2 - 2 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Operations Management Framework Insert New Resource/Profit Model

2 - 3 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. C H A P T E R 2 Profitability L E A R N I N G O B J E C T I V E S ▬Understand the concepts of value and profitability. ▬Understand and describe the effects operations management has on profitability measures. ▬Describe Economic Value Added (EVA). ▬Calculate the average level of inventory from a delivery pattern. ▬Understand productivity measures for resources. ▬Calculate utilization and efficiency. ▬Explain the importance of customer relationships. ▬Distinguish between local and global productivity measures. ▬Identify conflicts between productivity measures. ▬Describe how to improve productivity measures. ▬Set up and complete a decision tree analysis. ▬Describe the balanced scorecard approach.

2 - 4 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Financial Reality Businesses Face What do investors give us to start and run a business? -Money. What is their goal in giving us this money? -To get even more money back. Why give it to us instead of to someone else? -Because they think we can make them more money (greater return) than anyone else can. What do we do with the money that investors give us? -Invest in the resources (inventory, workforce, facilities, etc.) used to run our business. Definition of Operations Management  “The management of resources used to create saleable products and services”

2 - 5 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Link Between Value and Investment Results Operations provides the means to accomplish financial goals. Financial return must be good enough, given other alternatives. Uncertainty comes from not knowing, in advance, how customers will value outputs (NPV).

2 - 6 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost/Benefit Decisions Need to consider competitor actions. Exhibit 2.1 Realistic Cost/ Benefit Decisions Insert Exhibit 2.1

2 - 7 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Evaluating Progress Toward “The Goal” Net income: Net Sales – Cost of Goods sold – Depreciation – Interest - Taxes Challenge of Net Income  “My business made $50,000 last year” How did I do??? Consider the amount invested to generate the profit: If I used $10,000 If I used $1,000,000 If I used $10,000,000 Definition of Productivity  “The ratio of the outputs generated by the business to the inputs it used”

2 - 8 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. General Measures of Resource Productivity Profit Margin -Income / SalesIncome / Sales -Profit generated per dollar of sales. -Low costs  efficient use of operations resources in processes -High sales  high levels of value created by those processes

2 - 9 McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. General Measures of Resource Productivity Return on Assets (ROA) -Net Income / Total AssetsTotal Assets -Profit per dollar of assets -Efficient use of resources reduces asset needs -Relevant because operations managers control so many valuable assets Return on Equity (ROE) -Net Income / Total EquityTotal Equity -Productivity of stockholder investment -Less directly applicable to operations managers because ROA measures the assets themselves But ultimately how the company is judged by investors

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Value Added Economic Value Added (EVA) -Operating profit minus cost of capital -Not a ratio, but an absolute measure of the value created Book Example: You use $3,000 to start your business. “Cost of Capital” is 8% $3,000 * 8% = $240 $240 is the “opportunity cost” of the resources you used. Profit > $240 means you created “economic value” Profit < $240 means you destroyed “economic value” EVA is increased by reducing cost or by selecting high return investments for the firm.

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profitability from Operations Resources Resource categories: -Inventory -Workforce -Capacity -Facilities -Customer relationships Productivity measures for resources are often like local profitability measures.

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Inventory Products and components of products sold Average inventory level is basis for productivity measurement. Inventory turnover is most common productivity measure. Exhibit 2.2 Daily orders vs Monthly Orders to Meet 100 unit/Month Demand

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Inventory Inventory turnover is most common productivity measure Inventory Turnover = Net Sales /Average InventoryNet SalesAverage Inventory Average inventory level is basis for productivity measurement Beginning Inv. + Ending Inv. 2

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Inventory Example 2.1 Deliveries of 800 cases weekly (assume all are consumed evenly during a five-day week) Cases are valued at $265 Financial consequences of inventory turnover -“Turning Over” once per week vs. five times per week. Average investment in inventory WeeklyDailyDifference $106,000$21,200$84,800 What is average level of inventory? What is average level of inventory if change to daily delivery?

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capacity: Equipment Capability to produce output in a given amount of time Utilization: Comparison of time spent actually working against theoretical time available to work Actual running time/time available

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Capacity: Equipment Efficiency -Comparison of what actually happened against what “should have” happened -Actual output/ Standard output Standard = 5400/hour

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Facilities Buildings used to house all aspects of a business. Expensive, long-term investments. Output per square foot of facilities is common productivity measure.

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Workforce Workforce = Employees Productivity pressure increases as opportunities to push “offshore” increase Software development Customer service Tax preparation Financial analysis Relevant measures depend on firm strategy Technology improves ability to track workforce efficiency Example 2.4 Exhibit 2.5: Monthly Performance Data for Sales Force Exhibit 2.6: Possible Productivity Measures for Sales Force

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Local vs. Global Optima – Productivity Tradeoffs It is not always possible to maximize productivity everywhere -Tradeoffs are required. Example: Inventory vs. Service Levels -Service Level  Percent of demand satisfied from stock Inv. Svc. Level ∞

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Measurement Improvement Increase output (numerator), decrease input (denominator), or both. For profitability, increase net income or decrease costs (or assets) or do both.

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Decision Tree Analysis Useful technique for organizing some decisions by identifying expected revenues associated with alternatives. -Provide a very structured framework for a decision, so that all alternative can be understood -Enable the decision maker to quantify uncertainty -Allow the decision maker to mix facts and predictions -Provide the best outcome, given the available information

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Decision Tree Analysis Decision Tree for a New Product Design Decision Insert Exhibit 2.7

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Decision Tree Analysis Example 2.5 Insert Exhibit 2.8

McGraw-Hill/Irwin Operations Now, 2/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Balanced Scorecard Measuring performance beyond financial measures. -Financial objectives -Customer outcomes -Internal business processes -Learning and growth Insert Exhibit 2.9