modern net-
works. One of the primary challenges relates to transforming the supply chain from a
supplier-centric network into a more customer-centric network. While the traditional
supply chain design and planning begins at the point of supply and production, con-
temporary supply chain design positions the customer at the center of all supply chain
activities and marketing takes on a greater role in designing the supply chain to meet
customer expectations.

The McKinsey 7S model (Bryan, 2008) introduces the elements that need to be
addressed in order to transform and modernize tradition supply chain design. They are
as follows:

1. Strategy. Top management should be responsible for developing a customer-centric

strategy. The strategy then needs to be communicated to and adopted by all func-
tional divisions.
2. Structure. Both horizontal and vertical reporting lines should be maintained at the
organizational level. However, the horizontal structure could become more effective
by aligning with product and market segments.
3. Systems. Effective systems should be in place to deal with customer complaints and
market sentiment. Companies should find a way to improve their response time to
customer complaints.
4. Share value. Customer value should be the primary focus when engaging in long-
term strategic decision-making.
5. Style. Companies should adopt a leadership style that supports the strategic objec-
tives.
98 Unit 6

6. Staff. People should be treated as an asset of the firm. Strategic decisions made by
top management should be communicated with employees to make a positive
impact on the overall company performance.
7. Skills. Companies should enhance the skills of their existing workforce to better
serve customers and other stakeholders in the value chain.

Summary

The application of supply chain management in the manufacturing process has

made a remarkable impact across the globe. Globalization has made a significant
impact on the development of modern supply chains. Advances in information
technology (IT) have facilitated the efficient management of supply chains. Compa-
nies around the world are embracing Industry 4.0, which promotes automation.
Given these developments, companies need dynamic supply chains established via
complex networks with supply chain partners. An effective supply chain requires
reduced information asymmetry. Adopting IT solutions that provide enhanced mon-
itoring of production units can improve operational efficiency and reduce adminis-
trative costs. In the past, adoption of such IT solutions was only available to large
enterprises given the substantial initial investment and commitment to continuous
improvement required. However, we have seen remarkable developments in IT in
recent years in the form of cloud computing and artificially intelligence. Software
developers are now providing affordable solutions that can be adopted by small
and medium enterprises. The long-term sustainability of companies relies on their
ability to adopt dynamic supply chain models that integrate effective IT solutions.

Knowledge Check

Did you understand this unit?

You can check your understanding by completing the questions for this unit on the
learning platform.

Good luck!
Unit 7
Behavioral Operations Management

STUDY GOALS

On completion of this unit, you will be able to …

… understand decision heuristics for solving complex problems.

… explain decision behavior and decision prognosis.

… describe the decision-making process.

… understand key aspects of behavioral operations management.

DL-E-DLMBAEOIM01-U07
100 Unit 7

7. Behavioral Operations Management

Introduction
Operations management (OM) plays a vital role in optimizing the manufacturing proc-
ess to enhance stakeholder value. Such optimization relies on effective managerial
decisions. Integrating knowledge of organizational behavior and human resource man-
agement with operations management can foster improved managerial decision-mak-
ing.

In this unit, we explore several behavioral issues affecting operations management. The
first behavioral issue we reflect on is the heuristic and behavioral biases in managerial
decision-making. The next behavioral issue relates to social interactions in operations
management. Social interactions play a significant role in behavioral biases and shape
the cognitive biases of individuals. Finally, we explore elements that influence manage-
rial decision-making, borrowing concepts from cognitive and social psychology to iden-
tify factors that lead to better operational management decisions.

7.1 Decision Heuristics for Solving Complex Problems

The field of behavioral operations management is linked with social science, drawing
on concepts from psychology to understand human behavior under certain conditions.
The behavioral aspects of operations management are evident in the choices made by
managers and the rationale behind such choices. Here, we discuss several theoretical
perspectives on decision-making that have broad applications in operations manage-
ment.

Prospect Theory

Prospect theory Kahneman and Tversky (1979) first introduced prospect theory, proposing that individ-
This describes the ual preferences do not rely on the final state of the outcome but rather rely on a set of
role of risk aversion predetermined reference points. There are two types of deviations from the predeter-
in decision-making. mined reference points. They are as follows:

1. Positive deviation is gain resulting from a decision made using predetermined refer-
ence points.
2. Negative deviation is loss incurred from a decision made using predetermined refer-
ence points.

The following figure illustrates the two deviations thus described. It indicates a hypo-
thetical value function based on the prospect theory introduced by Kahneman and
Tversky (1979). The S-shaped figure represents the value function and depends on the
two reference points (losses and gains). As we can see in the following figure, the line is
convex in the loss-domain, reflecting the higher level of pain experienced by an indi-
vidual resulting from a loss of 100 USD as compared to a gain of 100 USD.
 Unit 7 101

Behavioral Operations Management

Prospect theory introduces the two following cognitive biases:

1. The endowment effect describes how individuals place a higher value on objects
they possess and are more likely to retain an object that they already own than
acquire the same object if they do not already own it.
2. The status quo bias occurs when individuals are reluctant to change and prefer to
maintain the same pattern even in cases where changes might lead to attractive
benefits.

Prospect theory provides an understanding of human decision-making under certain

conditions. In general, prospect theory deals with risk and loss aversion, which applies
to the field of operations management. Basic operations management models perceive
managers to be risk-averse and require them to focus primarily on the maximization of
profit for the organization. However, prospect theory introduces the decision-making
perspective based on predetermined reference points, which can have an impact on
the optimal decision-making among managers.

Heuristics and Biases

Heuristics refers to the use of the “rule of thumb” while making a decision. It is often
difficult for a manager to evaluate all aspects related to a set of alternatives while mak-
ing decisions. As a result, managers often use heuristics to make quick decisions. Heu-
ristics are those mental shortcuts that allow people to make decisions quickly. While
the decision reached may not be the most optimal, heuristics such as intelligent
guesses, trial and error, process of elimination, and analysis of historical data lead to
swift decisions that are essentially “good-enough” under the circumstances. However,
the use of heuristics has limitations and can lead to cognitive biases. A number of heu-
ristics commonly used in decision-making are explained here.
102 Unit 7

Representativeness heuristic
People are biased towards alternatives that look similar to their past choices. Kahne-
man and Tversky (1972) introduced the representativeness heuristic by exploring the
pattern of individual decision-making that favors an event that resembles a similar cat-
egory of past events. According to the representativeness heuristic, an individual is
more likely to choose an unfamiliar item if it falls within an existing category of items
based on past choices. For example, a procurement manager is more likely to select a
known supplier who has been supplying raw materials to the company in the past over
a new supplier with better quality of materials. In this case, the manager’s decision-
making is biased by familiarity with the existing supplier, which affects any evaluation
of prospective suppliers.

Availability heuristic
Individuals tend to think that an event occurs more often if they are able to generate
examples or instances of it happening more easily, i.e., the more immediately an exam-
ple of an event is accessed by an individual, the more likely that individual is to over-
estimate its likelihood of occurring. Tversky and Kahneman (1973) explain that individu-
als rely on the availability heuristic during decision-making when they recall more
immediate events representing a decision alternative, which in turn biases their deci-
sion-making. The availability heuristic affects our ability to evaluate the magnitude of
selecting an alternative as we rely on our memory and familiarity while making a deci-
sion. Tversky and Kahneman explored the availability heuristic in an experiment where
they asked individuals to list words that begin with the letter “k” and words that have
“k” as the third letter. This experiment revealed that respondents were able to recall
more words that start with the letter “k” even though there are more words that have
“k” as the third letter. An example of the availability heuristic is risk assessment, where-
upon greater mitigation and management efforts are dedicated to risks that are more
obvious to management or have been more recently experienced and thus represent
more apparent rather than objectively greater risk.

Anchoring heuristic
This heuristic is used when individuals start from an initial value (which can be either
arbitrary or informed) and make adjustments to this predetermined value based on the
available alternatives. Bolton and Katok (2007) identified the use of anchoring heuris-
tics in supply chain management. They performed experiments related to the newsven-
dor problem and found that inventory policies were affected by anchoring values. In a
newsvendor problem, managers deal with seasonality and stochastic demand and the
profit of the company depends on the order quantity, which cannot be adjusted
according to changes in seasonal demand. Bolton and Katok (2007) proved that manag-
ers suffer from anchoring bias in newsvendor conditions.

Affect heuristic
This heuristic accounts for the role of emotion in decision-making. Affect heuristics can
lead to biases that limit the manager’s ability to evaluate the long-term effect of the
decision when that decision is influenced by the current emotion experienced by the
manager (e.g., fear, pleasure, surprise). Slovic et al. (1980) introduced the concept of an
affect heuristic where the emotional state of feeling “good” (positive affect) or “bad”
(negative affect) affected the selection of alternatives. Positive affect led to an alterna-
 Unit 7 103

Behavioral Operations Management

tive being judged as representing a higher level of benefits with lower associated risk
compared to other alternatives, whereas negative affect led to an alternative being
judged as representing greater risk as compared to other options.

7.2 Decision Behavior and Decision Prognosis

Emotions often take center stage in decision-making. Emotions are patterns of chemi-
cal and neural responses that occur during decision-making. Emotions are shaped by
cultural values, meaning that different individuals around the world will have different
emotional responses to the same decision-making scenario. Emotion is not the only
factor that plays a crucial role in the decision-making process—conscious rational
thought is also usually involved—but emotions can be more insidious in the context of
business decision-making and therefore warrant additional scrutiny.

LeDoux (1998) has identified the following essential qualities of emotions in the deci-
sion-making process:

• Repeated pattern. Emotion follows a repeated pattern in the decision-making proc-

ess. Individuals often favor decisions that involve a positive emotional response. For
example, a good meal at a restaurant could create a positive emotional response,
which becomes the basis for a repeated pattern of dining at this restaurant and the
creation of a loyal customer.
• Conditioning. Emotional responses during decision-making are built on various con-
ditional elements that have developed over the course of human development.
• Trigger for mental functions. Emotion can trigger various mental functions for indi-
viduals during decision-making. Emotional responses are typically connected to
memory, which plays a regulatory role by reflecting on past events.

The first quality of emotions—repeated pattern—allows the development of algorithm

quality. The following figure identifies several types of emotional algorithms.
104 Unit 7

Competitive emotional algorithms focus on maximizing self-interest, which can affect

the individual decision-making process. The competitive aspects of emotional algo-
rithms can be divided into the following factors:

• Resource striving refers to the focus on accumulating material possessions. Individ-

uals with resource striving emotions prioritize achieving short-term objectives by
compromising long-term goals.
• Status seeking refers to the need to have a certain level of social status. Culture
plays a vital role in shaping the status-seeking emotional responses of individuals.
The need for recognition can be addressed in the organization by creating and com-
municating a hierarchy that is connected with the appropriate level of performance
appraisal.

Cooperative emotional algorithms rely on building social networks. The cooperative

aspects of emotional algorithms can be divided into the following factors:

• Reciprocation need refers to the desire among individuals to develop meaningful

relationships with other individuals based on trust.
• Group identity seeking refers to the desire to belong to a social group.

7.3 Decision-Making Process

When an individual faces a set of alternatives, the alternative selected by that individ-
ual depends on their chosen decision-making strategy. In the following figure, we can
see the different decision-making criteria used by individuals. The first two elements—
intuitive and empirical—are the subject of much study in the field of cognitive psychol-
ogy. The majority of decisions made by individuals can be classified as intuitive in
nature, relying on familiarity, expectation, and judgement. While empirical strategies
are often adopted by businesses in the decision-making process, in most cases, intui-
tive aspects of decision-making, such as individual preference and common sense, are
also involved. In the first section of this unit, we discussed heuristic decision-making
approaches and their inherent biases.
 Unit 7 105

Behavioral Operations Management

Wang and Ruhe (2007) introduced the layer reference model of the brain (LRMB), which
describes decision-making as one of the thirty-seven fundamental cognitive process
functions of the brain. The LRMB model identifies three critical elements in human
memory: objects, attributes, and relations (OAR). According to the LRMB and OAR
model, the cognitive decision-making process follows four steps:

1. The first step is to analyze the problem and identify goals. In this step, individuals
identify the objects and attributes related to the decision.
2. In the second step, individuals analyze alternatives to identify alternative solutions
for the given problem.
3. In the third step, individuals develop decision criteria by carefully evaluating deci-
sion problems and available alternatives.
4. In the fourth step, individuals select the best alternative based on their cognitive
decision-making criteria.

Summary

The behavioral aspects of decision-making have been the subject of study in multi-
ple disciplines. Industry and academic experts have explored the behavioral
aspects of decision-making and their impact on the field of operations manage-
ment. In this unit, we explored the heuristic decision-making problem in general as
well as from the perspective of supply chain managers. Heuristic decision criteria
often lead to biases that can affect the ability of individuals to make optimal deci-
106 Unit 7

sions. In the second section, we looked at the emotional aspects of decision-mak-

ing. It is essential to understand the ways that emotion can influence the decision-
making process to ensure it does not have undue influence in the managerial
decision-making process. Finally, we looked at the cognitive decision-making proc-
ess according to the layer reference model of the brain (LRMB) and object, attrib-
ute, relational (OAR) model. In the modern business environment, business success
depends on the effectiveness of managerial decision-making. High quality manage-
rial decisions can create a competitive advantage and ensure the sustainable
growth of the business. Alternatively, poor decisions can damage the future pros-
pects of the business. Additional research is required to understand the effects of
heuristic biases on supply chain decisions and how the decision-making process of
operational managers differs under various conditions such as during a financial
crisis.

Knowledge Check

Did you understand this unit?

You can check your understanding by completing the questions for this unit on the
learning platform.

Good luck!
 Evaluation 107

Congratulations!

You have now completed the course. After you have completed the knowledge tests on
the learning platform, please carry out the evaluation for this course. You will then be
eligible to complete your final assessment. Good luck!
Appendix 1
List of References
110 Appendix 1

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Appendix 2
List of Tables and Figures
116 Appendix 2

List of Tables and Figures

Overview of an Operations Function

Source: Ashfaq, 2020.

Operations Management in Production and Service Organizations

Source: Ashfaq, 2020.

Stages of a Product Life Cycle

Source: ProfitWise, 2014.

Seven Steps of Forecasting

Source: Author, based on Heizer et al. (2016).

Moving Average Forecast

Source: Ashfaq, based on Heizer et al. (2016).

Actual Data for KaPow Corporation

Source: Ashfaq, 2020.

Forecast Calculations for KaPow Corporation

Source: Ashfaq, 2020.

Meat Processing Firm: Location Example

Source: Ashfaq, 2020.

Meat Processing Firm: Location Solution

Source: Ashfaq, 2020.

XYZ Corporation: Location Example

Source: Ashfaq, 2020.

XYZ Corporation: Location Solution

Source: Ashfaq, 2020.

Graphic Representation of the Break-Even Analysis

Source: Ashfaq, 2020.
 Appendix 2 117

List of Tables and Figures

XYZ Corporation Longitude and Latitude Information

Source: Ashfaq, 2020.

Location Under Fluctuating Demand

Source: Google Maps, n.d.-a.

Location Under Constant Demand

Source: Google Maps, n.d.-b.

Factors Affecting the Process Design

Source: Ashfaq, based on Stevenson (2002).

Six Management Processes of SCOR

Source: Supply Chain Council, 2012.

SCOR Hierarchical Process Model

Source: Supply Chain Council, 2012.

Manufacturing Processes and Their Relationship to Product Categories

Source: Author, based on Hill & Hill (2018).

Activities and Functions Affected by Process Design

Source: Author, based on Stevenson (2002).

Example of Spaghetti Diagram

Source: Uddin et al., 2013.

Typical EPC Process Model

Source: Davis, 2001.

KPIs for Sequential Planning

Source: Meier et al., 2013.

Economic Order Quantity

Source: Ashfaq, 2020.
118 Appendix 2

Differences between Fixed Order and Fixed Period Inventory Systems

Source: Ashfaq, 2020.

Re-Order Point
Source: Ashfaq, 2020.

XYZ Corporation Information

Source: Ashfaq, 2020.

Differences between MRP and JIT Production

Source: Ashfaq, 2020.

XYZ Corporation Capacity Information

Source: Ashfaq, 2020.

XYZ Corporation Scheduling Date

Source: Ashfaq, 2020.

XYZ Corporation Scheduling Date: First-Come-First-Served (FCFS)

Source: Ashfaq, 2020.

XYZ Corporation Scheduling Date: Shortest Processing Time

Source: Ashfaq, 2020.

XYZ Corporation Scheduling Date: Earliest Due Date

Source: Ashfaq, 2020.

Stages in New Product Design

Source: Bunse et al., 2011.

Summary of Supply Chain IT Solutions

Source: Ashfaq, 2020.

Propositions of Prospect Theory

Source: Kahneman & Tversky, 1979.
 Appendix 2 119

List of Tables and Figures

Emotional Algorithms Affecting Individual Decisions

Source: Ashfaq, 2020.

Taxonomy of Decision-Making Criteria

Source: Wang & Ruhe, 2007.
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